Policy

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Real Wages Are Declining Real Wages Are Declining Chart 2Consumer Confidence Has Soured Consumer Confidence Has Soured Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories Here Comes Goldilocks Here Comes Goldilocks The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Here Comes Goldilocks Here Comes Goldilocks Chart 6The Clogged-Up Port Of Shanghai Here Comes Goldilocks Here Comes Goldilocks Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Here Comes Goldilocks Here Comes Goldilocks Special Trade Recommendations Current MacroQuant Model Scores Here Comes Goldilocks Here Comes Goldilocks

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Yen And Interest Rates The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates The Yen And Interest Rates The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish The BoJ Is Expected To Stay Dovish The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen A Technical Profile Of The Japanese Yen A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases The Yen Drawdown Has Matched Previous Capitulation Phases The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Sentiment On The Yen Is Very Depressed Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers The Yen Tends To Rebound When The Japanese Economy Recovers The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Demographics Are Weighing On Japanese Inflation Demographics Are Weighing On Japanese Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Long-Term Inflation Expectations In Japan Are Rising, But Muted Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds The BoJ Has Not Been Aggressively Buying Government Bonds The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene The MoF Could Soon Intervene The MoF Could Soon Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Currency Weakness Will Only Temporarily Help Boost Inflation Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover Core CPI Will Not Meaningfully Recover Core CPI Will Not Meaningfully Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Valuation Matters For The Japanese Yen Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce Global Yields Need To Stabilize For The Yen To Bounce Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge The Yen Remains A Good Hedge The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Go Short CHF/JPY Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   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 The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 3India And China Both Depend On Middle East For Oil Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 4China’s Naval Power Pales Versus US Allies In Asia Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 7America Can Provide Military Heft To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 8US Is A Key Trading Partner For India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 10India Offers US Firms Access To High Growth Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 11India Is A Key Market For American Big Tech Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 17China & Pakistan: Iron Brothers? Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 18Indians View China And Pakistan Negatively Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis?   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation 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 A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 Global Bond Yields Take A Breather Global Bond Yields Take A Breather In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking ​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish ​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US Global Bond Yields Take A Breather Global Bond Yields Take A Breather The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out ​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation? A Peak In US Core Inflation? A Peak In US Core Inflation? ​​​​​ Chart 9Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures Global Bond Yields Take A Breather Global Bond Yields Take A Breather The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking ​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing ​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Global Bond Yields Take A Breather Global Bond Yields Take A Breather Chart 17Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. 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 Global Bond Yields Take A Breather Global Bond Yields Take A Breather The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Global Bond Yields Take A Breather Global Bond Yields Take A Breather Tactical Overlay Trades

Executive Summary Above Fair Value Above Fair Value Above Fair Value March’s CPI report will mark peak inflation for 2022. We recommend several ideas to profit from peak inflation. First, investors should keep portfolio duration close to benchmark. The bond market is fairly priced for the likely near-term pace of rate hikes, and long-dated forward yields are now above fair value. Second, investors should underweight TIPS versus nominal Treasuries. They should also favor inflation curve steepeners, real yield curve flatteners and outright short positions in 2-year TIPS. Third, investors should favor the 5-year nominal Treasury note relative to a duration-matched barbell consisting of the 2-year and 10-year notes. The Fed published its plan for shrinking its balance in the minutes from the last FOMC meeting. We estimate that the Fed will be able to shrink its balance sheet at its intended pace for at least the next two years before it is forced to stop. Bottom Line: Investors should position for peak inflation by keeping portfolio duration close to benchmark, by underweighting TIPS versus nominal Treasuries and by favoring the 5-year nominal Treasury note versus the 2-year and 10-year. Feature Chart 1Base Effects Kick In Next Month Base Effects Kick In Next Month Base Effects Kick In Next Month Last week’s March CPI report showed that 12-month core consumer price inflation came in at 6.44%, a level that will almost certainly mark the peak for the year. Several reasons justify our peak inflation call. First, base effects will send year-over-year core CPI sharply lower during the next three months (Chart 1). Monthly core CPI growth rates were 0.86%, 0.75% and 0.80% in April, May and June 2021 (Chart 1, bottom panel). These exceptionally high prints will roll out of the 12-month average during the next three months. Second, monthly core CPI grew 0.32% in March, a significant step down from the 0.5%-0.6% range that had been the norm since October. If monthly core CPI growth rates remain between 0.3% and 0.4% from now until the end of the year, then 12-month core CPI will fall to a range of 4.19% to 5.13%. We think that trends in the major components of core inflation make this outcome likely, and we could even see inflation falling to below that range. Chart 2 shows the contributions of shelter, goods and services (ex. shelter) to overall core CPI. Chart 2Monthly Core Inflation By Major Component Peak Inflation Peak Inflation Starting with core goods, we see that prices fell in March for the first time since February 2021. This represents an important inflection point. Core goods, particularly autos, have been the principal driver of current extremely high inflation rates (Chart 3), and these prices will continue to fall in the coming months as supply chain issues are resolved and as goods spending reverts to its pre-pandemic trend (Chart 3, bottom panel). Few dispute that core goods inflation will be weaker going forward. However, one critical question is whether the impact from falling goods prices will simply be offset by the rising cost of services. There was indeed some evidence for this in March. Core services (ex. shelter) prices rose 0.71% in March, up from 0.55% in February. While this is a strong print, it was not sufficient to prevent a drop in overall core inflation from 0.51% to 0.32%. What’s more, March’s core services print was heavily influenced by a surge in airfares that represents a rebound from steep declines seen near the end of last year. With airfares excluded, core services inflation would have only come in at 0.50% in March (Chart 4). Chart 3Goods Inflation Goods Inflation Goods Inflation Chart 4Services & Shelter Inflation Services & Shelter Inflation Services & Shelter Inflation Finally, we turn to the outlook for shelter inflation. Monthly shelter inflation has rebounded to above its pre-COVID levels, but its acceleration has abated during the past few months (Chart 4, bottom panel). Trends in home prices and some indicators of market rents suggest that shelter inflation has some further near-term upside.1 However, shelter inflation is also very sensitive to the economic cycle and the unemployment rate. With that in mind, rapid shelter inflation during the past 12 months is mostly explained by the fact that the unemployment rate fell by almost 2.5%! With the labor market already close to full employment, this sort of cyclical economic improvement will not be repeated during the next 12 months. All in all, we think monthly shelter inflation will average close to its current level during the next nine months. Bottom Line: March’s CPI report marked an inflection point for inflation. Year-over-year inflation will fall sharply during the next few months and will settle close to 4% by the end of the year. Profiting From Peak Inflation Portfolio Duration We have been recommending an “at benchmark” portfolio duration stance in US bond portfolios since mid-February, yet Treasury yields have continued their upward march during the past two months. Our sense is that bond yields now look somewhat too high, and some pullback is likely as inflation moves lower during the next few months. First, let’s consider that the bond market is priced for 262 bps of tightening during the next 12 months (Chart 5), the equivalent of more than ten 25 basis point rate hikes at the next eight FOMC meetings. Our view is that this pricing is close to fair. Chart 5Rate Expectations Rate Expectations Rate Expectations A 50 basis point rate hike at the May FOMC meeting is now a near certainty. The minutes from the last meeting revealed that “many” participants would have preferred a 50 bps increase in March, but uncertainty surrounding the war in Ukraine prevented that view from becoming consensus. The Treasury curve has also re-steepened significantly during the past few weeks, a development that will ease any concerns about near-term over-tightening. It’s also worth noting that the precedent for a 50 bps hike has now been set by the Reserve Bank of New Zealand and the Bank of Canada. Both central banks lifted their policy rates by 50 bps at their most recent meetings. Chart 6Above Fair Value Above Fair Value Above Fair Value Beyond May, we expect to see more 25 basis point rate hikes than 50 basis point hikes. Falling inflation will ease some of the Fed’s urgency and the Fed will continue to tighten policy with the goal of getting the fed funds rate close to estimates of the long-run neutral rate by the end of the year. A 25 basis point rate increase at every meeting after May would bring the fed funds rate to a range of 2.0% - 2.25% by the end of the year, just below the Fed’s median estimate of the long-run neutral rate (2.4%). One additional 50 bps hike would bring the funds rate right up to neutral, and such a path would still be consistent with what is currently priced in the curve. Meanwhile, bond pricing at the long end of the yield curve now looks a touch cheap. The 5-year/5-year forward Treasury yield – a market proxy for the long-run neutral rate – has moved up to 2.87%, significantly above survey estimates of the long-run neutral rate (Chart 6). Some pullback closer to survey levels is likely as inflation trends lower. Bottom Line: Keep portfolio duration close to benchmark. Front-end pricing looks fair and long-dated forward yields are somewhat too high. TIPS Perhaps the most obvious way to profit from peak inflation in 2022 is by shorting TIPS versus nominal Treasuries. The 10-year TIPS breakeven inflation rate has risen to 2.91%, well above the Fed’s target range of 2.3%-2.5% (Chart 7). The combination of Fed tightening and falling inflation will send this rate back toward the Fed’s target between now and the end of the year. However, the potential downside in the 10-year TIPS breakeven inflation rate is nothing compared to the 2-year rate. The 2-year TIPS breakeven inflation rate is 4.4% (Chart 7, panel 2) and this short-maturity rate is much more sensitive to the incoming inflation data. Finally, long-maturity TIPS breakeven inflation rates look elevated compared to survey estimates of long run inflation. The 5-year/5-year forward TIPS breakeven inflation rate is currently 2.46%, above the range of estimates from the New York Fed’s Survey of Primary Dealers (Chart 7, bottom panel). In addition to underweight positions in TIPS versus nominal Treasuries, we continue to see the opportunity for an outright short position in 2-year TIPS. The 2-year TIPS yield has risen significantly since the end of last year, but this has been driven by a rising 2-year nominal yield (Chart 8). Going forward, the 2-year TIPS yield still has room to rise but it’s increase will be driven less by a rising nominal yield and more by a falling 2-year TIPS breakeven inflation rate. Chart 7Inflation Expectations Inflation Expectations Inflation Expectations Chart 8Sell 2-Year TIPS Sell 2-Year TIPS Sell 2-Year TIPS Consistent with our view that the cost of short-maturity inflation compensation has more downside than the cost of long-maturity inflation compensation, we view positions in 2-year/10-year inflation curve steepeners and 2-year/10-year TIPS curve flatteners as likely to profit during the next nine months (Chart 8, bottom panel). Bottom Line: Investors should underweight TIPS versus nominal Treasuries. They should also position in inflation curve steepeners and real yield curve flatteners and hold outright short positions in 2-year TIPS. Nominal Treasury Curve Chart 9Go Long 5yr Versus 2/10 Go Long 5yr Versus 2/10 Go Long 5yr Versus 2/10 One final idea is for investors to take a long position in the 5-year Treasury note versus a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. This 5 over 2/10 trade currently offers an attractive 18 bps of yield pick-up, which is much higher than we normally see when the 2-year/10-year Treasury slope is this flat (Chart 9). In fact, a simple model of the 2/5/10 butterfly spread versus the 2-year/10-year slope shows the 5-year bullet to be very cheap relative to history (Chart 9, panel 2). This position will profit from continued 2-year/10-year curve steepening, or more likely, it will profit if the 2-year/10-year slope remains near its current level but the 2-year/5-year slope flattens as the Fed tightening cycle progresses (Chart 9, panel 3). Bottom Line: The recent steepening trend in the 2-year/10-year Treasury slope is likely exhausted, but the 5-year Treasury yield is too high relative to the current 2-year/10-year slope. Investors should go long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The Fed’s Balance Sheet Plan The minutes from the March FOMC meeting revealed the Fed’s plan for shrinking its balance sheet. This plan will likely be put into action at either the May or June FOMC meeting. Specifically, the Fed intends to allow a maximum of $60 billion of Treasuries and $35 billion of MBS to passively run off its portfolio each month. The Fed also hinted that it may decide to start with lower caps and raise them up to the $60 billion and $35 billion targets over a period of three months. However, with the market already well positioned for Quantitative Tightening (QT), this phase-in period will probably not be deemed necessary. For its Treasury securities, the Fed intends to allow a maximum of $60 billion of coupon securities to run off its portfolio each month. If fewer than $60 billion of coupon securities are maturing that month, then the Fed will redeem T-bills to reach the $60 billion target. For MBS, the Fed’s $35 billion per month cap will probably not be binding. Given the slow pace of mortgage refinancings, which will only slow further as interest rates rise, it is unlikely that there will be many months with more than $35 billion of maturing MBS. In fact, some recent Fed research estimated that average MBS runoff will be closer to $25 billion per month going forward.2 Assuming the Fed’s plan starts in June and that MBS runoff averages $25 billion per month, we calculate that the Fed’s Treasury holdings and total assets will still be above pre-COVID levels in 2026 (Chart 10). More important than the Fed’s total assets, however, are the total reserves supplied to the banking system. It is the amount of reserves, after all, that determine whether the Fed can maintain adequate control over interest rates. If too few reserves are supplied, then the fed funds rate will threaten to break above the upper end of the Fed’s target band and the Fed will be forced to increase reserves by either re-starting purchases or engaging in repo transactions. This is exactly what happened when the Fed was forced to abandon its last QT effort in September 2019 (Chart 11). Chart 10Fed Asset Projections Fed Asset Projections Fed Asset Projections Chart 11Reserve Projections Reserve Projections Reserve Projections Making a few additional assumptions about the growth rate of currency-in-circulation and the size of the Treasury’s General Account, we are able to forecast the path for reserves going forward (Chart 11, top panel). We estimate that reserves will fall to roughly $2 trillion by the end of 2025, still slightly above the levels that caused problems in fall 2019. Ultimately, neither us nor the Fed knows exactly what level of reserves will be adequate to maintain control of interest rates going forward. The Fed will track usage of its new Standing Repo Facility as it shrinks its balance sheet. If usage of the repo facility increases, that will be the sign that the Fed has done enough QT and it is time to start slowly increasing the balance sheet once again. Given the recently published pace of runoff, we think this won’t be story for at least another two years.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 https://www.newyorkfed.org/newsevents/speeches/2022/log220302 Recommended Portfolio Specification Peak Inflation Peak Inflation Other Recommendations Peak Inflation Peak Inflation Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The Currency And Interest Rates: On A Collision Course? The Currency And Interest Rates: On A Collision Course? The Currency And Interest Rates: On A Collision Course? The dip in the Swedish krona has priced in a recession in the domestic economy. If a contraction does indeed occur, the impact on the currency is already a fait accompli. If it does not, the currency is poised for a coiled spring rebound. Fundamentally, the krona is cheap, and there is a dearth of SEK bulls, which is positive from a contrarian perspective. The Riksbank’s mandate is price stability. Given inflationary pressures and a weak currency, the Riksbank will have no choice but to turn more hawkish or lose credibility (Feature chart). There is potential for a brewing demand boom in Sweden – via refugees from Ukraine and Russia – that would increase government outlays and strengthen the need for higher rates. Admittedly, catalysts for SEK weakness remain in place – geopolitical tensions, rising energy costs and a stampede into safe-haven assets, including the dollar. Our strategy therefore is to buy on dips. We could be on the precipice of a capitulation phase that will present investors with an opportunity to accumulate the SEK at a fire-sale price. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/sek 10.15 2022-04-14 0.27 Bottom Line: Sweden is a small, open economy, very sensitive to global economic conditions. A recession is already priced by weakness in the SEK. Investors willing to tolerate volatility should buy the SEK on any further weakness. Feature Chart 1The SEK Tracks The DXY The SEK Tracks The DXY The SEK Tracks The DXY The Riksbank has been one of the more dovish central banks, both within the G10 and globally. Policy rates in Sweden are still at the zero bound, while they are rising in many other countries. In the Riksbank’s latest monetary policy report, domestic inflationary pressures were characterized as transitory. As such, the repo rate would not be raised until the second half of 2024.  The consequence of the Riksbank’s dovishness has been weakness in the Swedish krona, and a steep rise in inflation expectations. Most central banks are admitting that emergency policy settings are no longer appropriate in the current environment, especially after unprecedented monetary and fiscal stimulus. Yet, Sweden remains in the dovish camp. In this report, we argue that the Riksbank will have to raise rates sooner rather than later to maintain credibility and fend off inflationary pressures. The result of the Riksbank’s easy monetary policy has been the proliferation of massive carry trades, as investors sell the SEK and buy the dollar and/or other higher yielding currencies (Chart 1). As a small open economy, this could potentially unanchor longer-term inflation expectations, via a weak currency. Why Should The Riksbank Hike Rates? Chart 2The SEK Has Priced A Swedish Recession The SEK Has Priced A Swedish Recession The SEK Has Priced A Swedish Recession Sweden is likely to experience a technical recession in the coming quarters. The new orders-to-inventories ratio has contracted sharply, underscoring that the manufacturing sector will deflate (Chart 2). As a small, open economy, the manufacturing sector holds the key to the business cycle. Despite this, our bias is that the Riksbank will overlook the temporary dip in economic activity for the following reasons: The currency has already acted as a relief valve, which should cushion further downside in manufacturing activity (Chart 3). This is especially beneficial in a world where purchasing managers’ indices are declining everywhere. By the same token, the incentive for a central bank to raise rates when inflation is rising and the currency is more compelling, compared to a regime where a stronger currency tightens monetary conditions. Chart 4 shows that is weak is krona has been a fluid conduit for higher inflation in Sweden. A stronger krona will cap rising inflation expectations. Chart 3SEK Weakness Has Been A Welcome Relief Valve SEK Weakness Has Been A Welcome Relief Valve SEK Weakness Has Been A Welcome Relief Valve Chart 4SEK Weakness = High Imported Inflation SEK Weakness Equals High Imported Inflation SEK Weakness Equals High Imported Inflation It is remarkable that the traditional relationship between the SEK and oil prices (which is positive) has broken down (Chart 5). This is because rising oil prices usually reflect strong global demand, which benefits Sweden. This time around, a weak SEK is a tax on the economy as energy prices soar. Chart 5The Energy Shock To Sweden Has Been Unusual The Energy Shock To Sweden Has Been Unusual The Energy Shock To Sweden Has Been Unusual The Chinese credit impulse has bottomed, which is historically a good sign that Swedish central bankers can tolerate a stronger currency (Chart 6). Sweden’s biggest trade surplus is with the US, which in turn has the biggest trade deficit with China (Chart 7). As such, the relationship between the Swedish krona and the Chinese credit impulse is tightly knit. China’s zero COVID-19 policy is generating huge supply bottlenecks that are affecting inter-oceanic supply chains, but the pent-up demand once that ends could be tectonic. Chart 6The SEK Tracks The Chinese Credit Impulse The SEK Tracks The Chinese Credit Impulse The SEK Tracks The Chinese Credit Impulse Chart 7Sweden Needs The US And China Sweden Needs The US And China Sweden Needs The US And China The Riksbank’s mandate is to manage inflation expectations. Inflation is at 6%. The Riksbank’s own measure of resource utilization is at a level that has typically been associated with a much higher repo rate. The output gap is closing, raising the risk of a wage inflation spiral (Chart 8). Simply put, the Riksbank would have to raise interest rates or engender a crisis of confidence in monetary policy. Chart 8A Taylor Rule Approach Suggests Interest Rates Are Too Low A Taylor Rule Approach Suggests Interest Rates Are Too Low A Taylor Rule Approach Suggests Interest Rates Are Too Low Finally, house prices are surging to record highs, on the back of very low mortgage rates and extremely accommodative monetary policy (Chart 9). Chart 9Low Rates Have Led To A Debt Binge And Housing Boom Low Rates Have Led To A Debt Binge And Housing Boom Low Rates Have Led To A Debt Binge And Housing Boom A Potential Demand Boom The unemployment rate in Sweden remains above pre-pandemic levels. More importantly, it might rise in the coming quarters, but that would not be particularly worrisome. The reason is a potential increase in the labor dividend in Sweden, as new entrants increase the size of the labor force. First, the employment component of the manufacturing PMI index suggests employment growth should remain around 2% or so. There has been a tight correlation between employment growth in Sweden and the purchasing managers’ survey of the employment outlook (Chart 10). In our view, there is good reason to expect employment growth to remain resilient and in turn, stimulate demand. Related Report  Foreign Exchange StrategyThe Unsung Case For The Euro Sweden has a long history of openness towards immigration compared to many other European countries. If we go back to the Syrian crisis several years ago, the number of asylum seekers skyrocketed to over 160,000 or circa 1.5% of the total population (Chart 11). This was a huge labor dividend. This time around, migrants from both Ukraine and Russia will add to the skilled pool of domestic workers. Some estimates suggest there could be as many as 200,000 immigrants, just from the current crisis. This said, it will also increase frictional unemployment, as new migrants integrate into the labor force and adopt a new language. Chart 10Employment Is Holding Up In Sweden Employment Is Holding Up In Sweden Employment Is Holding Up In Sweden Chart 11There Is Potential For A Huge Labor Dividend There Is Potential For A Huge Labor Dividend There Is Potential For A Huge Labor Dividend Foreign-born workers have been rising as a share of the Swedish labor force and now constitute about 20% of the total population (Chart 12). This growth dividend will be reaped for years to come. With the Social Democrats in power, upside surprises to immigration numbers are within a reasonable confidence interval of outcomes. In a nutshell, Sweden enjoys a relatively positive demographic outlook (Chart 13). Chart 12Foreign Workers Are Important Foreign Workers Are Important Foreign Workers Are Important Chart 13Sweden Has A Demographic Dividend Sweden Has A Demographic Dividend Sweden Has A Demographic Dividend The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase of lower-paying jobs, there is still upward pressure on housing and consumption, notwithstanding a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 16.2%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. The difference this time is that inflation is surging, and the potential for cost-push pressures to translate into demand-pull inflation (via higher wages) is rising in Sweden. In our view, Governor Stefan Ingves will renormalize policy as quickly as possible, given that he is managing a small open economy with one of the cheapest currencies in the G10 universe, with a large footprint of imported inflation. Trading Strategy Chart 14The Riksbank Will Have To Raise Rates The Riksbank Will Have To Raise Rates The Riksbank Will Have To Raise Rates Our currency strategy is to buy the SEK on weakness. The recent dovish path by the ECB will mean that the Riksbank will tread very carefully in sounding too hawkish. However, every real-time indicator of its mandate suggests emergency policy settings are no longer necessary. Real rates are falling in Sweden relative to both the US and the euro area. As such, the SEK has not yet priced a shift in the Riksbank's policy setting. (Chart 14). This suggests that while the carry cost is high from being long the SEK at current levels, a capitulation phase will present investors with an opportunity to accumulate the SEK at a fire-sale price. As for Long EUR/SEK, the cross could overshoot, but will head lower on a 12–18-month horizon. Long SEK/CHF positions are also attractive.   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 The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Is A Recession Inevitable? Is A Recession Inevitable? Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones Is A Recession Inevitable? Is A Recession Inevitable? To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Is A Recession Inevitable? Is A Recession Inevitable? Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Is A Recession Inevitable? Is A Recession Inevitable? Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Image Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Is A Recession Inevitable? Is A Recession Inevitable? Special Trade Recommendations Current MacroQuant Model Scores Is A Recession Inevitable? Is A Recession Inevitable?

Executive Summary Macron Still Favored, But Le Pen Cannot Be Ruled Out Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron is still favored to win the French election but Le Pen’s odds are 45%. Le Pen would halt France’s neoliberal structural reforms, paralyze EU policymaking, and help Russia’s leverage in Ukraine. But she would lack legislative support and would not fatally wound the EU or NATO. European political risk will remain high in Germany, Italy, and Spain. Favor UK equities on a relative basis. Financial markets are complacent about Russian geopolitical risk again. Steer clear of eastern European assets. Do not bottom feed in Chinese stocks. China faces social unrest. North Korean geopolitical risk is back. Australia’s election is an opportunity, not a risk. Stay bullish on Latin America. Prefer Brazil over India. Stay negative on Turkey and Pakistan.   Trade Recommendation Inception Date Return TACTICALLY LONG US 10-YEAR TREASURY 2022-04-14   Bottom Line: Go long the US 10-year Treasury on geopolitical risk and near-term peak in inflation. Feature Last year we declared that European political risk had reached a bottom and had nowhere to go but up. Great power rivalry with Russia primarily drove this view but we also argued that our structural theme of populism and nationalism would feed into it. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War In other words, the triumph of the center-left political establishment in the aftermath of Covid-19 would be temporary. The narrow French presidential race highlights this trend. President Emmanuel Macron is still favored but Marine Le Pen, his far-right, anti-establishment opponent, could pull off an upset victory on April 24. The one thing investors can be sure of is that France’s ability to pursue neoliberal structural reforms will be limited even if Macron wins, since he will lack the mandate he received in 2017. Our GeoRisk Indicators this month suggest that global political trends are feeding into today’s stagflationary macroeconomic context. Market Complacent About Russia Again Global financial markets are becoming complacent about European security once again. Markets have begun to price a slightly lower geopolitical risk for Russia after it withdrew military forces from around Kyiv in an open admission that it failed to overthrow the government. However, western sanctions are rising, not falling, and Russia’s retreat from Kyiv means it will need to be more aggressive in the south and east (Chart 1). Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia has not achieved its core aim of a militarily neutral Ukraine – so it will escalate the military effort to achieve its aim. Any military failure in the east and south would humiliate the Putin regime and make it more unpredictable and dangerous. The West has doubled down on providing Ukraine with arms and hitting Russia with sanctions (e.g. imposing a ban on Russian coal). Germany prevented an overnight ban on Russian oil and natural gas imports but the EU is diversifying away from Russian energy rapidly. Sanctions that eat away at Russia’s export revenues will force it to take a more aggressive posture now, to achieve a favorable ceasefire before funding runs out. Sweden and Finland are reviewing whether to join NATO, with recommendations due by June. Russia will rattle sabers to underscore its red line against NATO enlargement and will continue to threaten “serious military-political repercussions” if these states try to join. We would guess they would remain neutral as a decision to join NATO could lead to a larger war. Bottom Line: Global equities will remain volatile due to a second phase of the war and potential Russian threats against Ukraine’s backers. European equities and currency, especially in emerging Europe, will suffer a persistent risk premium until a ceasefire is concluded. What If Le Pen Wins In France? By contrast with the war in Ukraine, the French election is a short-term source of political risk. A surprise Le Pen victory would shake up the European political establishment but investors should bear in mind that it would not revolutionize the continent or the world, as Le Pen’s powers would be limited. Unlike President Trump in 2017, she would not take office with her party gaining full control of the legislature. Le Pen rallied into the first round of the election on April 10, garnering 23% of the vote, up from 21% in 2017. This is not a huge increase in support but her odds of winning this time are much better than in 2017 because the country has suffered a series of material shocks to its stability. Voters are less enthusiastic about President Macron and his centrist political platform. Macron, the favorite of the political establishment, received 28% of the first-round vote, up from 24% in 2017. Thus he cannot be said to have disappointed expectations, though he is vulnerable. The euro remains weak against the dollar and unlikely to rally until Russian geopolitical risk and French political risk are decided. The market is not fully pricing French risk as things stand (Chart 2). Chart 2France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator The first-round election results show mixed trends. The political establishment suffered but so did the right-wing parties (Table 1). The main explanation is that left-wing, anti-establishment candidate Jean-Luc Mélenchon beat expectations while the center-right Republicans collapsed. Macron is leading Le Pen by only five percentage points in the second-round opinion polling as we go to press (Chart 3). Macron has maintained this gap throughout the race so far and both candidates are very well known to voters. But Le Pen demonstrated significant momentum in the first round and momentum should never be underestimated. Table 1Results Of France’s First-Round Election Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​​ Chart 3French Election: Macron Maintains Lead French Election: Macron Maintains Lead French Election: Macron Maintains Lead ​​​​​​ Are the polls accurate? Anti-establishment candidates outperformed their polling by 7 percentage points in the first round. Macron, the right-wing candidates, and the pro-establishment candidates all underperformed their March and April polls (Chart 4). Hence investors should expect polls to underrate Le Pen in the second round. Chart 4French Polls Fairly Accurate Versus First-Round Results Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Given the above points, it is critical to determine which candidate will gather the most support from voters whose first preference got knocked out in the first round. The strength of anti-establishment feeling means that the incumbent is vulnerable while ideological camps may not be as predictable as usual. Mélenchon has asked his voters not to give a single vote to Le Pen but he has not endorsed Macron. About 21% of his supporters say they will vote for Le Pen. Only a little more of them said they would vote for Macron, at 27% (Chart 5). Chart 5To Whom Will Voters Drift? Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Diagram 1, courtesy of our European Investment Strategy, illustrates that Macron is favored in both scenarios but Le Pen comes within striking distance under certain conservative assumptions about vote switching. Diagram 1Extrapolating France’s First-Round Election To The Second Round Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron’s approval rating has improved since the pandemic. This is unlike the situation in other liberal democracies (Chart 6). Chart 6Macron Handled Pandemic Reasonably Well Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The pandemic is fading and the economy reviving. Unemployment has fallen from 8.9% to 7.4% over the course of the pandemic. Real wage growth, at 5.8%, is higher than the 3.3% that prevailed when Macron took office in 2017 (Chart 7). Chart 7Real Wages A Boon For Macron Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) But these positives do not rule out a Le Pen surprise. The nation has suffered not one but a series of historic shocks – the pandemic, inflation, and the war in Ukraine. Inflation is rising at 5.1%, pushing the “Misery Index” (inflation plus unemployment) to 12%, higher than when Macron took office, even if lower than the EU average (Chart 8). Chart 8Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron   Le Pen has moderated her populist message and rebranded her party in recent years to better align with the median French voter. She claims that she will not pursue a withdrawal from the European Union or the Euro Area currency union. This puts her on the right side of the one issue that disqualified her from the presidency in the past. Yet French trust in the EU is declining markedly, which suggests that Le Pen is in step with the median voter on wanting greater French autonomy (Chart 9). Le Pen’s well-known sympathy toward Vladimir Putin and Russia is a liability in the context of Russian aggression in Ukraine. Only 35% of French people had a positive opinion of Russia back in 2019, whereas 50% had a favorable view of NATO, and the gap has likely grown as a result of the invasion (Chart 10). However, the historic bout of inflation suggests that economic policy could be the most salient issue for voters rather than foreign policy. Chart 9Le Pen Only Electable Because She Accepted Europe Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Chart 10Le Pen’s NATO Stance Not Disqualifying Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Le Pen’s economic platform is fiscally liberal and protectionist, which will appeal to voters upset over the rising cost of living and pressures of globalization. She wants to cut the income tax and value-added tax, while reversing Macron’s attempt at raising the retirement age and reforming the pension system. France’s tax rates on income, and on gasoline and diesel, are higher than the OECD average. In other words, Macron is running on painful structural reform while Le Pen is running on fiscal largesse. This is another reason to take seriously the risk of a Le Pen victory. What should investors expect if Le Pen pulls off an upset? France’s attempt at neoliberal structural reforms would grind to a halt. While Le Pen may not be able to pass domestic legislation, she would be able to halt the implementation of Macron’s reforms. Productivity and the fiscal outlook would suffer. Le Pen’s ability to change domestic policy will be limited by the National Assembly, which is due for elections from June 12-19. Her party, the National Rally (formerly the Front National), has never won more than 20% of local elections and performed poorly in the 2017 legislative vote. Investors should wait to see the results of the legislative election before drawing any conclusions about Le Pen’s ability to change domestic policy. France’s foreign policy would diverge from Europe’s. If Le Pen takes the presidency, she will put France at odds with Brussels, Berlin, and Washington, in much the same way that President Trump did. She would paralyze European policymaking. Yet Le Pen alone cannot take France out of the EU. The French public’s negative view of the EU is not the same as a majority desire to leave the bloc – and support for the euro currency stands at 69%. Le Pen does not have the support for “Frexit,” French exit from the EU. Moreover European states face immense pressures to work together in the context of global Great Power Rivalry. Independently they are small compared to the US, Russia, and China. Hence the EU will continue to consolidate as a geopolitical entity over the long run. Russia, however, would benefit from Le Pen’s presidency in the context of Ukraine ceasefire talks. EU sanctions efforts would freeze in place. Le Pen could try to take France out of NATO, though she would face extreme opposition from the military and political establishment. If she succeeded on her own executive authority, the result would be a division among NATO’s ranks in the face of Russia. This cannot be ruled out: if the US and Russia are fighting a new Cold War, then it is not unfathomable that France would revert to its Cold War posture of strategic independence. However, while France withdrew from NATO’s integrated military command from 1966-2009, it never withdrew fully from the alliance and was always still implicated in mutual defense. In today’s context, NATO’s deterrent capability would not be much diminished but Le Pen’s administration would be isolated. Russia would be unable to give any material support to France’s economy or national defense. Bottom Line: Macron is still favored for re-election but investors should upgrade Le Pen’s chances to a subjective 45%. If she wins, the euro will suffer a temporary pullback and French government bond spreads will widen over German bunds. The medium-term view on French equities and bonds will depend on her political capability, which depends on the outcome of the legislative election from June 12-19. She will likely be stymied at home and only capable of tinkering with foreign policy. But if she has legislative support, her agenda is fiscally stimulative and would produce a short-term sugar high for French corporate earnings. However, it would be negative for long-term productivity. UK, Italy, Spain: Who Else Faces Populism? Chart 11Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Between Russian geopolitical risk and French political risk, other European countries are likely to see their own geopolitical risk premium rise (Chart 11). But these countries have their own domestic political dynamics that contribute to the reemergence of European political risk. Germany’s domestic political risk is relatively low but it faces continued geopolitical risk in the form of Russia tensions, China’s faltering economy, and potentially French populism (Chart 11, top panel). In Italy, the national unity coalition that took shape under Prime Minister Mario Draghi was an expedient undertaken in the face of the pandemic. As the pandemic fades, a backlash will take shape among the large group of voters who oppose the EU and Italian political establishment. The Italian establishment has distributed the EU recovery funds and secured the Italian presidency as a check on future populist governments. But it may not be able to do more than that before the next general election in June 2023, which means that populism will reemerge and increase the political risk premium in Italian assets going forward (Chart 11, second panel). Spain is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023. However, the conservative People’s Party, the chief opposition party, has suffered from renewed infighting, which gives temporary relief to the ruling Socialist Worker’s Party of Prime Minister Pedro Sanchez. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for the People’s Party’s new leadership and a test run for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The risk for Sanchez and the Socialists is that the opposition has a strong popular base and this fact combined with the stagflationary backdrop will keep political polarization high and undermine the government’s staying power (Chart 11, third panel). While Prime Minister Boris Johnson has survived the scandal over attending social events during Covid lockdowns, as we expected, nevertheless the Labour Party is starting to make a comeback that will gain momentum ahead of the 2024 general election. Labour is unlikely to embrace fiscal austerity or attempt to reverse Brexit anytime soon. Hence the UK’s inflationary backdrop will persist (Chart 11, fourth panel). Bottom Line: European political risk has bottomed and will rise in the coming months and years, although the EU and Eurozone will survive. We still favor UK equities over developed market equities (excluding the US) because they are heavily tilted toward consumer staples and energy sectors. Stay long GBP-CZK. Favor European defense stocks over tech. Prefer Spanish stocks over Italian. China: Social Unrest More Likely China’s historic confluence of internal and external risks continues – and hence it is too soon for global investors to try to bottom-feed on Chinese investable equities (Chart 12). A tactical opportunity might emerge for non-US investors in 2023 but now is not the right time to buy. Chart 12China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator In domestic politics, the reversion to autocracy under Xi is exacerbating the economic slowdown. True, Beijing is stimulating the economy by means of its traditional monetary and fiscal tools. The latest data show that the total social financing impulse is reviving, primarily on the back of local government bonds (Chart 13). Yet overall social financing is weaker because private sector sentiment remains downbeat. The government is pursuing excessively stringent social restrictions in the face of the pandemic. Beijing is doubling down on “Covid Zero” policy by locking down massive cities such as Shanghai. The restrictions will fail to prevent the virus from spreading. They are likely to engender social unrest, which we flagged as our top “Black Swan” risk this year and is looking more likely. Lockdowns will also obstruct production and global supply chains, pushing up global goods inflation. Meanwhile the property sector continues to slump on the back of weak domestic demand, large debt levels, excess capacity, regulatory scrutiny, and negative sentiment. Consumer borrowing appetite and general animal spirits are weak in the face of the pandemic and repressive political environment (Chart 14). Chart 13China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived ​​​​​​ Chart 14Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering ​​​​​​ Hence China will be exporting slow growth and inflation – stagflation – to the rest of the world until after the party congress. At that point President Xi will feel politically secure enough to “let 100 flowers bloom” and try to improve economic sentiment at home and abroad. This will be a temporary phenomenon (as were the original 100 flowers under Chairman Mao) but it will be notable for 2023. In foreign politics, Russia’s attack on Ukraine has accelerated the process of Russo-Chinese alliance formation. This partnership will hasten US containment strategy toward China and impose a much faster economic transition on China as it pursues self-sufficiency. The result will be a revival of US-China tensions. The implications are negative for the rest of Asia Pacific: Taiwanese geopolitical risk will continue rising for reasons we have outlined in previous reports. In addition, Taiwanese equities are finally starting to fall off from the pandemic-induced semiconductor rally (Chart 15). The US and others are also pursuing semiconductor supply security, which will reduce Taiwan’s comparative advantage. Chart 15Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator South Korea faces paralysis and rising tensions with North Korea. The presidential election on May 9 brought the conservatives back into the Blue House. The conservative People Power Party’s candidate, Yoon Suk-yeol, eked out a narrow victory that leaves him without much political capital. His hands are also tied by the National Assembly, at least for the next two years. He will attempt to reorient South Korean foreign policy toward the US alliance and away from China. He will walk away from the “Moonshine” policy of engagement with North Korea, which yielded no fruit over the past five years. North Korea has responded by threatening a nuclear missile test, restarting intercontinental ballistic missile tests for the first time since 2017, and adopting a more aggressive nuclear deterrence policy in which any South Korean attack will ostensibly be punished by a massive nuclear strike. Tensions on the peninsula are set to rise (Chart 16). Three US aircraft carrier groups are around Japan today, despite the war in Europe (where two are placed), suggesting high threat levels. Chart 16South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator Australia’s elections present opportunity rather than risk. Prime Minister Scott Morrison formally scheduled them for May 21. The Australian Labor Party is leading in public opinion and will perform well. The election threatens a change of parties but not a drastic change in national policy – populist parties are weak. No major improvement in China relations should be expected. Any temporary improvement, as with the Biden administration, will be subject to reversal due to China’s long-term challenge to the liberal international order. Cyclically the Australian dollar and equities stand to benefit from the global commodity upcycle as well as relative geopolitical security due to American security guarantees (Chart 17). Chart 17Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Bottom Line: China’s reversion to autocracy will keep global sentiment negative on Chinese equities until 2023 at earliest. Stay short the renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Look favorably on the Australian dollar. Turkey, South Africa, And … Canada Turkish geopolitical risk will remain elevated in the context of a rampant Russia, NATO’s revival and tensions with Russia, the threat of commerce destruction and accidents in the Black Sea region, domestic economic mismanagement, foreign military adventures, and the threat posed to the aging Erdogan regime by the political opposition in the wake of the pandemic and the lead-up to the 2023 elections (Chart 18). Chart 18Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator While we are tactically bullish on South African equities and currency, we expect South African political risk to rise steadily into the 2024 general election. Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have been lifted and the national state of disaster has ended, which has helped quell social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs (Chart 19). While fiscal austerity is under way in South Africa, we have argued that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Thus South Africa benefits tactically from commodity prices but cyclically the currency is vulnerable. Chart 19South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Canadian political risk will rise but that should not deter investors from favoring Canadian assets that are not exposed to the property bubble. Prime Minister Justin Trudeau has had a net negative approval rating since early 2021 and his government is losing political capital due to inflation, social unrest, and rising difficulties with housing affordability (Chart 20). While he does not face an election until 2025, the Conservative Party is developing more effective messaging. Chart 20Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator India Will Stay Neutral But Lean Toward The West Chart 21Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) US President Joe Biden has openly expressed his administration’s displeasure regarding India’s response to Russia’s invasion of Ukraine. This has led many to question the strength of Indo-US relations and the direction of India’s geopolitical alignments. To complicate matters, China’s overtures towards India have turned positive lately, leading clients to ask if a realignment in Indo-China relations is nigh. To accurately assess India’s long-term geopolitical propensities, it is important to draw a distinction between ‘cyclical’ and ‘structural’ dynamics that are at play today. Such a distinction yields crystal-clear answers about India’s strategic geopolitical leanings. In specific: Indo-US Relations Will Strengthen On A Strategic Horizon: As the US’s and China’s grand strategies collide, minor and major geopolitical earthquakes are bound to take place in South Asia and the Indo-Pacific. Against this backdrop, India will strategically align with the US to strengthen its hand in the region (Chart 21). While the Russo-Ukrainian war is a major global geopolitical event, for India this is a side-show at best. True, India will retain aspects of its historic good relations with Russia. Yet countering China’s encirclement of India is a far more fundamental concern for India. Since Russia has broken with Europe, and China cannot reject Russia’s alliance, India will gradually align with the US and its allies. India And China Will End Up As A Conflicting Dyad: Strategic conflict between the two Asian powers is likely because China’s naval development and its Eurasian strategy threaten India’s national security and geopolitical imperatives, while India’s alliances are adding to China’s distrust of India. Thus any improvement in Sino-Indian diplomatic relations will be short-lived. The US will constantly provide leeway for India in its attempts to court India as a key player in the containment strategy against China. The US and its allies are the premier maritime powers and upholders of the liberal world order – India serves its national interest better by joining them rather than joining China in a risky attempt to confront the US navy and revolutionize the world order. Indo-Russian Relations Are Bound To Fade In The Long Run: India will lean towards the US over the next few years for reasons of security and economics. But India’s movement into America’s sphere of influence will be slow – and that is by design. India is testing waters with America through networks like the Quadrilateral Dialogue. It sees its historic relationship with Russia as a matter of necessity in the short run and a useful diversification strategy in the long run. True, India will maintain a trading relationship with Russia for defense goods and cheap oil. But this trade will be transactional and is not reason enough for India to join Russia and China in opposing US global leadership. While these factors will mean that Indo-Russian relations are amicable over a cyclical horizon, this relationship is bound to fade over a strategic horizon as China and Russia grow closer and the US pursues its grand strategy of countering China and Russia. Bottom Line: India may appear to be neutral about the Russo-Ukrainian war but India will shed its historical stance of neutrality and veer towards America’s sphere of influence on a strategic timeframe. India is fully aware of its strategic importance to both the American camp and the Russo-Chinese camp. It thus has the luxury of making its leanings explicit after extracting most from both sides. Long Brazil / Short India Brazil’s equity markets have been on a tear. MSCI Brazil has outperformed MSCI EM by 49% in 2022 YTD. Brazil’s markets have done well because Brazil is a commodity exporter and the war in Ukraine has little bearing on faraway Latin America. This rally will have legs although Brazil’s political risks will likely pick back up in advance of the election (Chart 22). The reduction in Brazil’s geopolitical risk so far this year has been driven mainly by the fact that the currency has bounced on the surge in commodity prices. In addition, former President Lula da Silva is the current favorite to win the 2022 presidential elections – Lula is a known quantity and not repugnant to global financial institutions (Chart 23). Chart 22Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Chart 23Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Whilst there is no denying that the first-round effects of the Ukraine war have been positive for Brazil, there is a need to watch out for the second-round effects of the war as Latin America’s largest economy heads towards elections. Surging prices will affect two key constituencies in Brazil: consumers and farmers. Consumer price inflation in Brazil has been ascendant and adding to Brazil’s median voter’s economic miseries. Rising inflation will thus undermine President Jair Bolsonaro’s re-election prospects further. The fact that energy prices are a potent polling issue is evinced by the fact that Bolsonaro recently sacked the chief executive of Petrobras (i.e. Brazil’s largest listed company) over rising fuel costs. Furthermore, Brazil is a leading exporter of farm produce and hence also a large importer of fertilizers. Fertilizer prices have surged since the war broke out. This is problematic for Brazil since Russia and Belarus account for a lion’s share of Brazil’s fertilizer imports. Much like inflation in general, the surge in fertilizer prices will affect the elections because some of the regions that support Bolsonaro also happen to be regions whose reliance on agriculture is meaningful (Map 1). They will suffer from higher input prices. Map 1States That Supported Bolso, Could Be Affected By Fertilizer Price Surge Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Chart 24Long Brazil Financials / Short India Long Brazil Financials / Short India Long Brazil Financials / Short India Given that Bolsonaro continues to lag Lula on popularity ratings – and given the adverse effect that higher commodity prices will have on Brazil’s voters – we expect Bolsonaro to resort to fiscal populism or attacks on Brazil’s institutions in a last-ditch effort to cling to power. He could even be emboldened by the fact that Sérgio Moro, the former judge and corruption fighter, decided to pull out of the presidential race. This could provide a fillip to Bolso’s popularity. Bottom Line: Brazil currently offers a buying opportunity owing to attractive valuations and high commodity prices. But investors should stay wary of latent political risks in Brazil, which could manifest themselves as presidential elections draw closer. We urge investors to take-on only selective tactical exposure in Brazil for now. Equities appear cheap but political and macro risks abound. To play the rally yet stave off political risk, we suggest a tactical pair trade: Long Brazil Financials / Short India (Chart 24). Whilst we remain constructive on India on a strategic horizon, for the next 12 months we worry about near-term macro and geopolitical headwinds as well as India’s rich valuations. Don’t Buy Into Pakistan’s Government Change Chart 25Pakistan’s Military Is Unusually Influential Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The newest phase in Pakistan’s endless cycle of political instability has begun. Prime Minister Imran Khan has been ousted. A new coalition government and a new prime minister, Shehbaz Sharif, have assumed power. Prime Minister Sharif’s appointment may make it appear like risks imposed by Pakistan have abated. After all, Sharif is seen as a good administrator and has signaled an interest in mending ties with India. But despite the appearance of a regime change, geopolitical risks imposed by Pakistan remain intact for three sets of reasons: Military Is Still In Charge: Pakistan’s military has been and remains the primary power center in the country (Chart 25). Former Prime Minister Khan’s rise to power was possible owing to the military’s support and he fell for the same reason. Since the military influences the civil administration as well as foreign policy, a lasting improvement in Indo-Pak relations is highly unlikely. Risk Of “Rally Round The Flag” Diversion: General elections are due in Pakistan by October 2023. Sharif is acutely aware of the stiff competition he will face at these elections. His competitors exist outside as well as inside his government. One such contender is Bilawal Bhutto-Zardari of the Pakistan People’s Party (PPP), which is a key coalition partner of the new government that assumed power. Imran Khan himself is still popular and will plot to return to power. Against such a backdrop the newly elected PM is highly unlikely to pursue an improvement in Indo-Pak relations. Such a strategy will adversely affect his popularity and may also upset the military. Hence we highlight the risk of the February 2021 Indo-Pak ceasefire being violated in the run up to Pakistan’s general elections. India’s government has no reason to prevent tensions, given its own political calculations and the benefits of nationalism. Internal Social Instability Poor: Pakistan is young but the country can be likened to a social tinderbox. Many poor youths, a weak economy, and inadequate political valves to release social tensions make for an explosive combination. Pakistan remains a source of geopolitical risk for the South Asian region. Some clients have inquired as to whether the change of government in Pakistan implies closer relations with the United States. The US has less need for Pakistan now that it has withdrawn from Afghanistan. It is focused on countering Russia and China. As such the US has great need of courting India and less need of courting Pakistan. Pakistan will remain China’s ally and will struggle to retain significant US assistance. Bottom Line: We remain strategic sellers of Pakistani equities. Pakistan must contend with high internal social instability, a weak democracy, a weak economy and an unusually influential military. As long as the military remains excessively influential in Pakistan, its foreign policy stance towards India will stay hostile. Yet the military will remain influential because Pakistan exists in a permanent geopolitical competition with India. And until Pakistan’s economy improves structurally and endemically, its alliance with China will stay strong. Investment Takeaways Cyclically go long US 10-year Treasuries. Geopolitical risks are historically high and rising but complacency is returning to markets. Meanwhile inflation is nearing a cyclical peak. Favor US stocks over global. It is too soon to go long euro or European assets, especially emerging Europe. Favor UK equities over developed markets (excluding the US). Stay long GBP-CZK. Favor European defense stocks over European tech. Stay short the Chinese renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. 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