Policy

Executive Summary Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week. Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007. Higher volatility will continue to buoy the Swiss franc in the short run. Structural appreciation in the franc is also likely over the coming decades (Feature Chart).  Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks. Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade. BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks. Feature Chart 1The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains. Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition. To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor. An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish. Switzerland Versus The World Global economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy: Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland A Productivity Profile For Switzerland A Productivity Profile For Switzerland Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization.  Chart 7Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas. Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy. The SNB, The SARON Curve, And The Swiss Franc If the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency. Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Less Intervention By The SNB Less Intervention By The SNB Chart 9The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher Chart 10EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Chart 12Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant. The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP Chart 14BA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve. What About Swiss Equities? Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark. This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Swiss Stocks Are Expensive Swiss Stocks Are Expensive Chart 17A Lost Tailwind A Lost Tailwind A Lost Tailwind In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer. Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Chart 19Swiss Stocks Are About Quality Swiss Stocks Are About Quality Swiss Stocks Are About Quality These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Chart 21The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector.  Investment Conclusions Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week. Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1). Higher volatility will continue to buoy the Swiss franc in the short run. Structural appreciation in the franc is also likely over the coming decades. Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks. Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade. BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary Chief European Strategist Mathieu@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Forecast Summary

Dear Client, Next Friday we will publish a Special Report on Gold in conjunction with our colleagues in BCA Research’s Foreign Exchange and Global Investment strategy groups.  We will return to our regular schedule of publishing on Thursdays the following week, with our June 30 ESG report.  Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade The World Bank’s somewhat sanguine expectation re stagflation risks for 2023 and beyond misreads continuing pressure on commodity markets due to low capex, and disincentives to invest. If central banks are successful in cooling consumer spending via a policy-induced recession, pressure on spare capacity in oil-producing and refining markets will lessen slightly. However, higher interest rates will increase capex costs. Weaker demand from a recession will not batter crude oil prices: core-OPEC 2.0 – KSA and the UAE – and US shale producers will maintain their production-management strategies, keeping markets relatively balanced. Our forecast for 2H22 and 2023 Brent is $115/bbl and $117/bbl on average, down ~ $6 and $5/bbl from last month’s forecast. WTI will trade $3/bbl lower. Europe will enter a recession earlier than other DMs, with natural-gas shipments to the EU from the US and Russia set to decline precipitously. This will tighten food and metals markets, and keep inflation expectations elevated. Bottom Line: Low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will offset lower demand, and continue to support crude and product prices. The odds of prices exceeding $140/bbl remain high. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). Separately, we were stopped out of our XOP, XME and PICK ETFs, with gains of 19%, 7.2% and 7.6% respectively. We will look for opportunities to re-instate them. Feature Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy While the World Bank sharply downgraded its global growth expectations for this year and next, it nonetheless maintains a somewhat sanguine view of the risk of stagflation going forward.1 The Bank notes current market conditions closely resemble those of the last bout of prolonged stagflation in the 1970s – characterized by flat-to-lower economic growth and high inflation – but differs in important ways that reduce the likelihood of a recurrence.2 In particular, the Bank cites research indicating the proximate causes of the 1970s stagflation have mostly been addressed, and how central banks are better equipped to avoid the mistakes that produced it: Thus far, markets expect that inflation in the near future will decline, albeit remaining elevated, as global growth cools, monetary policy gets tighter, fiscal support is withdrawn, energy and food prices level off, and supply bottlenecks ease. Moreover, most commentators argue that monetary policy has the tools to return inflation to target rates over time (pp. 53-4). We disagree with this assessment, and expect stagflation risks to remain elevated. This is driven by our high-conviction view that weak capex – and, importantly, continued disincentives to invest in hydrocarbon production and refining – will keep industrial-commodity markets tight well into this decade. Base metals producers also have been parsimonious in capex allocations. The Russia-Ukraine war brought forward the capex reckoning for commodity markets and inflation by highlighting the EU’s near-total dependence on Russian oil and natural gas imports, and the risks on outsourced manufacturing and refining away from domestic markets.3 Addressing long-term policy errors and re-forging global supply chains will be expensive, and will require decades of capex investment to overcome the lack of capacity needed to meet higher demand for coal, oil and natgas. This will delay the global energy-transition to a zero- or low-carbon economy and – because exploration, production, refining and distribution of hydrocarbon-based fuels remains constrained – will keep energy markets, particularly oil, tight. As a result, these markets will be predisposed to frequent price spikes, which will lift the average cost of crude oil and refined products over the foreseeable future. Downgrading Oil Demand Again We are once again downgrading our demand expectation for this year and next, on the back of the macro forces outlined in the World Bank’s June forecast: 1) Tightening monetary policy globally, led by the Fed; 2) Higher inflation, which has been exacerbated by the Russia-Ukraine war; and 3) Supply dislocations in energy and grain markets. Global GDP growth this year is expected to be close to half that of 2021 – 2.9% in real terms vs 5.7% – and was revised sharply lower vs the Bank’s January forecast of 4% growth. On the heels of the Bank’s lower growth expectation, we lowered our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast (Chart 1). For next year, we expect oil demand to grow 1.8mm b/d. Of particular interest, China’s growth in the first five months of this year was negative – actual demand from Jan-May22 averaged 15.2mm b/d vs 15.4mm b/d last year. This reflects the demand destruction caused by the lockdowns arising from China’s COVID-19 zero-tolerance policy, and is the first time since 2009 y/y growth has fallen (Chart 2). Chart 1Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Chart 2Oil Demand Destruction In China Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices OPEC 2.0 Will Adjust Output We expect core-OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the UAE – to continue to calibrate its supply to match the ebb and flow of demand. As a result we expect production declines among “the other guys” – i.e., member states that cannot increase supply or maintain current output – to not be fully compensated by the core producers if they see actual demand falling sharply in 2H22 and next year (Chart 3). As the supplier of the last resort, crude oil production from core-OPEC 2.0 tracks demand. This is the cohort of suppliers within OPEC 2.0 which has sufficient spare capacity to bring supply online and, importantly, is able to maintain higher levels of production in order to meaningfully influence oil markets. Chart 3Core-OPEC 2.0 Might Be Slower Offseting Declines Among "The Other Guys" Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices All else equal, in 2023 KSA and UAE – the two core-OPEC 2.0 nations with most spare capacity within OPEC 2.0 – will need to collectively raise supply by ~ 2mm b/d relative to average oil production in 2021 to ensure inventories do not draw sharply. OPEC 2.0 has been unable to stick to the 400 kb/d monthly crude oil production increases agreed in its July 2021 meeting, as declining investment and weak governance have plagued output from member states. Most recently, Libya has closed nearly all oil fields over the course of this month and last, taking nearly 1.1 mmb/d of oil supply off the market. The difference between the actual and agreed OPEC 2.0 output increases accumulated to ~ 2.0mm b/d as of May 2022. We continue to expect Russia to be firmly in the camp of the “other guys,” with production falling 1.6mm b/d this year and 2mm b/d in 2023 (vs 2021 levels). The production lost due to not being able to fully offset lost sales to the EU following its invasion of Ukraine could approach 3mm b/d next year (vs 2021 levels), depending on how successful Russia is in finding new customers. We also expect the US shale-oil producers to continue to maintain their capital discipline, and not ramp production in response to higher prices (Chart 4). This will be critical for maintaining access to capital markets, particularly if oil demand weakens in response to a global GDP decline. Chart 4US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline Markets Will Remain Balanced Our supply-demand assessments leave oil markets relatively balanced with slightly lower prices resulting from lower demand (Chart 5). Oil inventories likely rise somewhat before resuming their downward trajectory as supply and demand adjust to lower growth prospects (Chart 6). Chart 5Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Chart 6Oil Inventories Will Draw Oil Inventories Will Draw Oil Inventories Will Draw Importantly, OPEC 2.0’s core producers might welcome a slight rebuilding of inventories, given the relatively low levels of spare capacity available to meet unexpected supply outages or product shortages, say, for a hurricane in the US Gulf (Chart 7). This becomes particularly acute next year, when, as mentioned above, we expect core-OPEC 2.0 will have to increase their output by 2mm b/d vs 2021 levels to balance markets. Given the dynamics of our supply-demand modeling described above, our price forecasts for 2H22 and 2023 are little changed from last month’s estimates (Chart 8). We expect 2H22 Brent prices to average $115/bbl vs $121.30/bbl. This leaves the 2022 average at $110/bbl vs. $113/bbl estimate last month. For 2023, we expect Brent to average $117/bbl vs our earlier estimate of $122/bbl. Chart 7OPEC Spare Capacity Likely Will Tighten Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 8Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade These price forecasts and balances are our base case (Table 1). We do not estimate the risk premium the market is likely to impound in prices to cover the high level of uncertainty around oil, natgas and electricity prices in global markets. A sudden cut-off of Russian oil supplies to the EU could easily spike Brent prices above $140/bbl, e.g. Indeed, we continue to accord this outcome a non-trivial probability. Likewise, the Atlantic Hurricane Season starts this month, with the US Climate Prediction Center calling for a higher-than-average number of hurricanes for 2022, given above-average Atlantic temperatures and an ongoing La Niña event.4 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Investment Implications The World Bank’s weaker GDP growth forecast leads us to expect slightly lower demand in 2H22 and 2023. However, low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will keep Brent prices close to $115-117/bbl in 2H22 and 2023, which, as our base case, is not far removed from last month’s forecasts. The odds of prices exceeding $140/bbl remain high, reflecting the razor-thin back-up supply margins available to the crude and product markets globally. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). We will look for opportuities to re-establish our XOP, XME and PICK ETF positions, which were stopped out with gains of 19%, 7.2% and 7.6%, respectively, over the course of this past week.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas prices are surging on the back of a loss of exportable LNG volumes from the US Gulf, and on press reports Russia will cut exports to Germany on the Nord Stream (NS) 1 pipeline by ~ 40%. The US supply loss arises from an explosion to at a Freeport LNG terminal in Texas, which accounts for more than 15% of US LNG exports and takes ~ 5 bcm of gas out of the export market. Repairs reportedly will take three months. The loss of natgas supplies on NS1 is being blamed by Russia on an inability to move parts needed to repair the line from Canada due to sanctions imposed following its invasion of Ukraine in February. European gas prices – at the Title Transfer Facility (TTF) in the Netherlands and the National Balancing Point in the UK – surged on the back of this news, and were up 44.28% and 10.15% respectively from Monday’s close to Wednesday trading this week (Chart 9). US gas futures were down 13.81% this week, reflecting a back-up of pipeline natgas that will not make it to the LNG pool until repairs at Freeport are done. Base Metals: Bullish BCA’s China Investment Strategy reported a possible inflection point in household borrowing after nearly two decades of growth (Chart 10). Pandemic-induced lockdowns and declining home prices reduced households’ propensity to take on new debt. Household deleveraging could reduce demand for durables spending and real estate investment, driving down industrial metals’ demand. If deleveraging and lower demand becomes structural, China’s relevance in global metal demand likely will decline. Precious Metals: Bullish On the back of last Friday’s hot inflation data, the Federal Reserve announced a 75 bps rate hike following the June Federal Open Market Committee (FOMC) meeting. This likely will reduce the Fed’s credibility after Powell hinted at a 50 bps rate hike for the June meeting in last month’s meeting. The higher rate hike puts the Fed on a more hawkish path, risking the soft landing it has been aiming for. A US recession will be supportive for gold prices.   Chart 9 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 10 Chinese Households Leverage Ratio Fell The Most Since The GFC Chinese Households Leverage Ratio Fell The Most Since The GFC     Footnotes 1     Please see Stagflation Risk Rises Amid Sharp Slowdown in Growth, which includes a link to the Bank’s full June 2022 update. 2     Please see discussion beginning on p. 51 of the Banks June report, “Special Focus 1, Global Stagflation.”  This focus provides a well-researched history of the evolution of inflation. 3    Please see One Hot Mess: EU Energy Policy and Commodities' Watershed Moment, which we published 26 May and on March 10, 2022, for discussion of the EU’s energy dependence on Russia. See also La Niña And The Energy Transition, published on September 30, 2021, for a discussion of refining-concentration risks – particularly for base metals refining, where roughly half of global capacity is concentrated in China. 4    Please see NOAA predicts above-normal 2022 Atlantic Hurricane Season published on May 24, 2022.   Investment Views and Themes Recommendations  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG S&P OIL & GAS EXPLORATION & PRODUCTION (XOP) ETF TRADE ON JUNE 13, 2022 WITH A RETURN OF 19%. WE WERE STOPPED OUT OF OUR LONG MSCI GLOBAL METALS & MINING PRODUCERS (PICK) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.56%. WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS AND MINING (XME) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.17%. Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report  Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Worrying Signs For Global Growth Worrying Signs For Global Growth ​​​​​​ Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here ​​​​​​ Chart 4Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here ​​​​​​ For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed ​​​​​​ Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' ​​​​​​ Chart 7Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts ​​​​​​ Chart 11Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? ​​​​​​ The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? ​​​​​​ Chart 13Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a)     reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b)     the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Volcker's Ghost Volcker's Ghost The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Volcker's Ghost Volcker's Ghost Tactical Overlay Trades

In lieu of next week’s report, I will host a Webcast on Monday, June 27 to explain the recent market turmoil and how to navigate it through the second half of 2022. Please mark the date, and I do hope you can join. Executive Summary The recent sharp underperformance of the HR and employment services sector presages an imminent rise in the US unemployment rate. Central banks have decided that a recession is a price worth paying to slay inflation. In this sense, the current setup rhymes with 1981-82, when the Paul Volcker Fed made the same decision. The correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Go long the December 2023 Eurodollar (or SOFR) futures contract. While interest rates are likely to overshoot in the near term, the pain that they will unleash will require a commensurate undershoot in 2023-24. Cryptocurrencies will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal trading watchlist: Czechia versus Poland, German telecoms, Japanese telecoms, and US utilities. The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Bottom Line: An imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Feature Financial markets have collapsed in 2022, but jobs markets have held firm, at least so far. For example, the US economy has added an average of 500 thousand jobs per month1, and the unemployment rate, at 3.6 percent, remains close to a historic low. But now, an excellent real-time indicator warns that cracks are appearing in the US jobs market. The excellent real-time indicator of the jobs market is the performance of the human resources (HR) and employment services sector. After all, with its role to place and support workers in their jobs, what better pulse for the jobs market could there be than HR? What better pulse for the jobs market could there be than the human resources sector? Worryingly, the recent sharp underperformance of the HR and employment services sector warns that the pulse of the jobs market is weakening, and that consumers will soon be reporting that jobs are becoming less ‘plentiful’ (Chart I-1). In turn, consumers reporting that jobs are becoming less plentiful presages an imminent rise in the unemployment rate (Chart I-2). Chart I-1The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Chart I-2Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment 2 Percent Inflation Will Require A Sharp Rise In Unemployment The health of the jobs market has a huge bearing on the big issue du jour – inflation. Specifically, in the US, the unemployment rate (inversely) drives the inflation of rent and owners’ equivalent rent (OER) because, to put it simply, you need a steady job to pay the rent. Furthermore, with rent and OER comprising almost half of the core CPI basket, the ‘rent of shelter’ component is by far the most important long-term driver of core inflation.2 Shelter inflation at 3.5 percent equates to core inflation at 2 percent. For the past couple of decades, full employment has been consistent with rent of shelter inflation running at 3.5 percent, which itself has been consistent with core inflation running at 2 percent (Chart I-3). Hence, the Fed could achieve the Holy Grail of full employment combined with inflation running close to 2 percent. Chart I-3Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... But here’s the Fed’s problem. In recent months, there has been a major disconnect between the jobs market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-4). Chart I-4...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent This means that to bring rent of shelter and core inflation back to 3.5 percent and 2 percent respectively, the unemployment rate will have to rise by 2 percent. In other words, to achieve its inflation goal, the Fed will have to sacrifice its full employment goal. Put more bluntly, if the Fed wants to reach 2 percent inflation quickly, it will have to take the economy into recession. The cracks appearing in the HR and employment services sector suggest this process is already underway. There Are Two ‘Neutral Rates Of Interest’. Which One Will Central Banks Choose? The ‘neutral rate of interest rate’, also known as the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*, is the short-term interest rate that is consistent with the economy at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. But here’s the subtle point that many people miss. The neutral rate is defined in terms of stable inflation without stating what that stable rate of inflation is. Therein lies the Fed’s problem. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. Now let’s add a third goal of ‘financial stability’, and the message from the ongoing crash in stock, bond, and credit markets is crystal clear. The near-term neutral rate that is consistent with inflation at 2 percent is also much higher than the near-term neutral rate that is consistent with financial stability (Chart I-5 and Chart I-6). Chart I-5Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up… So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far Chart I-6When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices This leaves the Fed, and other central banks, with a major dilemma. Which neutral rate goal to pursue – full employment and financial stability, or inflation at 2 percent? In the near term, the answer seems to be inflation at 2 percent. This is because the lifeblood of central banks is their credibility. With their credibility as inflation fighters in tatters, this may be the last chance to repair it before it is shredded forever. Taking this long-term existential view, central banks have decided that a recession is a price worth paying to slay inflation and repair their credibility. In this important sense, the current setup rhymes with 1981-82 when the Paul Volcker Fed made the same decision. Therefore, the correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82, which we detailed in More On 2022-2023 = 1981-82, And The Danger Ahead. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Eventually, the central banks’ major dilemma between inflation and growth will resolve itself. The triple whammy of a recession in asset prices, profits, and jobs will unleash a strong disinflationary – or even outright deflationary – impulse, causing inflation to collapse to well below 2 percent in 2023-24. And suddenly, there will be no conflict between the neutral rate that is consistent with full employment and financial stability, and that which is consistent with inflation at 2 percent. Both neutral rates will be ultra-low.  Hence, while interest rates are likely to overshoot in the near term, the pain that they will cause will require a commensurate undershoot in 2023-24. On this basis, go long the December 2023 Eurodollar (or SOFR) futures contract (Chart I-7). Chart I-7Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Cryptos Will Bottom When The Nasdaq Bottoms The turmoil across financial markets has naturally engulfed cryptocurrencies, and this has generated the usual Schadenfreude among the crypto-doubters. But in the short-term, cryptocurrencies just behave like leveraged tech stocks, meaning that as the Nasdaq has fallen sharply, cryptos have fallen even more sharply (Chart I-8). Chart I-8In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq Most cryptocurrencies are just the tokens that secure their underlying blockchains, so their long-term value hinges on whether their underlying blockchain technologies will succeed in displacing the current ‘trusted third party’ model of intermediation. In this sense, blockchain tokens are the ultimate long-duration growth stocks, whose present values are highly sensitive to the performance of the blockchain technology sector, which in turn is highly sensitive to the long-duration bond yield. Hence, while the bear markets in bonds, Nasdaq, and cryptos appear to be separate stories, they are just one massive correlated trade! Given that nothing fundamental has changed in the outlook for blockchains, long-term investors should treat this crypto crash, just like all the previous crypto crashes, as a buying opportunity. Cryptos will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal Trading Watchlist Amazingly, while most markets have crashed, the financial-heavy Czech stock market is up by 20 percent this year, in sharp contrast to its neighbouring Polish stock market which is down by 25 percent. In fact, over the last year, Czechia has outperformed Poland by 100 percent. From both a fundamental and technical perspective, this outperformance is now vulnerable to reversal (Chart I-9). Accordingly, a recommended trade is to underweight Czechia versus Poland, setting the profit target and stop-loss at 15 percent. Elsewhere, the outperformances of German telecoms, Japanese telecoms, and US utilities are all at, or close, to points of fractal fragilities which make them vulnerable to reversals. As such, these have entered out watchlist. The full watchlist of 27 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Chart I-9Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Fractal Trading Watchlist: New Additions German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 1BRL/NZD At A Resistance Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 2Homebuilders Versus Healthcare Services Has Turned Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 3CNY/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 4US REITS Are Oversold Versus Utilities Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 5CAD/SEK Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 6Financials Versus Industrials Has Reversed Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 7The Outperformance Of Resources Versus Biotech Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 13Food And Beverage Outperformance Is Exhausted Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 14German Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 18A Potential Switching Point From Tobacco Into Cannabis Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 19Biotech Is A Major Buy Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 20Norway's Outperformance Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 21Cotton Versus Platinum Is At Risk Of Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 22Switzerland's Outperformance Vs. Germany Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 23USD/EUR Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 25A Potential New Entry Point Into Petcare Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 26GBP/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 27US Utilities Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  Based on the nonfarm payrolls. 2 Rent of shelter also includes lodging away from home, but the two dominant components are rent of primary residence and owners’ equivalent rent of residences. Fractal Trading System Fractal Trades Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Bonds sold off dramatically in response to Friday’s surprisingly high CPI number. Markets are now pricing in a much more rapid increase in the fed funds rate, with some probability of a 75 bps move this week. We think a 75 bps rate hike at any one FOMC meeting is possible, but unlikely. Rather, we see the Fed continuing to hike by 50 bps per meeting until inflation shows signs of rolling over. The guts of the CPI report were less concerning than the headline figure, and it is still more likely than not that core CPI will trend down during the next 6-12 months. Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Bottom Line: Investors should maintain benchmark portfolio duration as it is unlikely that the Fed will deliver a more aggressive pace of tightening than what is already in the price. Investors should also underweight TIPS versus nominal Treasuries as a play on a hawkish Fed and moderating consumer prices. The May CPI Print Ensures An Ultra-Hawkish Fed  The “peak inflation” narrative took a blow last week when core CPI came in well above expectations for May. While the annual rate ticked down due to base effects, monthly core CPI saw its largest increase since last June (Chart 1). The bond market reacted to the news with an abrupt bear-flattening of the Treasury curve. The 2-year Treasury yield rose above 3% for this first time this cycle and the 10-year yield hit 3.27% on Monday morning (Chart 2). The 2-year/10-year Treasury slope flattened sharply, and it now sits at just 5 bps (Chart 2, bottom panel). Chart 1Strong Inflation In May Strong Inflation In May Strong Inflation In May Chart 2A Big Bear-Flattening A Big Bear-Flattening A Big Bear-Flattening With core inflation not showing any signs of slowing, the Fed will maintain its ultra-hawkish tone when it meets this week. While there’s an outside chance that the Fed will try to shock markets with a 75 basis point rate hike, we think it’s more likely that it will deliver the 50 basis point rate increase that Jay Powell teased at the last meeting while signaling that further 50 basis point rate increases are likely at both the July and September FOMC meetings. While inflation is not falling as quickly as either we or the Fed had previously anticipated, a look through the guts of the CPI report still leads to the conclusion that core inflation is more likely to fall than rise in the second half of this year. The main reason for this conclusion is that we aren’t seeing much evidence that inflation is transitioning from the goods sectors that were most heavily impacted by the pandemic to non-impacted service sectors. Rather, the main issue is that core goods inflation remains stubbornly high. Chart 3 shows the breakdown of core CPI into its three main components: (i) goods, (ii) shelter, and (iii) services excluding shelter. We can see that after only one month of decline in March, core goods prices accelerated to +0.69% in May, the largest monthly increase since January. The bulk of the May increase in goods inflation came from new and used cars (Chart 4), a sector where we should see price declines in the second half of this year now that motor vehicle production is ramping back up. Chart 3Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Chart 4Contribution To Month-Over-Month Core Goods CPI No Relief From High Inflation No Relief From High Inflation Turning to services, we observe a deceleration in May relative to April (Chart 3), and also notice that airfares continue to account for an outsized chunk of services inflation (Chart 5). Excluding airfares, core services inflation was just 0.36% in May. Chart 5Contribution To Month-Over-Month Core Services CPI (Excluding Shelter) No Relief From High Inflation No Relief From High Inflation Finally, we see that shelter CPI increased by 0.61% in May, up from 0.51% in April. Shelter is the most cyclical component of CPI and as such it tends to closely track the unemployment rate. The unemployment rate has been flat at 3.6% for three consecutive months and it is more likely to rise than fall going forward. Therefore, we don’t anticipate further acceleration in shelter inflation during the next 6-12 months. Monetary Policy & Investment Implications At the last FOMC meeting, Chair Powell went out of his way to guide market expectations toward 50 basis point rate hikes at both the June and July FOMC meetings. After which, Powell hinted that the Fed would re-assess the economic outlook and would likely continue to lift rates at each meeting in increments of either 50 bps or 25 bps, depending on the outlook for inflation. Powell clearly wanted to set a firm marker down for the pace of rate hikes so that Fed policy doesn’t “add uncertainty to what is already an extraordinarily uncertain time.”1 For this reason, we don’t expect the Fed to lift rates by more than 50 basis points at any single meeting. However, May’s elevated CPI number will likely cause Powell to tease an additional 50 basis point rate hike for September. After September, if inflation finally does soften, the Fed will likely downshift to a pace of 25 bps per meeting. Taking a look at market expectations, we see that fed funds futures are fully priced for a 50 bps rate hike this week and are even discounting a small chance of a 75 bps hike (Chart 6A). Meanwhile, the market is almost fully priced for 125 bps of tightening by the end of the July FOMC meeting, i.e., one 50 bps hike and one 75 bps hike (Chart 6B). Looking out to the September FOMC meeting, we see the market priced for 180 bps of cumulative tightening (Chart 6C). This is consistent with a little more than two 50 basis point rate increases and one 75 basis point rate increase at the next three FOMC meetings. Chart 6AJune FOMC Expectations June FOMC Expectations June FOMC Expectations Chart 6BJuly FOMC Expectations July FOMC Expectations July FOMC Expectations Chart 6CSeptember FOMC Expectations September FOMC Expectations September FOMC Expectations   Looking even further out, we find the market priced for the fed funds rate to hit 3.28% by the end of the year and to peak at 3.88% in June 2023 (Chart 7).2 Chart 7Rate Expectations Rate Expectations Rate Expectations Our own expectation is that the Fed will deliver three or four more 50 basis point rate increases this year, followed by a string of 25 basis point hikes. This will bring the fed funds rate up to a range of 2.75% to 3.25% by the end of 2022, slightly below what is currently priced in the yield curve. As for portfolio duration, we recommend keeping it close to benchmark for the time being. Many indicators – such as economic data surprises, the CRB Raw Industrials/Gold ratio and the relative performance of cyclical versus defensive equities – suggest that bond yields are too high.3 That said, with inflation surprising to the upside and the Fed in a hawkish frame of mind, it is not wise to bet too aggressively on bonds. We also reiterate our view that investors should underweight TIPS versus nominal Treasuries. It’s notable that long-maturity TIPS yields moved higher and that the 10-year TIPS breakeven inflation rate was close to unchanged on Friday, despite the surprisingly high CPI number. This tells us that the market is not pricing-in a scenario where the Fed is losing control of long-dated inflation expectations. Rather, the market is discounting a scenario where the Fed does what is necessary to bring inflation back down. Softish Or Volckerish? Chart 8The Everything Selloff The Everything Selloff The Everything Selloff Of course, the big question for financial markets is whether the Fed will be forced to cause a recession to bring inflation down, or whether it will achieve what Jay Powell called a “softish” landing.4 The Fed’s hoped for “softish landing” scenario is one where inflation recedes naturally as we gain further distance from the pandemic. This outcome would limit the speed at which the Fed is forced to lift rates and push back the expected start date of the next recession. Unfortunately, trends in financial markets suggest that investors are putting less faith in the softish landing scenario. Our BCA Counterpoint Strategy recently observed that stocks, bonds, industrial metals and gold have recently all sold off in concert (Chart 8).5 It is rare for all four of these assets to sell off at the same time, but they did in 1981 when Paul Volcker was in the midst of dramatically lifting rates to conquer inflation. If we truly are on the cusp of the Fed tightening the economy into recession, then it makes sense for all four of those assets to perform poorly. Bond yields rise because the Fed is hiking much more quickly than was previously anticipated. Stocks and industrial metals sell off because of an increase in recession fears. Finally, gold sells off because of rising expectations that the Fed will do what it takes to bring inflation back down. And it’s not just financial markets that are warning that the Fed will be forced to repeat Chairman Volcker’s aggressive tightening. Two influential macroeconomists, Larry Summers and Olivier Blanchard, recently put out papers suggesting that the Fed needs another Volcker moment.6 Summers’ paper (with two co-authors) notes that changes in how the Bureau of Labor Statistics calculates shelter inflation make historical comparisons using CPI problematic. The authors estimate what core CPI would look like prior to 1983 if the current methodology had been employed and find that year-over-year core CPI peaked at 9.9% in 1980 well below the originally published figure of 13.6% and much closer to today’s 6% (Chart 9). The implication is that inflation is already almost as out of control now as it was in the early-1980s, and it will take a similar amount of monetary policy tightening to conquer it. In his paper, Olivier Blanchard makes a similar point by noting that the gap between the real fed funds rate and 12-month core CPI is as wide today as it was in 1975. The implication is that the Fed must play a similar amount of catch-up to bring inflation back down. Chart 9Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 We think comparisons to the early-1980s are mistaken for three reasons. First, the Fed targets PCE inflation not CPI and PCE inflation does not suffer from the methodological inconsistencies that Summers et al identified. If we look at core PCE inflation, of which data only go to April, we see that 12-month core PCE inflation is currently 4.9% compared to a peak of 9.8% in 1980 (Chart 10). In other words, there is still a fair amount of distance between today’s PCE inflation and what was seen in the early 1980s. Chart 10The Fed Targets PCE Inflation The Fed Targets PCE Inflation The Fed Targets PCE Inflation Second, inflation was more broadly distributed in the 1970s/80s than it is today. At different points in the 1970s and early-1980s all three of the major components of core inflation – goods, shelter and services excluding shelter – were above 10% in year-over-year terms (Chart 11). Today, only core goods inflation has moved above 10% and year-over-year shelter and services ex. shelter inflation sit at 5.4% and 4.8%, respectively. Chart 11Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Finally, wages had been accelerating rapidly for a full decade before inflation peaked in 1980 and this led to the emergence of a wage/price spiral (Chart 12). Firms increased prices to compensate for rising labor costs and then employees demanded further wage gains to compensate for rising consumer prices. Today, the evidence of a wage/price spiral is far less convincing. Wage growth has just recently moved above 5%, and we have seen recent indications that it is already starting to moderate.7  Typically, it takes a prolonged period of rapid wage growth for long-dated inflation expectations to rise and for a wage/price spiral to take hold. At present, we have seen only a modest move up in long-dated inflation expectations (Chart 13) and, as noted above, market-based measures of long-dated inflation expectations barely budged in response to last Friday’s inflation report. Chart 12No Wage/Price Spiral Yet No Wage/Price Spiral Yet No Wage/Price Spiral Yet Chart 13Inflation Expectations Inflation Expectations Inflation Expectations The bottom line is that inflation is still more likely to fall than rise during the next 6-12 months, and this will prevent the Fed from tightening more quickly than what is already priced in the yield curve. That said, while inflation is likely to dip, it will remain above the Fed’s 2% target and a recession will eventually be required to restore price stability. That recession, however, may not occur until late-2023 and it will likely be preceded by far less aggressive monetary tightening than what Paul Volcker delivered in the early-1980s.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  For more details on the Fed’s forward guidance please see US Bond Strategy Weekly Report, “On A Dovish Hike And A 3% Bond Yield”, dated May 10, 2022. 2 These numbers are as of last Friday’s close. 3 For details on these indicators please see US Bond Strategy Webcast, “Will The Fed Get Its Soft Landing?”, dated May 17, 2022. 4 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.pdf 5 Please see BCA Counterpoint Weekly Report, “Markets Echo 1981, When Stagflation Morphed Into Recession”, dated May 19, 2022. 6 Please see Bolhius, Cramer, Summers, “Comparing Past and Present Inflation”, June 2022. https://www.nber.org/papers/w30116. And also Blanchard, “Why I worry about inflation, interest rates, and unemployment”, March 2022. https://www.piie.com/blogs/realtime-economic-issues-watch/why-i-worry-about-inflation-interest-rates-and-unemployment.  7 Please see US Bond Strategy Portfolio Allocation Summary, “The Case For A Soft Landing”, dated June 7, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary ECB & Inflation: Whatever It Takes? Pricey Industrials Pricey Industrials Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials.     Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB Don’t Fight The ECB Don’t Fight The ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The Labor Market Must Cool The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Dwindling Commodity Impulse Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse The BTP-EUR/USD Valse The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Pricey Industrials Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior Pricing Power Is The Savior Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox The Commodity Paradox The Commodity Paradox Chart 11The Inventory Buildup Threat The Inventory Buildup Threat The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Where the US Goes, So Does Europe Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade A Relative Value Trade A Relative Value Trade Chart 15An Unusual Disconnect An Unusual Disconnect An Unusual Disconnect Chart 16German Industrials And Growth Expectations German Industrials And Growth Expectations German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Commodities: From Friends To Foes Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe Energy: From Friend To Foe Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Stagflation Hurts Germany More Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Relative Growth Matters Relative Growth Matters Chart 22The China Factor The China Factor The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Hiring is slowing and layoffs have begun to rise, but today's robust net increases in non-farm payrolls are inconsistent with an approaching recession. The demise of the American consumer has been greatly exaggerated. Households have lots of savings to spend and the capacity to borrow against them if they choose. The extensive forward guidance that the Fed has been at pains to provide to markets may have fueled a sharp preemptive tightening in financial conditions that might prove premature if it reduces the Fed's need to cool the economy itself. None of the three components of our simple recession indicator (the slope of the yield curve, the year-over-year change in the Leading Economic Index and our assessment of monetary policy settings) is sounding the alarm, or even flashing yellow. No Recession Warning In This Series No Recession Warning In This Series No Recession Warning In This Series Bottom Line: Although gloom is increasingly pervasive among investors, we remain constructive on risk assets and the economy over the next twelve months, and reiterate our recommendation to overweight equities in a balanced portfolio. Feature Per the mosaic theory of security analysis, analysts, portfolio managers and independent investors piece together fragments of publicly available information to form a thesis about a company’s prospects. After appraising the company’s securities based on that thesis, the analyst/PM/investor determines whether they’re overvalued, undervalued or fairly valued and takes the appropriate action in his/her portfolio. All market participants are in a race to be among the first to see the outline of the complete picture as the opportunities to exploit mispricings are inversely related to the available share of relevant data. Security fair values become more apparent as more bits of colored glass begin to circulate and alpha-seeking investors have to move on to the next mostly incomplete puzzle to find an edge. Related Report  US Investment StrategyAll The Way To Ticker Symbols The same framework applies to macroeconomic analysis. It’s especially apt now, given the lack of a close precedent for the monetary and fiscal support policy makers lavished on the economy to protect it from COVID-19’s potential ravages and the way that data flows have refused to conform to a well-defined trend supported by a stable narrative theme. Macro data and news from individual companies are stuck in a one-step-forward, one-step-back pattern as embodied by stagnant stock indexes. The S&P 500 paced the same 100-point path between 4,075 and 4,175 for two full weeks before tumbling through the bottom of the range last Thursday and losing contact with it on Friday after the May CPI report showed that inflation remains stubbornly high (Chart 1). Chart 1Stocks See The Glass As Half-Empty Assembling The Mosaic Assembling The Mosaic The details of the May CPI report weren’t as bad as the headlines, though we were surprised and disappointed by its failure to confirm our view that inflation is peaking. From the full range of puzzle pieces we already have, however, we continue to think the picture for risk assets and the economy one year from now will be encouraging. We spent last week speaking and mingling at a conference and meeting with clients one-on-one last week, confirming that our sanguine view is decidedly in the minority as investors have become increasingly resigned to the idea that inflation cannot be brought down to a tolerable level without squeezing the economy. We think there is a middle way, at least over the next twelve months, as we highlight below by reviewing some of the largest and most important factors. Employment If a recession were imminent, we would expect to see hiring begin to sputter. Year-over-year payrolls growth has slowed, but it remains more than a standard deviation above the mean (Chart 2, top panel), at its highest level in 38 years. Annualized month-over-month growth is strong as well, if not as much of an outlier as year-over-year growth (Chart 2, bottom panel). Going forward, payrolls growth is poised to remain strong (Chart 3, top panel), as small businesses’ hiring intentions are very high (Chart 3, second panel), temporary employment is still elevated (Chart 3, third panel) and initial unemployment claims, while rising, are extremely low (Chart 3, bottom panel). Chart 2Payrolls Are Growing At A Nice Clip ... Payrolls Are Growing At A Nice Clip ... Payrolls Are Growing At A Nice Clip ... ​​​​​​ Chart 3... And Will Continue To Do So ... And Will Continue To Do So ... And Will Continue To Do So ​​​​​​ Consumption Chart 4Solid Footing Solid Footing Solid Footing We have stressed that households’ massive pandemic savings have provided them with ample ability to consume. They have worked down the debt they took on ahead of the financial crisis, restoring the household debt-to-GDP ratio to its 2002 level (Chart 4, second panel), which is much more lightly borne today than it was then, thanks to interest rates that remain extremely low despite their recent backup (Chart 4, bottom panel). It is an open question, subject to occasionally fierce debate within BCA, if households have the willingness to consume the mountain of savings they have amassed since COVID-19 reached the US. Our answer has been an unequivocal yes, and we have been working under the purposely conservative assumption that households will spend just half of their $2 trillion-plus stash. So far, the data are on our side: consumers have not lost their appetite for dining out, returning to restaurants at their pre-pandemic pace once the Omicron coast was clear (Chart 5, top panel). Travelers are returning to the skies, as well, undeterred by soaring airfares (Chart 5, bottom panel). Although passenger levels have not made it all the way back to their 2019 levels, nearly 60% more passengers have passed through TSA checkpoints so far this year than they did at this point in 2021, and credit card usage indicates that reduced business travel is responsible for the shortfall, as individuals have eagerly sought to cure their cabin fever (Chart 6). Chart 5Back To Restaurants, Bars ... Back To Restaurants, Bars ... Back To Restaurants, Bars ... ​​​​​​ Chart 6... And The Friendly Skies ... And The Friendly Skies ... And The Friendly Skies ​​​​​​ Private Investment/Credit Spreads Although consumption accounts for two-thirds of overall US output, or three-and-a-half times more than investment, the latter is slightly more likely to bring about a contraction in GDP because it is considerably more volatile.1 Nonresidential investment accounts for the lion’s share of private investment and BCA’s capex model projects that it will remain robust over the next two quarters (Chart 7). Residential investment will have to grapple with the housing slowdown imposed by the sudden and significant increase in mortgage rates, but we agree with our Bank Credit Analyst colleagues’ assessment that housing is unlikely to tank the economy.2 Homes remain undersupplied after several years of insufficient construction and the spread between the baseline 30-year fixed mortgage rate and the 10-year Treasury yield has become so stretched that it appears that the mortgage rate may have already reached its 2022 peak (Chart 8). Chart 7Capex Prospects Are Good ... Capex Prospects Are Good ... Capex Prospects Are Good ... Wider corporate bond spreads and intimations that banks are becoming less eager to lend could signal a further tightening of financial conditions. There have been three major spread-widening episodes in the high yield era (Chart 9, top panel) and none began until three preconditions had been met. Chart 8... And Mortgage Borrowers Are Due For A Break ... And Mortgage Borrowers Are Due For A Break ... And Mortgage Borrowers Are Due For A Break ​​​​​ The Fed had to have completed its rate hiking cycle (Chart 9, second panel), our proprietary Corporate Health Monitor (CHM) had to have crossed into deterioration (Chart 9, third panel) and the Fed’s quarterly Senior Loan Officer survey had to indicate that a majority of banks was imposing tighter credit standards on business borrowers (Chart 9, bottom panel). None of those conditions is in place yet, though banks' lending appetites may be shrinking and the first quarter was not great for corporate health. Chart 9Perhaps Forward Guidance Was TMI Perhaps Forward Guidance Was TMI Perhaps Forward Guidance Was TMI Broad Recession Probability Pulling back to 30,000 feet, none of the key recession prerequisites we constantly monitor is yet signaling any distress. The 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping (Chart 10). The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis (Chart 11), and the target fed funds rate is far below our estimate of the equilibrium fed funds rate (Chart 12). Each series has issued its own false signal – an above-equilibrium fed funds rate has been a necessary, but hardly sufficient, recession condition – but they have a perfect track record when considered together. Chart 10When The Yield Curve Inverts, ... When The Yield Curve Inverts, ... When The Yield Curve Inverts, ... Chart 11... Year-Over-Year LEI Contracts ... ... Year-Over-Year LEI Contracts ... ... Year-Over-Year LEI Contracts ... Chart 12... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows ... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows ... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows Investment Implications The May CPI report only strengthened the conviction of those holding bearish views and will at least temporarily fuel a barrage of gloomy headlines that might sway the uncommitted. It has reduced the marginal probability that the Fed will be able to thread the needle and meet its price stability mandate without taking direct aim at its full employment goals. We still expect that the Fed will be able to maintain its balancing act for another twelve months because we think inflation will begin to come down on its own once the fevers in new and used auto prices and airfares finally break. The more remote that prospect seems to investors, the more stock prices will fall and bond yields will rise if the bullish view, or something slightly less bearish than discounted, comes to pass. The University of Michigan’s consumer sentiment survey made an all-time low in the preliminary June data released Friday morning. We are less concerned about the headline number – Open Table reservations and busy TSA security lines suggest investors are better served by focusing on what consumers do than how they feel, and the Michigan gloom is contradicted by the Conference Board survey's modest optimism – than we are about the upward turn in consumers’ long-run inflation expectations. Respondents to the Michigan survey increased their median estimate for inflation in five to ten years to 3.3% from 3% over the previous four months (the estimate had been between 2.9 and 3.1% for ten months beginning last August). If workers’, businesses’, investors’ and consumers’ long-run inflation expectations become unmoored, an inflation mindset in which high prices beget still higher prices could threaten to take hold, forcing the Fed to channel its inner Paul Volcker, shattering our temporary thread-the-needle thesis. For now, the term structure of inflation expectations remains sharply inverted. That’s to say that TIPS breakevens, CPI swaps and survey respondents continue to expect that intermediate- and long-term inflation will slow considerably from its currently elevated levels. If they begin to lose faith that very high inflation readings are a temporary phenomenon, we will have to revisit our glass-half-full perspective. We are not irresolute, but like Lord Keynes, when the data change, we change our minds.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      The probability that investment could decline enough in any given quarter to zero out 2% growth in consumption and government spending is 23%, based on its historical distribution. The probability that consumption could wipe out 2% growth in investment and government spending is 17.6%. Government spending, which is one-fourth the size of consumption and considerably more stable than comparably sized investment, has just a 2.3% probability of negating trend growth in the other components. (All calculations disregard net exports.) 2     "Is The US Housing Market Signaling An Imminent Recession?" Bank Credit Analyst Special Report, June 2022.

Executive Summary Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Image Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure China: Less Stable, Less Secure China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 3BCyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 6China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe China Needs To Court Europe China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America China Stimulus Creates Opportunity For ... Latin America China Stimulus Creates Opportunity For ... Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Executive Summary Is Relative Inflation Peaking In The US? Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US The dollar has likely peaked in the near term. An unwinding of speculative bets, based on structurally higher inflation in the US, is the key driver (Feature Chart). Our theme of central bank convergence continues to play out. Rates in the euro area are headed higher. The next bet for higher rates is in Japan. The key for picking currency winners will be global growth barometers. The US dollar embeds a huge safety premium that will be eroded as we get more clarity on global growth and inflation. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 104.80 2022-05-13 2.22   Bottom Line: We are short the DXY index as of 104.8. We recommend sticking with this position. Feature The dollar very much remains well bid (Chart 1). But the macroeconomic environment that has helped the dollar is likely to reverse. As inflation in the US cools, especially relative to other DM economies, the policy divergence between the US and other economies will move in the opposite direction (Chart 2 and Chart 3).  Chart 1Long Dollar Positions Still Profitable Month In Review: Recession Risk Month In Review: Recession Risk Chart 2Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US Chart 3The Dollar And Interest Rates The Dollar And Interest Rates The Dollar And Interest Rates Last month, we posited that interest rate differentials played a key role in pushing the dollar higher but have not been the sole factor. The safe-haven premium in the DXY is around 8-10%. That premium will remain if growth concerns are at the forefront of investors’ minds but will evaporate otherwise. Over the last few weeks, we have had a few surprises from central banks, notably the ECB and the RBA. In this Month-In-Review, we go over our current currency thinking, and implications for portfolio strategy. US Dollar: Peak Hawkishness? Chart 4Is Inflation Peaking In The US Is Inflation Peaking In The US Is Inflation Peaking In The US The dollar DXY index is up 7.4% year to date. However, over the last month, there has been a big reversal in the dollar, down 1.5% month-to-date. As a momentum currency, technical forces are moving against the greenback. Incoming data for the US remains robust, but a peak in inflation expectations, that will temper the pace of Fed interest rate hikes, has been driving dollar momentum. Headline CPI is expected to come in at 8.3% in May, while the core measure should decelerate to 5.9%. It is possible that these numbers surprise to the downside. For example, used car prices, an important contribution to US CPI, are rolling over sharply (panel 2). Overall, supply-side price pressures appear to be easing (panel 3). The US added 390K jobs in May, so the employment report remains robust. Encouragingly, the participation rate is also picking up. This suggests the US can absorb more willing workers before we see additional upward pressure in wage growth. We are closely watching the Atlanta Fed wage growth tracker (panel 4). The ISM manufacturing index had a solid print of 56.1 in May, but the prices paid index dipped from 84.6 to 82.2. As we highlighted above, these developments have sapped market expectations for aggressive interest rate increases in the US relative to other G10 countries. Speculative froth in the dollar is also unwinding (panel 5). We went short the DXY index at 104.8, with a stop loss at 107. We recommend sticking with this position.  The Euro: A European Soft Landing? Chart 5The Euro Has Priced A Recession The Euro Has Priced A Recession The Euro Has Priced A Recession The euro is down 6.6% year-to-date. Over the last month, the euro is up 0.7%. The ECB cemented the fact that interest rates are headed higher this week. With a mandate of taming inflation, the central bank faces a tough job of reigning in price pressures, while engineering a soft landing in the economy. From the perspective of the euro, it is our view that most of the downside risks to this scenario have been priced in, while upside surprises have not (panel 1). Incoming data from the euro area has been improving. The Sentix Investor Confidence index ticked up in June. Energy prices remain high, but momentum has been softening. The ZEW expectations survey also delivered an upside surprise in May. The key point from an FX perspective is that the euro has already priced a recession in the European economy, but no prospect of a soft landing. That is positive from a contrarian perspective. With HICP inflation at 8.1% (panel 2), emergency monetary settings are no longer required, and the ECB should lift rates. As we suggested last month, a “least regrets” approach will gently nudge rates higher to address inflationary pressures but pay attention to cyclical sectors of the economy (panel 3). It is important to remember that interest rates in the eurozone are still at -0.5%. Related Report  Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar We remain long EUR/GBP on the prospect that the ECB could better engineer a soft landing, compared to the BoE. We also remain sellers of the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the cross has already priced in a much stronger global economy (panel 4). This is also a perfect hedge for a pro-cyclical currency positioning. The Japanese Yen: Back To Carry Trades Chart 6The Yen Will Soon Bottom The Yen Will Soon Bottom The Yen Will Soon Bottom The Japanese yen is down 14.3% year-to-date, the worst performing G10 currency this year. Over the last month, the yen is down 2.9%. The yen is a classic case of the risks of fighting the trend in currency markets (panel 1). That said we remain buyers, rather than sellers, on weakness. The drivers of the yen have been very clear and absolute. First, rising interest rates abroad, as we saw this week, have put selling pressure on the JPY (panel 2), given the BoJ will maintain yield curve control. Second, the pickup in energy prices continues to deflate the Japanese trade balance. These are negative shocks that are likely to continue inflicting pain on yen long positions in the near term. From a contrarian perspective, there is solace for yen bulls. First, it is the cheapest G10 currency according to our PPP models. It also happens to be one of the most heavily shorted currencies, according to CFTC data (panel 4). In terms of data, there have also been positive surprises over the last month. The Eco Watcher’s Survey surprised to the upside. PMIs have rebounded above 50. Inflation is above the 2% target and should keep rising. Machinery orders are picking up. The Bank of Japan is likely to stay dovish next week but that is largely priced in. Meanwhile, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. We have no active position on the yen right now but will be buyers on weakness.  British Pound: Sterling And A Policy Mistake Chart 7Cable Is At Risk Near Term Cable Is At Risk Near Term Cable Is At Risk Near Term The pound is down 7.6% year to date. Over the last month, the pound is up by 1.3%. We wrote a report on sterling last week. In our view, sterling faces headwinds in the near term but is likely to be a profitable long position for investors with a more structural view. First, the deterioration in the UK’s trade balance is cyclical and not structural. Fuels constitute 11% of UK imports so higher energy prices are affecting the balance of trade. This will soon reverse. Second, goods imports have picked up, but it is encouraging that a huge share has been machinery and transport equipment. Inflation remains a problem in England, with CPI at 9%. In our view, while sterling is pricing in a policy mistake by the BoE – tightening too fast into a slowing economy, our bias is that the BoE can engineer a soft landing for the economy. Only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply-side factors. The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). These could ease going forward. We are currently long EUR/GBP. This cross still heavily underprices the risks to the UK economy in the near term. However, if recession fears ease, our suspicion is that cable is poised for a coiled spring rebound.  Canadian Dollar: The BoC Will Stay Hawkish Chart 8CAD Should Benefit From Terms Of Trade CAD Should Benefit From Terms Of Trade CAD Should Benefit From Terms Of Trade The CAD is down 0.6% year to date. Over the last month, it is up 2.4%. The CAD has been the best performing G10 currency this year after the DXY, and the key drivers of loonie strength will persist. First, the CAD will benefit from a terms-of-trade boost, given it is trading at a discount to prevailing oil prices. Second, the BoC will stay hawkish, having hiked interest rates by 50 bps last month, and telegraphing more tightening going forward. Economic data out of Canada suggests tighter monetary policy is warranted. Both headline and core inflation remain strong, with headline inflation at 6.8% in April. The common, trim, and median inflation prints were at 3.2%, 5.1%, and 4.4%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad based (panel 2). House prices are rolling over so the wealth effect could temper hawkishness from the BoC. However, recent speeches from policy officials have highlighted a need to tame housing price pressures in Canada (panel 4). We remain buyers of the CAD on a lower dollar but are monitoring risks from a tightening in financial conditions.     New Zealand Dollar: Will Weaken At The Crosses Chart 9The RBNZ Is Trying To Engineer A Soft Landing The RBNZ Is Trying To Engineer A Soft Landing The RBNZ Is Trying To Engineer A Soft Landing The NZD is down 6.6% this year. Over the last month, the kiwi is down 1.0%. The RBNZ hiked interest rates by 50 bps in May, taking the overnight rate to 2%. This seems to be having the intended effect, with house price inflation rolling over as mortgage rates adjust higher. This “least regrets” approach is likely to continue in the short term. The labor market is extremely tight, with a shortage of high skilled labor given immigration has slowed. This is leading to substantial wage increases. As such, the RBNZ has been increasing guidance for annual CPI inflation, and therefore, interest rates, raising its overnight projection for June 2023 to 3.9% from 2.8%. There is reason to believe the RBNZ will tone down its hawkish rhetoric. For one, terms of trade are softening. Dairy prices, circa 20% of exports, are down 1% this month after reaching a 10-year high in May. A domestic slowdown is also likely to nudge the RBNZ toward more accommodation. In a nutshell, the kiwi has upside versus the dollar, but will underperform at the crosses.        Australian Dollar: Our Top Pick Against The Dollar Chart 10The RBA Will Continue To Hike The RBA Will Continue To Hike The RBA Will Continue To Hike The Australian dollar is down 2.3% year to date. Over the last month, the AUD is up 2%. The Reserve Bank of Australia raised interest rates by 50 bps this week, a surprise to markets, but in line with the hawkish tone telegraphed in prior meetings. Inflation in Australia is surprising to the upside. Meanwhile, unemployment remains well below NAIRU. As a result, an exit from emergency monetary settings makes sense. The key will be whether the RBA can engineer a soft landing in the Aussie economy. Job gains remain robust, and both the unemployment rate and the participation rate are at healthy levels. Terms of trade are holding up, and wage gains are improving. Home prices are rolling over, but it is a welcome development as the RBA is trying to calibrate financial conditions. We are long the AUD as of 72 cents. The big concern for this trade is China, and the potential for renewed lockdowns that will hurt the external balance. As such, we expect this trade to be volatile near-term, but pay off over a longer horizon.        Swiss Franc: A Safe Haven Chart 11The SNB Will Stay Constructive On The Franc The SNB Will Stay Constructive On The Franc The SNB Will Stay Constructive On The Franc The Swiss franc is down 7% year-to-date, but up versus the dollar over the last month. Swiss economic conditions have been rather resilient. GDP expanded by 0.5% in Q1, slightly above expectations, while industrial production also rose 2.4% in the same period. In April, Switzerland’s trade surplus widened to CHF 3.8bn, boosted by demand for machinery and chemicals. In May, the KOF leading indicator clocked 96.8 and the manufacturing PMI stood at 60, a slowdown month-on-month but still a very healthy reading. Inflation is surprising to the upside in Switzerland. Headline and core CPI growth came in at 2.9% and 1.7% year-on-year in May, respectively. Recently, several SNB board members have voiced the primacy of price stability and preparedness to hike rates if inflation becomes broad based. This has helped support the franc. The market now expects SNB to follow the ECB in removing the NIRP starting in September. But it is always good to remember that the Swiss franc is a defensive currency, so a path to policy normalization still presents upside for EUR/CHF. In our trading book, we are short CHF/SEK, but will take profits if Thomas Jordan proves to be more of an inflationary hawk.   Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 12The Norges Bank Will Stay Hawkish Month In Review: Recession Risk Month In Review: Recession Risk NOK is down 8.1% year to date and up 1.5% over the last month. In the three months through March, Norway’s GDP contracted by 1% quarter on quarter, led by drops in private consumption (1.5%), government spending (1.4%), and exports (3.5%). The decline largely reflects restriction measures imposed at the start of the year. That said, economic growth is rebounding and GDP growth will be around 3% in the next 12 months. Meanwhile, the trade surplus remains very healthy at 92.6bn NOK. As a result, the current account surplus hit at an all-time high of 341bn NOK in Q1. From a broader perspective, incoming numbers in Norway reflect a slowdown in global growth. Consumer confidence dropped to the lowest levels since 2016. The manufacturing PMI fell sharply to 54.9 in May, the lowest reading in over a year. Industrial production also decreased by 0.5% month-on-month in April. That said, the labor market continues to tighten. The unemployment rate fell to 1.7% in May, significantly below Norge Bank’s 2% projection. Renewed immigration might help alleviate some of the labor market tightness, but the strength in employment trends is very evident. As a result, our bias is that the committee will stick to its quarterly 25bps hikes, but upside surprises to this baseline are non-trivial. Terms of trade are a tailwind for Norway. In particular, NOK/SEK can be an attractive bet on a 12-month horizon, should oil prices remain firm.  Swedish Krona: Into A Capitulation Phase Chart 13More Hawkish Surprises From The Riksbank More Hawkish Surprises From The Riksbank More Hawkish Surprises From The Riksbank The SEK is down 8.7% year to date and up 1.6% over the last month.  Sweden sits right at the crosshairs of the Russia-Ukraine conflict. As a result, inflation remains a problem with CPIF at 6.4%, year-over-year in April, above updated projections from Riksbank. The issue is that there are rising risks that inflation will not be transitory, raising the prospect of a policy surprise from the Riksbank. The OIS curve is now pricing in a 1.75% policy rate by year-end. In our view, this will be a baseline scenario. The critical point is whether the Riksbank is on the verge of making a policy mistake. Economic growth is slowing. Swedish GDP contracted by 0.8% in Q1 from the previous quarter. However, if policymakers are overly fixated on inflation, the prospect of grinding the Swedish economy to a halt becomes a rising risk. Major rounds of collective wage negotiations early next year, affecting as much of as 40% of total labor force, is a risk to monitor. There is already some evidence of a slowdown in economic activity. Consumers reported the lowest level of confidence since the Global Financial Crisis. PMIs remain resilient, well above 50 but the risk is to the downside. Should the Chinese credit impulse bottom and supply constraints ease, economic activity will pick up in the second half of the year, but the risk of downside surprises are worth monitoring. The bottom line is that SEK has already priced in much of the negative news and remains undervalued in our models. We are short CHF/SEK on these grounds, a position 1.5% in the money.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Bond yields in the developed world have ticked higher recently, due to a renewed increase in oil prices and the spillover effect from more hawkish policy expectations out of Europe. The competing forces of slowing global growth momentum and geopolitical uncertainty on one side, and high inflation with tightening monetary policies on the other, will keep global government bond yields rangebound over the next several months. UK investment grade corporate bonds now offer an intriguing combination of higher yields, attractive spread valuations and strong financial health. By maturity, shorter-maturity corporates offer the best value. At the industry level, spreads look most attractive for Financials. A hawkish Bank of England, both through rate hikes and upcoming outright sales of corporate debt the central bank has purchased via quantitative easing, remains a major headwind to UK corporate bond returns. Sectors most at risk to central bank sales are Water, Consumer Cyclicals and Consumer Non-Cyclicals. Bottom Line: Stay neutral on overall duration exposure in global bond portfolios. Maintain a neutral stance on UK corporates, favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening. Trendless, Friendless Bond Markets Chart 1Recovering From The Ukraine War Shock... Recovering From The Ukraine War Shock... Recovering From The Ukraine War Shock... Although it may not feel like it given the ferocity of some daily price swings, many important financial markets have not moved all that much, cumulatively, since the first major shock of 2022 – the start of the Russian invasion of Ukraine on February 24. For example, the S&P 500 is only down around -2% from the pre-invasion level, while the VIX index of equity option volatility is at 24, seven points below the closing level on February 23 (Chart 1). The Bloomberg US investment grade corporate bond index spread is only 12bps above its pre-invasion level, down 20bps from the peak seen in mid-May. More recently, even US bond yields have shown signs of stabilization. The 10-year US Treasury yield has traded in a 2.70-3.15% range since the start of April, while the MOVE index of US Treasury option volatility has fallen by one-quarter since its most recent peak in early May. Not all markets, however, have seen this kind of relative stability. Global oil prices are trading close to post-invasion highs, as are government bond yields in Germany and the UK. High-yield credit spreads in the US and Europe are both still around 50bps above where they were pre-invasion. The DXY US dollar index is 6% above the pre-invasion level, led by the USD/JPY currency pair that has appreciated to levels last seen in 2002. Given the mix of slowing global growth momentum and ongoing geopolitical uncertainty, but with persistent high inflation and tightening global monetary policy, it is unsurprising that financial markets are having a difficult time formulating a consistent message. This is especially true for global government bond yields. Chart 2Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Even as market-based inflation expectations have eased a bit in recent weeks, bond yields across the developed world have been unable to decline because markets continue to discount more rate hikes (Chart 2). Yet with such a significant amount of monetary tightening now priced in across all countries, global bond yields are more likely to stay rangebound over the next 3-6 months than begin a new trend. Chart 3DM Bond Yields Discounting Tight Monetary Policy DM Bond Yields Discounting Tight Monetary Policy DM Bond Yields Discounting Tight Monetary Policy 10-year government bond yields and 2-year-ahead interest rate expectations in overnight index swap (OIS) curves are trading in lockstep in the US, Europe, UK, Canada and Australia (Chart 3). This correlation indicates that longer-term bond yields have become a pure play on future policy rate expectations, rather than a reflection of rising inflation expectations as was the case in 2021. However, both yields and rate expectations are now trading close to, or even well above, plausible estimates of neutral nominal policy rates in all regions - including estimates provided by central bankers themselves. For example, in Australia, where the RBA just delivered a 50bp rate hike this week, markets are pricing in a peak Cash Rate between 3.5-4%, even with RBA Governor Philip Lowe stating that the neutral rate is likely in the 2-3% range – a view that we agree with. The situation is even more extreme in the euro area, with the euro area OIS curve now pricing in a peak policy rate between 1.5-2%, with most of that increase coming over the next 12 months. While we expect the ECB to fully exit the negative (deposit) rate era by September, rate hikes beyond that are far less likely given slowing euro area growth momentum and still-moderate euro area inflation beyond the spillover effects from energy costs. Only in the US are markets potentially underestimating the potential peak in the fed funds rate for this tightening cycle. Estimates of the longer-run (neutral) funds rate from the latest set of FOMC projections back in March ranged from 2.0-3.0%. Thus, the current level of 10-year bond yields, and 2-year-ahead rates discounted in the US OIS curve, are only at the top end of that range. It is possible that the Fed will have to raise rates to restrictive levels (i.e. above 3%) given the size of the current US inflation overshoot. More importantly, the US neutral rate is likely higher than the Fed thinks it is, possibly as high as 4% according to BCA Research’s Chief Global Strategist, Peter Berezin. We continue to see the US as the one major government bond market where there is a risk that markets are underestimating the neutral policy rate. For that reason, we remain underweight US Treasuries in the BCA Research Global Fixed Income Strategy model bond portfolio. Don’t Dismiss The QT Effect One other factor that has likely kept global bond yields elevated, even as global growth has softened, has been the shift away from central bank asset purchases towards quantitative tightening (QT). As policymakers have moved to slow, or even stop, the buying of government bonds, the term premium component of longer-term bond yields has risen. The moves have been quite large. Using our own in-house estimates, the term premium on 10-year government bond yields have jumped by about 100bps on average in the US, UK, Canada, Australia and Europe since the lows seen during the 2020 COVID global recession (Chart 4). The jump in term premiums is occurring at the same time as markets have moved to price in more rate hikes and a higher path for real interest rates (bottom panel). Chart 4Yields Repricing As QE Moves To QT Yields Repricing As QE Moves To QT Yields Repricing As QE Moves To QT ​​​​​​ Chart 5Stay Neutral Global Duration Exposure Stay Neutral Global Duration Exposure Stay Neutral Global Duration Exposure ​​​​​​ That combined effect of the upward repricing of term premiums – especially as more price-sensitive private investors replace the demand for bonds from price-insensitive central banks - but with less upward movement in already elevated interest rate expectations will keep longer-term bond yields in trading ranges during the “Global QT Phase” over at least the next six months and likely longer. That message is reinforced by our Global Duration Indicator, which is heralding a peak in global bond yield momentum over the latter half of 2022 (Chart 5). Bottom Line: Stay neutral on overall duration exposure in global bond portfolios, with yields in the major developed markets likely to stay rangebound over the next few months. Assessing The Value In UK Investment Grade Corporates Chart 6A Big Jump In UK Investment Grade Corporate Yields A Big Jump In UK Investment Grade Corporate Yields A Big Jump In UK Investment Grade Corporate Yields Global credit markets have had a rough time in 2022, and UK corporate debt is no exception. The Bloomberg UK Corporate index of investment grade corporate debt has delivered a year-to-date total return of -11%, as the index yield-to-maturity rose 174bps to 4% - the highest level since 2014 (Chart 6). Relative to UK Gilts, the results have also been grim as corporate credit spreads have widened, with the Bloomberg UK corporate index realizing an excess return of -3% since the start of the year. We have maintained a neutral stance on UK corporate bond exposure in our global model bond portfolio during the selloff. This was the result of a relative value opinion, as we have concentrated our more defensive view on global investment grade corporate debt with an underweight to US corporates. However, after the significant repricing of UK investment grade credit, it is now a good time to reassess our opinion on the asset class. Spread Valuation From a pure spread valuation perspective, UK investment grade now looks more attractive. Our preferred valuation metric – 12-month breakeven spreads - shows that the UK investment grade corporate index spread, on a duration-adjusted basis, is now in the 75th percentile of its history over the past 25 years (Chart 7). Chart 7UK Corporate Spreads Now Offer Some Value UK Corporate Spreads Now Offer Some Value UK Corporate Spreads Now Offer Some Value We find 12-month breakevens to a useful spread valuation measure, as they show how much spreads would need to widen to make the expected one-year-ahead return on a credit product equal to that of a duration-matched position in government bonds. In other words, breakevens measure the spread “cushion” against excess return losses from spread widening. What makes the current attractive reading on UK investment grade spread valuation so interesting is that the absolute level of spreads is still relatively low. The Bloomberg UK investment grade corporate index spread is currently 170bps, but during previous episodes where the 12-month breakeven as near the top quartile ranking – as is currently the case – the index spread ranged from 200-350bps. The reason for that relates to the index duration which, at 7.3 years, is down 1.5 years from the 2020 peak and at the lowest level since 2011. Some of that lower duration is related to the convexity effect from higher corporate bond yields. But there has also been a reduction in the average maturity of the UK investment grade corporate bond universe, with the index average maturity now at 10.4 years, down a full year lower over the past 12 months and the lowest average maturity since 1999. UK companies appear to have shortened up the maturity profile of their bond issuance, which helped reduce the riskiness (duration) of corporate bond returns to rising yields. Thus, the message from the 12-month breakevens is correct – UK investment grade corporate bond yields are attractive from a historical perspective, on a duration-adjusted basis. Chart 8UK Credit Curves Are Relatively Flat UK Credit Curves Are Relatively Flat UK Credit Curves Are Relatively Flat When looking within the UK investment grade universe, the messages on valuation are a bit more mixed. The UK credit curve is not particularly steep, when looking at the spread differences by credit rating within the benchmark index universe (Chart 8). There is a similar message when looking at 12-month breakevens broken down by credit rating, where there is little difference between the percentile rankings (Chart 9). However, the 12-month breakeven percentile rankings broken down by maturity buckets show that shorter-maturity bonds have noticeably higher percentile rankings than longer-maturity UK corporates (top panel). From a cross-country perspective, UK corporate breakeven percentile rankings are much higher than equivalent rankings for US corporates, but are lower than those of the euro area. Chart 9Shorter-Maturity UK Spreads Are More Attractive Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields Corporate Financial Health Our top-down UK Corporate Health Monitor (CHM) - which uses data on non-financial corporate sector revenues, expenses and balance sheets taken from GDP accounts – has shown a very strong improvement in UK corporate financial health over the past few years (Chart 10). The biggest improvements are in the categories related to debt service, with interest coverage at the highest level since 2002 and debt coverage is at the highest level since 1999. Chart 10UK Corporates Can Withstand Higher Borrowing Rates UK Corporates Can Withstand Higher Borrowing Rates UK Corporates Can Withstand Higher Borrowing Rates ​​​​​​ Chart 11Stay Neutral UK Corporates Until The BoE Is Done Stay Neutral UK Corporates Until The BoE Is Done Stay Neutral UK Corporates Until The BoE Is Done ​​​​​ The message from our top-down UK CHM is similar to the conclusions from an October 2021 BoE report that analyzed the UK corporate sector from a financial stability perspective. In that report, the BoE used a bottom-up sample of 500 UK companies and concluded that corporate borrowing rates could rise as much as 400bps before the share of companies with a “distressed” interest coverage ratio below 2.5 would rise to the past historical peak. Within our top-down UK CHM, relatively wide corporate profit margins are also contributing to the strong reading on UK corporate health. Like the interest/debt coverage ratios, those margins provide some cushion to profits in the current environment of high inflation and elevated input costs for businesses. The all-in message from our UK CHM is that financial health is a fundamental tailwind for UK corporate bond performance. Monetary Policy Attractive spread valuations and strong financial health metrics would normally justify an overweight stance on any corporate bond market. However, the monetary policy cycle is also an important factor that drives corporate bond performance. Currently, with the BoE not only hiking rates but also moving to QT on asset purchases, monetary policy is a severe headwind to UK corporate bond returns. Related Report  Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts The annual growth rate of the BoE’s balance sheet has proven to be a reliable leading indicator of UK corporate bond annual excess returns. With the growth in the balance sheet set to turn negative in the latter half of 2022 (Chart 11), it will prove difficult for UK credit spreads to narrow in a way that will boost excess returns. The BoE’s aggressive (by its standards) rate hiking cycle, in response to UK inflation that is nearing 10% alongside a very tight labor market, remains a threat to UK economic growth that is already losing some momentum. As we discussed in a recent Special Report, the UK neutral interest rate is likely no more than 1.5-2%. If the BoE were to follow current market pricing and push Bank Rate toward 2.5%, this would be a restrictive policy stance that would likely result in a sharp growth slowdown if not a full-blown recession. Importantly, our UK Central Bank Monitor is showing signs of peaking (bottom panel), due to signs of slower economic growth and tightening financial conditions. A peak in UK inflation would help reduce the Monitor even further, and would likely correspond to a pause on BoE rate hikes – a necessary condition before we would upgrade our recommended stance on UK investment grade corporates to overweight. Some Final Thoughts On Industry Sector Valuation Our UK investment grade corporate sector valuation model is a cross-sectional analysis of individual industry/sector corporate credit spreads, after controlling for differences in duration, convexity and credit rating. The model is currently signaling that there are few compelling valuation stories with positive “risk-adjusted” spreads (Chart 12). Only Financials look cheap, while Consumer Cyclicals, Consumer Non-Cyclicals and Capital Goods are all trading at expensive risk-adjusted spreads. Chart 12Not Many Compelling Values Within UK Corporates By Industry Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields An additional risk to UK corporate bond performance relates to the BoE’s decision to unwind its corporate bond portfolio. The BoE has announced that there will be outright sales from the corporate holdings accumulated over the past couple of years, with a goal of having the stock of debt fully unwound by the end of 2023. This is important for much of the UK investment grade corporate bond universe, where the BoE holds between 8-10%, on average, of outstanding debt (Chart 13).1 Chart 13The BoE Has Become An Important Corporate Bondholder Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields When we compare our risk-adjusted spreads versus the BoE ownership share by sector, we conclude that Consumer Cyclicals, Consumer Non-Cyclicals and Other Utilities offer the most unattractive combination of expensive spreads and high BoE concentration (Chart 14). We recommended underweight allocations to those sectors within an overall neutral allocation to UK corporates. Chart 14BoE Asset Sales Are A Major Risk For Some UK Corporate Sectors Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields Bottom Line: Maintain a neutral stance on UK corporates, given the mix of attractive valuations but tighter monetary policy. Favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1      In Chart 13, we use the market capitalization of each sector from the Bloomberg UK corporate bond index in the numerator of all ratios shown, as a proxy for outstanding debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields