Policy

Executive Summary Fed officials maintained the drumbeat of hawkish commentary last week, reiterating their commitment to use the full might of their tools to bring inflation to heel. Stock and bond markets reacted adversely when dovish Governor Brainard joined the chorus, but no one should have been surprised. The FOMC is unanimous in its resolve to combat inflation before long-run expectations become unmoored. Markets may also have been discomfited by the coming shrinking of the Fed’s balance sheet. Though balance sheet runoff should exert some modest upward pressure on bond yields, we do not expect markets to dwell on it for long. Housing activity is squarely in the crosshairs of tighter monetary policy. Mortgage rates are extremely low relative to history, however, and homes remain quite affordable. We expect the housing market will weather the backup in rates. A plucky band of first-time organizers spurred workers in a New York City Amazon warehouse to vote to form a union. Labor advocates rejoiced, but it is premature to mark the event as a turning point for organized labor. What Goes Up Must Come Down What Goes Up Must Come Down What Goes Up Must Come Down Bottom Line: Last week’s Fed “news” was not particularly newsworthy. The FOMC will prioritize its inflation mandate over its full employment mandate until further notice, but the economy is well suited to withstand higher rates and even the housing market won’t buckle in the face of them. Feature Just when you thought it was safe to go back in the water, Fed speakers roiled rates markets again last week, pushing the 10-year Treasury yield over 2.6% for the first time in three years. Although Fed Governor Brainard was simply lining up behind every other governor and district president who’s been in range of a microphone over the last several weeks, her tough talk on inflation in a Tuesday morning speech jolted the 10-year yield 10 basis points (bps) higher, from 2.45% to 2.55%, and it tacked on another 10 bps overnight, hitting 2.65% as New York-based fixed income traders switched on their terminals Wednesday morning. Stocks tumbled after Brainard’s remarks, as well, with the S&P 500 shedding 1% in back-to-back sessions. Both markets got a respite after the March FOMC meeting minutes contained no further revelations but the 10-year yield marched to 2.70% on Friday. The market action demonstrated that investors remain on edge, despite the S&P 500’s 10% bounce. From our perspective, there was nothing too notable in Brainard’s comments. She may be seen as one of the more reliably dovish members of the FOMC, but Chair Powell has been at pains to stress that the entire committee is “determin[ed],” as the minutes put it, “to take the measures necessary to restore price stability.” With inflation readings persisting well above the FOMC’s target level, one participant after another has hammered home the message in speeches and interviews that the committee is unanimously resolved to wield its tools to bring it to heel. Related Report  US Investment StrategyIt All Depends On Whom You Ask Hiking the fed funds rate is the committee’s foremost weapon in the fight against inflation, and it has guided investors to discount a more rapid pace of 2022 increases and a modestly higher end point for this tightening cycle. We think the fixed income market is underestimating the terminal, or peak, rate but expect that it will require hard evidence before it reassesses its conviction that the economy cannot withstand a fed funds rate above 2.5%. It will take time to gather that evidence, as it won’t be available until the funds rate is at least 2%, so we expect that the 10-year yield will soon peak in tandem with inflation, but investors are especially uncertain and volatile financial markets reflect it. The FOMC can also adjust the size of its balance sheet to regulate the stimulus it’s providing to the economy. This tool pales in importance relative to the funds rate and despite Ben Bernanke’s smug remark at BCA’s 2015 conference that “quantitative easing works in practice but not in theory,” definitive evidence of its effects remains elusive. We therefore do not expect that curtailing reinvestment of principal repayments from the Fed’s stockpile of securities holdings will have a meaningful direct effect on the economy. Last week’s guidance that the runoff will be faster than it was in 2018-19 makes sense, given that the Fed’s securities holdings are twice as large (Chart 1), and that flush households and businesses are in markedly better shape than they were in the aftermath of the crisis. Chart 1The Funds Rate Matters More Than The Size Of The Balance Sheet The Funds Rate Matters More Than The Size Of The Balance Sheet The Funds Rate Matters More Than The Size Of The Balance Sheet There is no settled consensus on what the Fed’s balance sheet reduction will mean for the economy and markets. The US Investment Strategy view is that asset purchases are mainly a signaling device; they let economic participants and investors know that zero interest rate policy will remain in place until some period after they end. Balance sheet runoff doesn’t provide any similar information about the future; it simply indicates that the FOMC will be pursuing a supplemental stimulus reduction measure alongside its far more influential increases in short rates. Removing a price-insensitive buyer from the marketplace should put modest upward pressure on interest rates because they should have to rise, all else equal, to induce other buyers to step in to replace it. We expect, therefore, that the runoff will tighten financial conditions at the margin and exert a modest drag on economic activity. Some of that marginal tightening must have already occurred, as the Fed has taken pains to telegraph the balance sheet runoff, but it will likely contribute to volatility as markets try to settle on the proper outcome to discount. What About Housing? Interest rates affect the entire economy, but housing is the most rate-sensitive industry. Houses are the ultimate big-ticket items – they are the most expensive purchase most households will make and nearly all of them are financed via mortgages. Demand for single-family housing, away from the post-GFC phenomenon of investment buyers paying cash, is acutely sensitive to interest rates. The tide of available buyers ebbs and flows as monthly mortgage payments rise and fall. The housing market therefore finds itself in the crosshairs of the Fed’s tough talk about inflation and the homebuilder stocks have been demolished so far this year, losing a third of their value to lag every other subindustry group in the S&P 500 except closely related home furnishings (Chart 2). The stock rout contrasts with the upbeat housing market outlook we offered two months ago. Though we acknowledge that housing’s prospects have dimmed somewhat since mid-to-late February, we remain more optimistic than the consensus and are confident that a pronounced slowdown is not in store. Chart 2A Brutal Selloff ... A Brutal Selloff ... A Brutal Selloff ... The subsequent 75-bps surge in Freddie Mac’s national 30-year fixed-rate mortgage proxy (Chart 3, middle panel) has made homes less affordable for the median buyer (Chart 3, top panel). The drop in affordability has been modest, however, as it has been cushioned by a narrowing of the gap between median income and median home prices (Chart 3, bottom panel). Despite the last two months’ dip, homes remain quite affordable relative to history. Chart 3... Despite Solid Affordability ... Despite Solid Affordability ... Despite Solid Affordability ​​​​​ Since its predecessor index began in 1971, affordability had only ever surpassed the 140 level that has marked the bottom of the post-crisis range for a brief period in the early seventies (Chart 4, top panel). While mortgage rates are clearly moving in the wrong direction, they remain extremely low. One must squint to register their current advance in the context of the series’ entire history (Chart 4, third panel). Despite rising rates, median income gains have kept the mortgage servicing burden steady – and historically light – for several months (Chart 4, second panel). Though we expect that mortgage rates will stop vaulting upward and possibly even retrace some of their advance as inflation peaks, their recent move has been unfriendly to the housing market. Viewed from the perspective of the National Association of Realtors’ affordability index, however, their level remains quite favorable, and we do not worry that great swaths of would-be buyers are going to be shut out of the market. The respondents to the NAHB’s homebuilder sentiment survey agree. While the forward sales component swooned by ten points from January to February (Chart 5, bottom panel), current sales largely kept pace (Chart 5, second panel) and potential buyer traffic rose (Chart 5, third panel). The overall index slipped a bit since January but – stop us if you’ve heard this before – remains very strong relative to history (Chart 5, top panel). Chart 4The American Dream Is Not Out Of Reach The American Dream Is Not Out Of Reach The American Dream Is Not Out Of Reach ​​​​​​ Chart 5Homebuilders See Clear Skies Ahead ... Homebuilders See Clear Skies Ahead ... Homebuilders See Clear Skies Ahead ... ​​​​​ Though demand has surely waned, as rising rates sideline some marginal buyers, we expect it will remain robust, especially as the sizzling rental market offers little relief. Supplies of new and existing homes remain constrained. Restrictive zoning laws, sporadically soaring input costs, supply chain issues and difficulty finding skilled workers have hampered new home construction. Inventories of existing homes remain historically depleted (Chart 6, middle panel) and the share of homes that are vacant remains at all-time lows (Chart 6, bottom panel). Chart 6... As Their Product Is In Short Supply ... As Their Product Is In Short Supply ... As Their Product Is In Short Supply ​​​​​​ Chart 7Real Mortgage Rates Are Not A Problem Real Mortgage Rates Are Not A Problem Real Mortgage Rates Are Not A Problem ​​​​​​ The bottom line is that the housing picture has worsened somewhat but we still believe conditions are better than the gloomy consensus perception. Construction and sales activity will surprise to the upside over the rest of the year and residential investment will augment economic activity, not detract from it. Although the ITB homebuilder ETF has been a drag on performance since we added it to our cyclical ETF portfolio last month, we will continue to hold it as a pure play on the resilience of domestic demand. It is hard to see demand evaporating in the fashion implied by the homebuilders’ skid when real mortgage rates are at such extreme lows, no matter how they are adjusted for inflation (Chart 7). David Wins A Round Against Goliath Workers at a fulfillment center in Staten Island voted two weeks ago to become the first domestic Amazon employees to form a union. The vote, along with a concurrent re-vote at a Bessemer, Alabama warehouse that union organizers lost, was closely watched by labor relations experts. Amazon is the second-largest private employer in the US, with more than a million employees, and its size and reputedly trying working conditions make it an especially appealing target for unions. Labor advocates were quick to characterize the vote as a watershed moment, but it is far too early to call an inflection point. The outcome of the Amazon vote was front-page news because it was so improbable. Despite a cyclically favorable labor market, wage earners trying to unionize confront a gaping structural resource disparity with multinational companies. The fledgling Amazon Labor Union’s (ALU) victory in Staten Island was startling but it still faces an arduous climb to bring Amazon to the negotiating table and work out a contract agreement. Amazon will be able to introduce delays at every step of the process, eroding ALU’s meager resources while pursuing a strategy of running out the clock on the current labor-friendly administration. One of the key takeaways from our January-February 2020 Special Reports on US labor relations history was that employees are only to achieve gains when the government – courts, legislatures and the executive branch – does not favor employers. The series of reports were meant to alert investors to the possibility that Democratic wins in the 2020 election could send the pendulum swinging back in employees’ favor after 40 years of tilting toward employers, carrying important implications for corporate profit margins and inflation. Chart 8The Tortoise And The Hare The Tortoise And The Hare The Tortoise And The Hare The election did mark a change in the White House’s attitude toward labor, installing the self-declared “most pro-union president leading the most pro-union administration in American history.1” Since President Biden took office, the National Labor Relations Board has forcefully asserted itself in its role as the official referee of union elections to the point that Amazon has accused it of taking the unions’ side instead of serving as a neutral arbiter. The president himself would seem to have been taking sides last week when he took the rare step of calling out Amazon by name during remarks to a group of unionized workers. “The choice to join a union belongs to workers alone,” he said. “By the way, Amazon, here we come. Watch.” The White House press secretary quickly walked back the comments, placing them in the context of the president’s established support for unionization and collective bargaining. “What he was not doing is sending a message that he or the U.S. government would be directly involved in any of these efforts or take any direct action.2” Regardless of whether President Biden was attempting to send a message or had ventured off-topic as is his wont, it is unclear how much his administration can do to tilt the scales in workers’ favor. New Deal-era laws endowed workers with the right to organize and employers are not allowed to obstruct their efforts to do so. There are multiple gray areas in union election campaigns, however, and employers regularly deploy a wide range of actions that are not explicitly prohibited to keep unions out of their workplace. Most importantly, this administration may only be in charge until January 2025. It can use the NLRB, OSHA, the Department of Labor and the Department of Justice to try to advance workers’ cause for four years but labor has been on the back foot for four decades. It is likely to lose its legislative majorities in November’s midterms, the federal bench is populated by a majority of judges disposed to see things from employers’ point of view and many state legislatures are markedly anti-union. Without another term, the jury is out on the administration’s ability to effect durable change. The takeaway for investors is that a wage-price spiral has not yet taken hold and our bet is that it won’t. The tight labor market has endowed workers with more leverage than they’ve had in many cycles, but structurally the labor relations landscape bears more characteristics of the Reagan Era (1980-2020) than the New Deal Era (1933-1980). Real average hourly earnings have risen since the pandemic arrived in the US (Chart 8, top panel), but we find it telling that all of the real wage growth occurred in the first year of the pandemic. Across Year 2, nominal wages have failed to keep up with consumer price inflation (Chart 8, bottom panel), despite White House support in the midst of a labor market so tight that it squeaks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Remarks by President Biden in Honor of Labor Unions | The White House Accessed April 7, 2022. 2     Biden Appears to Show Support for Amazon Workers Who Voted to Unionize - The New York Times (nytimes.com) Accessed April 7, 2022.

Executive Summary The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%.  Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Month In Review: A Continued Hawkish Shift Month In Review: A Continued Hawkish Shift Chart 2The Dollar Has Broken Above Overhead ##br##Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The Case For More Tightening The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire.  More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18.  The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears Too Many Yen Bears Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report  Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128.  British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The Case For A Hawkish BoE The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term.    Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The RBA Will Stay Patient The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year.  New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10.  The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon.          Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The BoC Will Hike Next Week The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around.  Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84.   Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world.  In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels.   Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind NOK Has A Policy Tailwind NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December.  Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK.   Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term.    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 Ukraine war reinforces our key view that commodity producers will use their geopolitical leverage this year. The market is growing complacent again about Russian risks. Iran is part of the same dynamic. If US-Iran talks fail, as we expect, the Middle East will destabilize and add another energy supply risk on top of the Russian risk. The Ukraine war also interacts with our other two key views for 2022: China’s reversion to autocracy and the US’s policy insularity. Both add policy uncertainty and weigh on risk sentiment. The war also reinforces our strategic themes for the 2020s: Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. Stagflation Cometh Stagflation Cometh Stagflation Cometh Trade Recommendation Inception Date Return Cyclically Long Global Defensives Versus Cyclicals 2022-01-20 10.8% Bottom Line: Tactically stay long global defensives and large caps. Cyclically stay long gold, US equities, aerospace/defense, and cyber security. Feature In our annual outlook, “The Gathering Storm,” we argued that the post-pandemic world economy would destabilize due to intensifying rivalry among the leading nations. We argued that China’s reversion to autocracy, US domestic divisions, and Russia’s commodity leverage would produce a toxic brew for global investors in 2022. By January 27 it was clear to us that Russia would invade Ukraine, so the storm was arriving sooner than we thought, and we doubled down on our defensive and risk-averse market positioning. We derived these three key views from new cyclical trends and the way they interact with our underlying strategic themes – Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism (Table 1). These themes are mutually reinforcing, rooted in solid evidence over many years, and will not change easily. Table 1Three Geopolitical Strategic Themes Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm The Ukraine war reinforces them: Russia took military action to increase its security relative to the US and NATO; the West imposed sanctions that reduce globalization with Russia and potentially other states; Russian aggression stemmed from nationalism and caused a spike in global prices that will spur more nationalism and populism going forward. In this report we examine how these trends will develop in the second quarter and beyond. We see stagflation taking shape and recommend investors prepare for it by continuing to favor defensive sectors, commodities, and value plays. Checking Up On Our Russia View For 2022 Our third key view for 2022 – that oil producers like Russia and Iran possessed immense geopolitical leverage and would most likely use it – is clearly the dominant geopolitical trend of the year, as manifested in the Russian invasion of Ukraine.1 Russia first invaded Ukraine in 2014 and curtailed operations after commodity prices crashed. It launched a new and larger invasion in 2022 when a new commodity cycle began (Chart 1). Facing tactical setbacks, Russia has begun withdrawing forces from around the Ukrainian capital Kyiv. But it will redouble its efforts to conquer the eastern Donbas region and the southern coastline. The coast is the most strategic territory at stake (Map 1). Chart 1Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Map 1Russian Invasion Of Ukraine, 2022 Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The most decisive limitation on Russia’s military effort would come from a collapse of commodity exports or prices, which has not happened yet. Europe continues to buy Russian oil and natural gas, although it is debating a ban on the $4.4 billion worth of coal that it imports. With high energy prices making up for a drop in export volumes, Russian armed forces can still attempt a summer and fall campaign (Chart 2). The aim would be to conquer remaining portions of Donetsk and Luhansk, the “land bridge” to Crimea, and potentially the stretch of land between the Dnieper river and eastern Moldova, where Russian troops are already stationed. Chart 2Russia’s War Financing Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Ukraine’s military neutrality is the core Russian objective. Ukraine is offering neutrality in exchange for security guarantees in the current ceasefire talks. Hence a durable ceasefire is possible if the details of neutrality are agreed – Ukraine forswears joining NATO and hosting foreign military infrastructure while accepting limitations on military exercises and defense systems. The security guarantees that Ukraine demands are mostly symbolic, as the western powers that would be credible guarantors are already unwilling to use military force against Russia (e.g. the US, UK, NATO members). However, Russia’s withdrawal from Kyiv will embolden the Ukrainians, so we do not expect a durable ceasefire in the second quarter. Global investors will be mistaken if they ignore Ukraine in the second quarter, at least until core problems are resolved. What matters most is whether the war expands beyond Ukraine: The likelihood of a broader war is low but not negligible. So far the Russian regime is behaving somewhat rationally: Moscow attacked a non-NATO member to prevent it from joining NATO; it limited the size of the military commitment; and it is now accepting reality and withdrawing from Kyiv while negotiating on Ukrainian neutrality. But a major problem emerges if Russia’s military fails in the Donbas while Ukraine reneges on offers of neutrality. Any ceasefire could fall apart and the war could re-escalate. Russia could redouble its attacks on the country or conduct a limited attack outside of Ukraine to trigger a crisis in the western alliance. Moreover, if sanctions keep rising until Russia’s economy collapses, Moscow could become less rational. Finland and Sweden have seen a shift of public opinion in favor of joining NATO. Any intention to do so would trigger a belligerent reaction from Russia. These governments are well aware of the precarious balance that must be maintained to prevent war, so war is unlikely. But if their stance changes then Russia will threaten to attack. Russia would threaten to bomb these states since it cannot now credibly threaten invasion by land (Charts 3A & 3B). Chart 3ANordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​ Chart 3BNordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​​ The Black Sea is vulnerable to “Black Swan” events or military spillovers. Russia is re-concentrating its military efforts in the Donbas and land bridge to Crimea. Russia could expand its offensive to Odessa and the Moldovan border. Or Russia could attempt to create a new norm of naval dominance in the Black Sea. Or ships from third countries could hit mines or become casualties of war. For these and other reasons, investors should not take on additional risk in their portfolios on the basis that a durable ceasefire will be concluded quickly. Russia’s position is far too vulnerable to encourage risk-taking. Moscow could escalate tensions to try to save face. It is also critical to ensure that Russia and Europe maintain their energy trade: Neither side has an interest in total energy cutoff. Russia needs the revenue to finance its war and needs to discourage Europe from fulfilling its pledges to transition rapidly to other sources and substitutes. Europe needs the energy to avoid recession, maintain some tie with Russia, and enable its energy diversification strategy. So far natural gas flows are continuing (Chart 4). Chart 4Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) ​​​​​​ Chart 5Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance ​​​​​​ However, risks to energy trade are rising. Russia is threatening to cut off energy exports if not paid in rubles, while the EU is beginning to entertain sanctions on energy. Russia can reduce oil or gas flows incrementally to keep prices high and prevent Europe from rebuilding stockpiles for fall and winter. Partial energy cutoff is possible. Europe’s diversification makes Russia’s predicament dire. Substantial sanction relief is highly unlikely, as western powers will want to prevent Russia from rebuilding its economy and military. Russia could try to impose significant pain on Europe to try to force a more favorable diplomatic solution. A third factor that matters is whether the US will expand its sanction enforcement to demand strict compliance from other nations, at pain of secondary sanctions: Secondary sanctions are likely in the case of China and other nations that stand at odds with the US and help Russia circumvent sanctions. In China’s case, the US is already interested in imposing sanctions on the financial or technology sector as part of its long-term containment strategy. While the Biden administration’s preference is to control the pace of escalation with China, and thus not to slap sanctions immediately, nevertheless substantial sanctions cannot be ruled out in the second quarter. Secondary sanctions will be limited in the case of US allies and partners, such as EU members, Turkey, and India. Countries that do business with Russia but are critical to US strategy will be given waivers or special treatment. Russia is not the only commodity producer that enjoys outsized geopolitical leverage amid a global commodity squeeze. Iran is the next most critical producer. Iran is also critical for the stability of the Middle East. In particular, the consequential US-Iran talks over whether to rejoin the 2015 nuclear deal are likely to come to a decision in the second quarter. Chart 6Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply If the US and Iran agree to a strategic détente, then regional tensions will briefly subside, reducing global oil disruption risks and supply pressures. Iran could bring 1.3 million barrels per day of oil back online, adding to President Biden’s 1 million per day release of strategic petroleum reserves. The combination would amount to 2.3% of global demand and more than cover the projected quarterly average supply deficit, which ranges from 400k to 900k barrels per day for the rest of 2022 (Chart 5). If the US and Iran fail to agree, then the Middle East will suffer another round of instability, adding a Middle Eastern energy shock on top of the Russian shock. Not only would Iran’s 1.3 million barrels per day be jeopardized but so would Iraq’s 4.4 million, Saudi Arabia’s 10.3 million, the UAE’s 3.0 million, or the Strait of Hormuz’s combined 24 million per day (Chart 6). This gives Iran leverage to pursue nuclear weaponization prior to any change in US government that would strengthen Israel’s ability to stop Iran. We would not bet on an agreement – but we cannot rule it out. The Biden administration can reduce sanctions via executive action to prevent a greater oil shock, while the Iranians can accept sanction relief in exchange for easily reversible moves toward compliance with the 2015 nuclear deal. But this would be a short-term, stop-gap measure, not a long-term strategic détente. Conflict between Iran and its neighbors will revive sooner than expected after the deal is agreed, as Iran’s nuclear ambitions will persist. OPEC states are already producing more oil rapidly, suggesting no quick fix if the US-Iran deal falls apart. While core OPEC states have 3.5 million barrels per day in spare capacity to bring to bear, a serious escalation of tensions with Iran would jeopardize this solution. Finally, if commodity producers have geopolitical leverage, then commodity consumers are lacking in leverage. This is clear from Europe’s inability to prevent Russia’s attack or ban Russian energy. It is clear from the US’s apparent unwillingness to give up on a short-term deal with Iran. It is clear from China’s inability to provide sufficient monetary and fiscal stimulus as it struggles with Covid-19. Turkey, Egypt, and Pakistan are geopolitically significant importers of Russian and Ukrainian grain that are likely to face food insecurity and social unrest. We will address this issue below under our Populism/Nationalism theme. Bottom Line: Investors should not be complacent. Russia’s military standing in Ukraine is weak, but its ability to finance the war has not yet collapsed, which means that it will escalate the conflict to save face. What About Our Other Key Views For 2022? Our other two key views for 2022 are even more relevant in the wake of the Ukraine re-invasion. China’s reversion to autocracy is a factor in China’s domestic and foreign policy: Domestically China needs economic and social stability in the advance of the twentieth national party congress, when President Xi Jinping hopes to clinch 10 more years in power. In pursuit of this goal China is easing monetary and fiscal policy. However, with depressed animal spirits, a weakening property sector, and high debt levels, monetary policy is proving insufficient. Fiscal policy will have to step up. But even here, inflation is likely to impose a limitation on how much stimulus the authorities can utilize (Chart 7). Chart 7China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation ​​​​​​ Chart 8Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 China is also trying but failing to maintain a “Covid Zero” policy. The more contagious Omicron variant of the virus is breaking out and slipping beyond the authorities’ ability to suppress cases of the virus to zero. Shanghai is on lockdown and other cities will follow suit. China will attempt to redouble its containment efforts before it will accept the reality that the virus cannot be contained. Chinese production and shipping will become delayed and obstructed as a result, putting another round of upward pressure on global prices (Chart 8). Stringent pandemic restrictions could trigger social unrest. China is ripe for social unrest, which is why it launched the “Common Prosperity” program last year to convince citizens that quality of life will improve. But this program is a long-term program that will not bring immediate relief. On the contrary, the economy is still suffering and the virus will spread more widely, as well as draconian social restrictions. The result is that the lead up to the national party congress will not be as smooth as the Xi administration had hoped. Global investors will remain pessimistic toward Chinese stocks. In foreign affairs, China’s reversion to autocracy is reinforced by Russia’s clash with the West and the need to coordinate more closely. Xi hosted Putin in Beijing on February 4, prior to the invasion, and the two declared that their strategic partnership ushers in a “new era” of “multipolarity” and that their cooperation has “no limits,” which really means that military cooperation is not forbidden. China agreed to purchase an additional 10 billion cubic meters of Russian natural gas over 30-years. While this amount would only replace 3% of Russian natural gas exports to Europe, it would mark a 26% increase in Russian exports to China. More importantly it acts as a symbol of Chinese willingness to substitute for Europe over time. There is a long way to go for China to replace Europe as a customer (Chart 9). But China knows it needs to convert its US dollar foreign exchange reserves, vulnerable to US sanctions, into hard investments in supply security within the Eurasian continent. Chart 9Long Way To Go For China NatGas Imports To Replace EU Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours China is helping Russia circumvent sanctions. China’s chief interest is to minimize the shock to its domestic economy. This means keeping Russian energy and commodities flowing. China could also offer military equipment for Russia. The US has expressly warned China against taking such an action. China could mitigate the blowback by stipulating that the assistance cannot be used in Ukraine. This would be unenforceable but would provide diplomatic cover. While China is uncomfortable with the disturbance of the Ukraine war – it does not want foreign affairs to cause even larger supply shocks. At the same time, China does not want Russia to lose the war or Putin’s regime to fall from power. If Russia loses, Taiwan and its western allies would be emboldened, while Russia could pursue a détente with the West, leaving China isolated. Since China faces US containment policy regardless of what happens in Russia, it is better for China to have Putin making an example out of Ukraine and keeping the Americans and Europeans preoccupied. Chart 10China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China must also preserve ties with Europe. Diplomacy will likely succeed in the short run since Europe has no interest or desire to expand sanctions to China. The Biden administration will defer to Europe on the pace of sanctions – it is not willing or able to force Europe to break with China suddenly. Eventually Europe and China may sever relations but not yet – China has a powerful incentive to preserve them (Chart 10). China will also court India and other powers in an attempt to hedge its bets on Russia while weakening any American containment. Beyond the party congress, China will be focused on securing the economic recovery and implementing the common prosperity agenda. The first step is to maintain easy monetary and fiscal policy. The second step is to “let 100 flowers bloom,” i.e. relaxing social and regulatory controls to try to revive entrepreneurship and animal spirits, which are heavily depressed. Xi will have the ability to do this after re-consolidating power. The third step will be to try to stabilize economic relations with Europe and others (conceivably even the US temporarily, though no serious détente is likely). The remaining key view for 2022 is that the Biden administration’s domestic focus will be defensive and will invite foreign policy challenges. The Ukraine war vindicates this view but the question now is whether Biden has or will change tack: The Biden administration is focused on the midterm elections and the huge risk to the Democratic Party’s standing. Biden has not received a boost in opinion polls from the war. He is polling even worse when it comes to handling of the economy (Chart 11). While he should be able to repackage his budget reconciliation bill as an energy security bill, his thin majorities in both houses make passage difficult. Chart 11Biden And Democrats Face Shellacking In Midterm Election Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Biden’s weak standing – with or without a midterm shellacking – raises the prospect that Republicans could take back the White House in 2024, which discourages foreign nations from making any significant concessions to the United States in their negotiations. They must assume that partisanship will continue to contaminate foreign policy and lead to abrupt policy reversals. In foreign policy, the US remains reactive in the face of Russian aggression. If Russia signs a ceasefire, the US will not sabotage it to prolong Russian difficulties. Moreover Biden continues to exempt Europe and other allies and partners from enforcing the US’s most severe sanctions for fear of a larger energy shock. Europe’s avoidance of an energy ban is critical and any change in US policy to try to force the EU to cut off Russian energy is unlikely. China will not agree to structural reform or deep concessions in its trade negotiations, knowing that former President Trump could come back. The Biden administration’s own trade policy toward China is limited in scope, as the US Trade Representative Katherine Tai admitted when she said that the US could no longer aim to change China’s behavior via trade talks. Biden’s only proactive foreign policy initiative, Iran, will not bring him public kudos if it is achieved. But American inconstancy is one of the reasons that Iran may walk away from the 2015 nuclear deal. Why should Iran’s hawkish leaders be expected to constrain their nuclear program and expose their economy to future US sanctions if they can circumvent US sanctions anyway, and Republicans have a fair chance of coming back into power as early as January 2025? Biden’s unprecedented release of strategic petroleum reserves will not be able to prevent gasoline prices from staying high given the underlying supply pressures at home and abroad. This is especially true if the Iran talks fail as we expect. Even if inflation abates before the election, it is unlikely to abate enough to save his party from a shellacking. That in turn will weaken the global impression of his administration’s staying power. Hence Biden will focus on maintaining US alliances, which means allowing Europe, India, and others to proceed at a more pragmatic and dovish pace in their relations with Russia and China. Bottom Line: China’s reversion to autocracy and America’s policy insularity suggest that global investors face considerable policy uncertainty this year even aside from the war in Europe. Checking Up On Our Strategic Themes For The 2020s Russia’s invasion strongly confirmed our three strategic themes of Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. These themes are mutually reinforcing: insecurity among the leading nation-states encourages regionalization rather than globalization, while populism and nationalism encourage nations to pursue economic and security interests at the expense of their neighbors. First, the Ukraine war confirms and exacerbates Great Power Rivalry: Chart 12China And Russia Both Need To Balance Against US Preponderance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Russia’s action vindicates the “realist” school of international relations (in which we count ourselves) by forcing the world to wake up to the fact that nations still care primarily about national security defined in material ways, such as armies, resources, and territories. The paradox of realism is that if at least one of the great nations pursues its national self-interest and engages in competition for security, then all other nations will be forced to do the same. If a nation neglects its national security interests in pursuit of global economic engagement and cooperation, then it will suffer, since other nations will take advantage of it to enhance their security. Hence, as a result of Ukraine, nations will give a higher weight to national security relative to economic efficiency. The result will be an acceleration of decisions to use fiscal funds and guide the private economy in pursuit of national interests – i.e. the Return of Big Government. Since actions to increase deterrence will provoke counteractions for the same reason, overall insecurity will rise. For example, the US and China will take extra precautions in case of future sanctions and war. But these precautions will reduce trust and cooperation and increase the probability of war over the long run. For the same reason, China cannot reject Russia’s strategic overture – it cannot afford to alienate and isolate Russia. China and Russia have a shared interest in countering the United States because it is the only nation that could conceivably impose a global empire over all nations (Chart 12). The US could deprive Beijing and Moscow of the regional spheres of influence that they each need to improve their national security. This is true not only in Ukraine and Taiwan but in other peripheral areas such as Belarus, the Caucasus, Central Asia, and Southeast Asia. China has much to gain from Russia. Russia is offering China privileged overland access to Russian, Central Asian, and Middle Eastern resources and markets. This resource base is vital to China’s strategic needs, given its import dependency and vulnerability to US maritime power (Chart 13). Chart 13China’s Maritime Vulnerability Forces Eurasian Strategy, Russian Alliance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Investors should understand Great Power Rivalry in a multipolar rather than bipolar sense. As Russia breaks from the West, investors are quick to move rapidly to the bipolar Cold War analogy because that is what they are familiar with. But the world today has multiple poles of political power, as it did for centuries prior to the twentieth. While the US is the preponderant power, it is not hegemonic. It faces not one but two revisionist challengers – Russia and China. Meanwhile Europe and India are independent poles of power that are not exclusively aligned with the US or China. For example, China and the EU need to maintain economic ties with each other for the sake of stability, and neither the US nor Russia can prevent them from doing so. The same goes for India and Russia. China will embrace Russia and Europe at the same time, while hardening its economy against US punitive measures. India will preserve ties with Russia and China, while avoiding conflict with the US and its allies (the maritime powers), whom it needs for its long-term strategic security in the Indian Ocean basin. Ultimately bipolarity may be the end-game – e.g. if China takes aggressive action to revise the global order like Russia has done – but the persistence of Sino-European ties and Russo-Indian ties suggest we are not there yet. Second, the Ukraine war reinforces Hypo-Globalization: Since the pandemic we have argued that trade would revive on the global economic snapback but that globalization – the deepening of trade integration – would ultimately fall short of its pre-2020 and pre-2008 trajectory. Instead we would inhabit a new world of “hypo-globalization,” in which trade flows fell short of potential. So far the data support this view (Chart 14). Chart 14Globalization Falling Short Of Potential Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The Ukraine war has strengthened this thesis not only by concretely reducing Russia’s trajectory of trade with the West – reversing decades of integration since the fall of the Soviet Union – but also by increasing the need for nations to guard against a future Chinese confrontation with the Western world. Trust between China and the West will further erode. China will need to guard against any future sanctions, and thus diversify away from the US dollar and assets, while the US will need to do a better job of deterring China against aggression in Asia, and will thus have to diversify away from Chinese manufacturing and critical resources like rare earths. While China and Europe need each other now, the US and China are firmly set on a long-term path of security competition in East Asia. Eventually either the US or China will take a more aggressive stance and Europe will be forced to react. Since Europe will still need US support against a decaying and aggressive Russia, it will likely be dragged into assisting the US against China. Third, the Ukraine war reflects and amplifies Populism/Nationalism: Populism and nationalism are not the same thing but they both stem from the slowing trend of global income growth, the rise of inequality, the corruption of the elite political establishments, and now the rise in inflation. Nations have to devote more resources to pacifying an angry populace, or distracting that populace through foreign adventures, or both. The Ukraine war reflects the rise in nationalism. First, the collapse of the Soviet Union ushered in a period in which Moscow lost control of its periphery, while the diverse peoples could pursue national self-determination and statehood. The independence and success of the Baltic states depended on economic and military cooperation with the West, which eroded Russian national security and provoked a nationalist backlash in the form of President Putin’s regime. Ukraine became the epicenter of this conflict. Ukraine’s successful military resistance is likely to provoke a dangerous backlash from Moscow until either policy changes or the regime changes. American nationalism has flared repeatedly since the fall of the Soviet Union, namely in the Iraq war. The American state has suffered economically and politically for that imperial overreach. But American nationalism is still a potent force and could trigger a more aggressive shift in US foreign policy in 2024 or beyond. European states have kept nationalism in check and tried to subsume their various nationalist sentiments into a liberal and internationalist project, the European Union. The wave of nationalist forces in the wake of the European debt crisis has subsided, with the exception of the United Kingdom, where it flowered in Brexit. The French election in the second quarter will likely continue this trend with the re-election of President Emmanuel Macron, but even if he should suffer a surprise upset to nationalist Marine Le Pen, Europe’s centripetal forces will prevent her from taking France out of the EU or euro or NATO (Chart 15). Over the coming decade, nationalist forces will revive and will present a new challenge to Europe’s ruling elites – but global great power competition strongly supports the EU’s continued evolution into a single geopolitical entity, since the independent states are extremely vulnerable to Russia, China, and even the US unless they unite and strengthen their superstructure. Chart 15Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective In fact the true base of global nationalism is migrating to Asia. Chinese and Indian nationalism are very potent forces under President Xi Jinping and Prime Minister Narendra Modi. Xi is on the verge of clinching another ten years in power while Modi is still favored for re-election in 2024, so there is no reason to anticipate a change anytime soon. The effects are various but what is most important for investors is to recognize that as China’s potential GDP has fallen over the past decade, the Communist Party has begun to utilize nationalism as a new source of legitimacy, and this is expressed through a more assertive foreign policy. President Xi is the emblem of this shift and it will not change, even if China pursues a lower profile over certain periods to avoid provoking the US and its allies into a more effective coalition to contain China. Chart 16Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism The surge in global prices will destabilize regimes that lack food security and contribute to new bouts of populism and nationalism. Turkey is the most vulnerable due to a confluence of political, economic, and military risks that will unsettle the state. But Egypt is vulnerable to an Arab Spring 2.0 that would have negative security implications for Israel and add powder to the Middle Eastern powder keg. Pakistan is already witnessing political turmoil. Investors may overlook any Indonesian unrest due to its attractiveness in a world where Russia and China are scaring away western investment (Chart 16). All three of these strategic themes are mutually reinforcing – and they tend to be inflationary over the long run. Great powers that redouble the pursuit of national interest – through defense spending and energy security investments – while simultaneously being forced to expand their social safety nets to appease popular discontent, will drive up budget deficits, consume a lot of natural resources, and purchase a lot of capital equipment. They will also more frequently engage in economic or military conflicts that constrain supply (Chart 17). Chart 17War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary Bottom Line: The Ukraine war is a powerful confirmation of our three strategic themes. It is also a confirmation that these themes have inflationary macroeconomic implications. Investment Takeaways Chart 18Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Now that great power rivalry is intensifying immediately and rapidly, and yet China’s and Europe’s economies are encountering greater difficulties, we expect stagflation to arrive sooner rather than later. High headline and core inflation, the Ukraine war, tacit Chinese support for Russia, persistent Chinese supply kinks, US and EU sanctions, US midterm elections, and a potential US-Iran diplomatic breakdown will all weigh on risk sentiment in the second quarter. In Ukraine, Russia’s position is too weak to give comfort for investors, who should continue to favor defensive over cyclical equities and US stocks over global stocks. Russia’s break with the West, and the West’s use of sanctions to prevent Russia from accessing its foreign exchange reserves, has raised new questions about the global currency reserve system and the dollar’s status within that system. Over the coming years China will redouble the efforts it began in the wake of the Great Recession to reduce its dependency on US dollar assets within its reserve basket, while also recycling new current account surpluses into non-dollar assets. However, the evidence does not suggest that King Dollar will suffer a structural breakdown. First, the world lacks alternative safe-haven assets to US Treasuries – and net foreign purchases of US bonds rose in the face of the Ukraine war (Chart 18). Second, the return of war to Europe will weaken the perceived long-term security of European currency and government bonds relative to US counterparts. Even if the Ukraine war is contained in the short run, as we expect, Russia is in structural decline and will remain a disruptive player for some time. We are not at all bearish on the euro or European bonds but we do not see the Ukraine war as increasing their value proposition, to put it lightly. The same logic extends to Japanese bonds, since China, like Russia, is an autocratic and revisionist state that threatens to shake up the security order in its neighborhood. Japan is relatively secure as a nation and we are bullish on the yen, but China’s de facto alliance with Russia weakens Japan’s security outlook over the very long run, especially relative to the United States. Thus, on a cyclical basis the dollar can depreciate, but on a structural basis the US dollar will remain the dominant reserve currency. The US is not only the wealthiest and most secure country in the world but also the largest oil producer. Meanwhile Chinese potential growth, domestic political stability, and foreign relations are all worsening. The US-Iran talks are the most critical geopolitical dynamic in the second quarter aside from Russia’s clash with the West. The fate of the 2015 nuclear deal will be decided soon and will determine whether an even bigger energy shock begins to emanate from the Middle East. We would not bet on a new US-Iran deal but we cannot rule it out. Any deal would be a short-term, stop-gap deal but would prevent an immediate destabilization of the Middle East this year. As such it would reduce the risk of stagflation. Since we expect the deal to fail, we expect a new energy shock to emerge. We see stagflation as more likely than the BCA House View. It will be difficult to lift productivity in an environment of geopolitical and political uncertainty combined with slowing global growth, rising interest rates, and a worsening commodity shock (Chart 19). We will gladly revise this stance if Biden clinches an Iran deal, China relaxes its Covid Zero policy and stabilizes domestic demand, Russia and Europe maintain energy trade, and commodity prices fall to more sustainable levels for global demand. Chart 19Stagflation Cometh Stagflation Cometh Stagflation Cometh Strategically we remain long gold, overweight US equities, overweight UK equities, long British pound and Japanese yen, long aerospace/defense stocks and cyber security stocks. We remain short Chinese renminbi and Taiwanese dollar and short emerging European assets. Our short Chinese renminbi trade and our short Taiwanese versus Korean equity trade are our worst-performing recommendations. However, the above analysis should highlight – and the Ukraine war should underscore – that these two economies face a fundamentally negative geopolitical dynamic. Both Chinese and Taiwanese stocks have been underperforming global peers since 2021 and our short TWD-USD trade is in the money. While we do not expect war to break out in Taiwan this year, we do expect various crisis events to occur, particularly in the lead up to the crucial Taiwanese and American 2022 midterms and 2024 presidential election. We also expect China to depreciate the renminbi when inflation peaks and commodity prices subside. Cyclically we remain long North American and Latin American oil producers and short Middle Eastern producers, based on our pessimistic read of the Iran situation. The Americas are fundamentally better protected from geopolitical risks than other regions, although they continue to suffer from domestic political risks on a country-by-country basis. Cyclically we continue to take a defensive positioning, overweighting defensive sectors and large cap equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      That the Russian threat fell under our third key view for 2022 implies that we did not get our priorities straight. However, consider the timing: shortly after publishing our annual outlook on December 15, the Russians issued an ultimatum to the western powers demanding that NATO stop expanding toward Russia. Diplomats from Russia and the West met on January 12-13 but Russia’s demands were not met. We upgraded the odds that Russia would invade Ukraine from 50% to 75% on January 27. Shuttle diplomacy ensued but failed. Russia invaded on February 24. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Fed policy and the US stock market are on a collision course. US core inflation will not fall below 3.5% unless the economy slows considerably below its potential for a few quarters. As long as US share prices do not fall considerably, i.e., financial conditions do not tighten substantially, the Fed has no reason to halt its tightening and revert its hawkish posture. Odds are that US profit margins and equity multiples will compress, leading to lower share prices in the coming months. In China, monetary and fiscal stimulus have so far been insufficient to produce an economic recovery given the headwinds from the property sector and the rolling lockdowns. A broad-based EM rally will occur only when a commodity bull market is demand driven. The recent spike in commodity prices has been due to supply curtailment. Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Bottom Line: Maintain an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive. We are waiting to buy EM local bonds later this year using the potential weakness in their currencies.     After a two-year hiatus, I traveled to the US last week for in-person meetings with clients. This report summarizes the key questions and points of discussion that emerged during these exchanges. Question: What are the key risks to EM markets at the moment? Answer: First, Fed policy and the US stock market are on a collision course. This is in fact a threat to global risk assets – not just US ones. Second, rolling lockdowns in China and the property market slump will delay the recovery of the mainland economy. Third, after the latest rebound in risk assets, geopolitical risks are underestimated. Before the situation in Ukraine stabilizes, President Putin will likely escalate the conflict to obtain a better negotiating position. The combination of these three risks warrants a cautious stance on EM assets. Chart 1The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation Question: Let’s start with the Fed. Why do you think US share prices and the Fed are on a collision course? Historically, there were episodes during which the S&P 500 rallied even though the Fed was hiking rates. Why is this time different? Answer: Extremely elevated US core inflation, rising inflation expectations as well as very expensive equity valuations make this current episode different from those periods in the 1990s, 2000s and even 2010s when US equities advanced amid Fed tightening.  In fact, share prices and bond yields were negatively correlated for 30 years between 1966 and 1997. The current episode is reminiscent of the late 1960s when core inflation spiked, and equity prices became negatively correlated with Treasury yields (Chart 1). As to the interaction between the Fed and financial markets, our reasoning is as follows: As long as US share prices do not fall and US credit spreads do not widen considerably, i.e., financial conditions do not tighten substantially, then the Fed has no reason to halt its tightening and revert its hawkish posture. The basis is that US core inflation is well above target, and inflation expectations are ratcheting up and could become entrenched. Question: Do you expect US inflation to moderate and in turn allow the Fed to go on hold? Answer: Investors and policymakers should differentiate between the annual inflation rate (a statistical measure) and a genuine inflation outbreak. The annual inflation rate is too high, and will likely drop in H2 this year. Chart 2Super Core US Consumer Inflation Is At 5% Super Core US Consumer Inflation Is At 5% Super Core US Consumer Inflation Is At 5% However, US inflationary pressures are genuine and broad-based. If these pressures are not contained, they will spiral out of control. Our measure of US average core inflation is currently around 5% (Chart 2). This series is an average of seven measures of core consumer price inflation from the Fed: core CPI and PCE, median CPI, market-based core PCE, trimmed-mean CPI and PCE, and sticky core CPI. Hence, this measure is not influenced by price movements of individual components. The annual rate of core CPI will drop in the US but we do not expect core CPI and PCE to fall below 3.5% unless the economy slows considerably below its potential for a few quarters, and labor market conditions deteriorate leading to lower wage growth. The reasoning is that underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be contained without bringing economic growth down below potential growth and weakening the labor market.  Chart 3US Wage Growth Is Between 4.3% and 7.7% US Wage Growth Is Between 4.3% and 7.7% US Wage Growth Is Between 4.3% and 7.7% The labor market is presently very tight, and wage growth will continue accelerating. Given that real wages have shrunk dramatically in the past 12 months, labor will be demanding wage increases that are on par or above the inflation rate. With sales still strong, companies will have to pay higher wages to maintain and attract skilled employees. US nominal wage growth is presently ranging between 4.3-7.7%, depending on the measure (Chart 3). With US underlying productivity growth unlikely to be more than 2% at best, unit labor costs are therefore rising at a rate of 2.5-5.5% and will accelerate further. Chart 4 illustrates that unit labor costs have been a major driver of core consumer price inflation in the US over the past 60 years. If unit labor costs accelerate, core inflation will not drop much from its current elevated levels. As core inflation proves to be sticky and does not fall rapidly below 3.5%, the Fed will have no choice but to keep raising interest rates… until something breaks. Chart 4Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Question: What will be the first thing to break? Do you think Fed rate hikes will push the US economy into recession? Answer: Equity markets will be the first to break. It is hard to make a judgement about whether US real GDP will contract, but odds are high that US/global share prices will drop as the Fed tightens. The S&P 500 can drop 20-25% from its early January high without a recession in the American economy. Drivers of this selloff will be compressing equity multiples and shrinking profit margins. Chart 5Rising Rates = Lower Equity Multiples Rising Rates = Lower Equity Multiples Rising Rates = Lower Equity Multiples First, there are three drivers of equity returns – the top line, profit margins and valuation multiples. We believe that two of these three – profit margins and multiples – will be negative for the US market in the coming months. Valuation multiples will compress as US interest rates rise further (Chart 5).  Profit margins will shrink as wage growth accelerates well above productivity gains, i.e., unit labor costs spike. Even if corporates’ top-line growth stays robust, the negative impact of compressing valuation multiples and lower profit margins will be overwhelming for equities. Hence, corporate profits could shrink mildly and share prices would drop materially even as real GDP does not contract. Second, it is important to mention that equity returns could be negative outside reccessions. Let’s recall what happened in 2000-2001 in the US. Nominal growth was robust, real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming (Chart 6, top panel). Yet, the S&P 500 EPS plunged by 30% and the stock index was down by 50% (Chart 6, bottom two panels). We do not mean that US profits are about to crash by 30% and share prices will plunge by 50% like they did in the bear market of 2000-2002. The point is that profits could experience a mild contraction despite solid consumer spending. Chart 6S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 Chart 7US Real Consumption Of Goods: A Mean Reversion Ahead? US Real Consumption Of Goods: A Mean Reversion Ahead? US Real Consumption Of Goods: A Mean Reversion Ahead? Third, there is chance of a stagflation scare. US purchases of goods ex-autos have been extremely strong due to generous fiscal transfers to households and pandemic dynamics that discouraged service spending and boosted goods purchases. Americans’ real spending on goods ex-autos has been running well above its pre-pandemic trend and is likely to experience some sort of mean reversion (Chart 7).  A shift in consumption away from goods ex-autos will weigh down on goods producers globally. Notably, manufacturers rather than service providers dominate equity markets outside the US. Hence, a period when US inflation is sticky, and the Fed is tightening while the global manufacturing cycle is slowing is a possibility. This will upset investors and lead them to pare back their equity holdings. Question: As we all know, the US dollar is very important for EM economies and financial markets. So, what is the outlook for the greenback? Answer: As long as the Fed sounds hawkish and continues tightening, the US dollar will strengthen. The motive is that when the central bank is willing to tighten and the economy does not collapse, the currency tends to appreciate. Even as the S&P 500 sells off, the risk-off phase is also positive for the US currency. The trade-weighted dollar will put a major top and will start depreciating only when the Fed does a dovish tilt. Odds are that this will take place later this year when the S&P 500 is down 25% or so. Yet, US inflation will still be entrenched. In other words, the Fed will fall behind the inflation curve. A central bank falling behind the inflation curve is bearish for the currency. Chart 8Mainstream EM Currencies: An Air Pocket? Mainstream EM Currencies: An Air Pocket? Mainstream EM Currencies: An Air Pocket? Concerning mainstream EM (excluding China, Korea and Taiwan) currencies, the total return index (including carry) versus the US dollar has hit a technical resistance (Chart 8). We expect a near-term relapse in EM exchange rates as a mirror image of US dollar strength and the risk-off trade in global markets. However, a major buying opportunity in EM currencies and fixed-income markets as well as EM equity markets will transpire later this year when the US dollar peaks. Question: Let’s turn to China. Growth continues to be disappointing. The COVID-related lockdowns are depressing economic activity. Have authorities stimulated enough for the business cycle to recover soon? Answer: We believe that monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus is sizable (Chart 9), but it has not yet fully entered the economy. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has not yet bottomed (Chart 10). Chart 9China's Fiscal Stimulus Is In The Pipeline China's Fiscal Stimulus Is In The Pipeline China's Fiscal Stimulus Is In The Pipeline Chart 10China: Corporate and Household Credit Impulse Has Not Bottomed Yet China: Corporate and Household Credit Impulse Has Not Bottomed Yet China: Corporate and Household Credit Impulse Has Not Bottomed Yet With rolling lockdowns impairing service employment and, hence, denting household income, and without sizable fiscal transfers to consumers, the economy will struggle to recover. Local government finances are squeezed by lack of revenues from land sales and their borrowing is limited by quotas set by the central government. So, only the central government is in a position to provide meaningful fiscal support to households, but it has not yet done so. Question: You mentioned that the current geopolitical climate remains a risk to financial markets as Putin will likely escalate before de-escalating. Is this not bullish for commodities? Also, you have argued over the years that commodity prices positively correlate with EM equity performance. Yet, there has been a major decoupling between commodity prices and EM equity absolute and relative performance (Chart 11). How do you explain this phenomenon? Chart 11Decoupling Between EM Stocks And Commodity Prices Decoupling Between EM Stocks And Commodity Prices Decoupling Between EM Stocks And Commodity Prices Answer: Re-escalation on the part of the Kremlin will be bullish for commodities in the short run. In the medium term however, as we argued in a report in early March, commodity prices will be very volatile, with upside risks for some (like wheat) but not for all of them. It all depends on how much of its resource exports Russia can sell/ship abroad. It is hard to forecast this in view of sanctions by Western governments and their private sectors, as well as the breakdown in existing market infrastructures (such as payment systems, freight, insurance, etc.). The breakdown between commodity prices and EM absolute and relative share prices is due to the following: When commodity prices rise due to demand from the real economy, EM stocks tend to rally and outperform. This is especially true when it is China’s demand that is driving commodity prices higher. The reason is that China is important for overall EM economies, and robust demand growth in China is bullish for EM assets. In such a scenario (a demand-driven commodity bull market), not only do commodity producers rally (Latin America) but also commodity consumers (Asia) perform well in absolute terms. The recent spike in commodity prices has been due to supply curtailment rather than demand strength. That has benefited commodity producers (Latin America) but not commodity consumers (Asia). Finally, TMT stocks have come to make up a large share of EM markets in recent years. So wild swings in their performance have distorted the correlation between the EM equity index and commodity prices. Question: Will equity and currency markets of commodity producers continue rallying? Answer: The key signals to monitor are the trend in the US dollar and the global risk-on/risk-off environment. If a risk-off move transpires and the US dollar firms (as we expect), share prices and currencies in commodity-producing countries will relapse in absolute terms. Also, Chart 12 illustrates net long positions in ZAR, BRL and MXN among asset managers and leveraged funds are elevated. In short, investors are already very long, and these currencies could correct. Finally, the prices of some commodities for which Russia and Ukraine are not major producers, like platinum, have already been relapsing. In fact, platinum prices correlate well with EM non-TMT share prices in US dollar terms and are currently pointing to downside risks (Chart 13). Chart 12Investors Are Very Long EM Commodity Currencies Investors Are Very Long EM Commodity Currencies Investors Are Very Long EM Commodity Currencies Chart 13Not All Commodity Prices Are Rising Not All Commodity Prices Are Rising Not All Commodity Prices Are Rising Question: Could high food and energy prices heighten political risks in some developing countries? How serious is this risk? Answer: This risk has already manifested itself in some countries, with protests in Peru and the 15% devaluation in Egypt. More countries could experience public demonstrations and political turbulence. An overarching theme for many developing nations will be a drag on growth from high food and energy prices. Unlike the US, wages in emerging economies are not rising fast, and labor markets are not tight. As a result, employees have no bargaining power, and their wages will shrink in real terms (adjusted for headline inflation). Given that food and energy make up a larger share of the consumer basket in emerging economies, high energy and food prices will meaningfully reduce household income available for discretionary spending. Consequently, EM household spending will disappoint. In light of lackluster consumer demand, business investment will not pick up much either. Finally, monetary and fiscal policies in EM are reasonably tight. In Latin America, the credit and fiscal spending and monetary impulses are pointing to economic weakness ahead (Chart 14).  Overall, potential political volatility and disappointing domestic demand are risks to EM financial markets. Chart 14Latin American Economies Will Decelerate Latin American Economies Will Decelerate Latin American Economies Will Decelerate Chart 15A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year Question: What is your recommended investment strategy for EM overall and country allocation? Answer: We continue recommending an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive as their yields have spiked (Chart 15). We are waiting to buy EM local bonds later this year using the potential weakness in their currencies. For now, we have the following positions in individual local rates: long 10-year Brazilian bonds, currency unhedged; receiving 10-year swap rates in China and Malaysia; betting on yield curve flattening in Mexico; receiving 10-year Czech / paying 10-year Polish swap rates. The list of country allocation for EM equity, credit and domestic bond portfolios is presented in Table 1. Table 1Our Country Allocation Across Asset Classes What Are Clients Asking? What Are Clients Asking? ​​​​​​​   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     What Are Clients Asking? What Are Clients Asking? What Are Clients Asking? What Are Clients Asking?

Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. The Bond Yield Turns About 2-3 Months Before Core Inflation The Bond Yield Turns About 2-3 Months Before Core Inflation Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size.   A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1).       Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent.  In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System Goods Demand Shows The Classic Hallmark Of A Non-Linear System Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2  To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation The Bond Yield Turns About 2-3 Months Before Core Inflation The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF Go Long JPY/CHF Go Long JPY/CHF The 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 The 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 Cotton’s Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal US 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 Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-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 I-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 I-3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart I-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 I-6US Healthcare Providers Vs. Software Approaching A Reversal US Healthcare Providers Vs. Software Approaching A Reversal US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-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 I-9Bitcoin'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 I-10Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart I-16The 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 I-17The 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 I-18Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US 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   Fractal Trading System   Fractal Trades Fat-Tailed Inflation Signals A Peak In Bond Yields Fat-Tailed Inflation Signals A Peak In Bond Yields Fat-Tailed Inflation Signals A Peak In Bond Yields Fat-Tailed Inflation Signals A Peak In Bond Yields 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 Long Small Cap Energy Versus Large Cap Investment Takeaways Investment Takeaways President Biden has not received a boost in opinion polls from the Ukraine war. If he has not by now then it is increasingly unlikely that he will do so. Yet Biden performs worse in polls for his handling of economic policy than foreign policy, despite falling unemployment and rising real wages. The economy should help stabilize his approval rating but not in time to prevent Democrats from losing the Senate as well as the House this fall.  Biden’s decision to tap the strategic petroleum reserve exemplifies our 2022 trend of executive action. However, the oil outlook still depends on Biden’s Iran talks and OPEC’s reaction. Recommendation Inception Level Inception Date Return Long Small Vs. Large Cap Energy 0.56 26-Jan-22 14.9% Bottom Line: The return of gridlock is bad for stocks in 2022 but good in 2023. Feature Investors need answers to three questions about US policy at the moment: 1.   Will President Biden’s reaction to the Ukraine war exacerbate the hit to the global and US economy? 2.   Will Biden’s domestic agenda revive? If so, how will it impact corporate earnings expectations? 3.   Will Biden’s foreign and domestic policies cause any changes to the midterm election outlook and hence US policy in 2023-24? In recent reports we have answered these questions as follows. Related Report  US Political StrategySecond Quarter Outlook: Gridlock Looms First, Biden will continue to pursue a defensive or reactive foreign policy, meaning that he will not force Europe or other allies to adopt Russia sanctions beyond their near-term economic and political capabilities. If Europe wants to boycott Russian energy then that is fine but it is Europe’s decision. In fact, Europe is pursuing gradual rather than immediate diversification. Russia needs the funds. So Europe is unlikely to experience a sharp energy cutoff that plunges its economy into recession. Nevertheless, the risk is substantial enough that we remain long DXY and defensive US sectors on a tactical time frame. Second, Biden’s congressional agenda is getting back on track, with the war providing Democrats with a basis for redesigning and rebranding their budget reconciliation bill. Therefore we did not downgrade our 65% subjective odds that Congress will pass a bill. The bill will be close to deficit neutral and focused especially on energy policy. The Senate version of the bill is not yet available but we will examine the likeliest policy options in a forthcoming special report with our US Equity Strategy. Third – our focus for this report – current political changes do not substantially alter the midterm election odds, which suggest Republicans will retake Congress. Gridlock will return – and is the norm in US policy. In an inflationary context gridlock may well be positive for equities in 2023 since it will curb fiscal spending. However, uncertainty is negative for equities this year. We remain tactically defensive. We recommend renewable energy, cyber stocks, defense stocks, and infrastructure stocks as cyclical plays. Biden’s Approval Stabilizing At Low Level Foreign policy shocks are likely to hurt the ruling party – especially if the nature of the shock exacts a toll on the voter’s pocketbook. We showed evidence to this effect just before Russia re-invaded Ukraine. We concluded that Biden would experience a bounce in opinion polls as the nation rallied around him in the face of the Russian menace but the likely rise in gasoline prices would end up hurting the Democratic Party in the midterm elections.  Yet 40 days after Russia’s attack Biden’s general job approval is still at the lowest of his presidency, in the 41-42% range, while his disapproval is still high, in the 52-53% range. So far the war has not given him an appreciable boost, outside of his own party (where the boost has still been small). The results are even worse when it comes to his handling of the economy. Here his approval is 39% and disapproval 54%. In foreign policy, Biden’s approval stands at 40% and disapproval at 52% (Chart 1). Presidential approval has a big influence on the midterm election – as does perception of the two parties. Republicans have taken the lead in the generic congressional ballot, at 43.7% support versus 42.2% for Democrats. The war has blunted the Republican rally but nothing more. The economy is the likeliest source of good news for Biden and the Democrats over the coming six months but even here there is not a basis for optimism among Democrats, as we will see in the next section.  Chart 1No ‘War Bounce’ For Biden War Not Helping Biden So Far War Not Helping Biden So Far Jobs And Wages Not Boosting Biden Either Our Political Capital Index shows that the Biden administration now has weak or moderate political capital in every category except economic conditions and financial markets (Appendix). Yet economic conditions are still mixed. While they will likely improve before November, they do not look to improve enough to change the election outlook: Both Republicans and Democrats are viewing the economy more negatively. Republican economic sentiment declined by 16% in March, while Democrat economic sentiment declined by 6%. The partisan gap widened, which means Republicans will remain motivated to vote (Chart 2). Manufacturing activity is slowing down (though not shrinking). The reading slipped lower than its level in November 2020, when Biden took office. This drop is the first sign of the negative effect of inflation and geopolitical risk on the economy. New manufacturing orders declined while inventories increased. The new-orders-to-inventories ratio, which should be a leading indicator of economic activity, fell by 15.7% compared to its February reading. It is now the weakest since May 2020 (Chart 3). Chart 2Economic Sentiment Declines For Both Parties Economic Sentiment Declines For Both Parties Economic Sentiment Declines For Both Parties The budget deficit is “normalizing” and weighing on demand. The fiscal thrust – or change in the budget deficit – turned negative as the stimulus of 2020 waned. The intensity of the drag is now lessening, both on the federal and state level, but it would require a massive new crisis for the US to outdo the stimulus of 2020, so the drag will persist for the foreseeable future (Chart 4). Any last-minute reconciliation bill from congressional Democrats would reduce the drag further, but not generate positive thrust, and not in time to affect the election. To pass the bill, Democrats need to reduce the deficit impact in the face of inflation and paper-thin congressional majorities. Chart 3First Sign Of Inflation, Geopolitics Hitting Manufacturing First Sign Of Inflation, Geopolitics Hitting Manufacturing First Sign Of Inflation, Geopolitics Hitting Manufacturing Chart 4US Fiscal Drag In Wake Of 2020 Stimulus US Fiscal Drag In Wake Of 2020 Stimulus US Fiscal Drag In Wake Of 2020 Stimulus Most worrisome for President Biden, his approval rating has suffered despite a tight labor market and real wage growth. The headline unemployment rate declined to 3.6% in March, down 3.1 percentage points since November 2020. The ISM manufacturing employment index stands at the highest point since March of 2021, and 17% higher than in November 2020 (Chart 5). Inflation is apparently eating away the benefits of low unemployment. Real wages grew by 3.3% on an annual basis in February, up from 2.5% in January. This wage growth is higher than that of November 2020, at 2.2%. Biden’s approval rating is probably in the process of stabilizing, if we assume that unemployment stays low and real wages keep growing. But it is stabilizing at a low level and not perking up as a result of the Russian menace. The likeliest culprit for Biden’s troubles is inflation. Fortunately for the Democrats inflation is likely to fall in the coming months. However, voters are likely to respond to year-on-year rather than month-on-month inflation. And voters make up their minds early in midterm election years. Plus, if inflation does not subside, or if Biden is perceived as making a foreign policy mistake, then his approval rating will not stabilize. Bottom Line: Biden’s approval rating is not perking up despite a foreign threat. His approval on economic policy is even worse than on foreign policy, despite low unemployment and real wage growth higher than when he took office. A drop in inflation would improve his fortunes but taken together the evidence suggests that the war has not helped, and may have hurt, the Democrats’ chances this fall. Chart 5Will Jobs And Real Wages Stabilize Presidential Approval? Will Jobs And Real Wages Stabilize Presidential Approval? Will Jobs And Real Wages Stabilize Presidential Approval? Biden Taps Strategic Oil Reserve But Implications Depend On Iran One of our key views for 2022 (reiterated in our Q2 outlook) is the Biden administration’s transition from congressional to executive action. Biden’s decision to tap the strategic petroleum reserve (SPR) on March 31 exemplifies this trend. Gasoline prices have spiked to $4.20 per gallon, which is more than double the level in November 2020 (Chart 6). Biden’s SPR order aims to mitigate the rise in prices. Biden ordered the release of 1 million barrels per day of crude oil over the next 180 days (six months). This would constitute the largest release since the SPR came into being in 1975 (Chart 7).1 Chart 6Prices At The Pump Trigger Red Alert In White House Prices At The Pump Trigger Red Alert In White House Prices At The Pump Trigger Red Alert In White House Chart 7Biden Taps Strategic Petroleum Reserve Biden Taps Strategic Petroleum Reserve Biden Taps Strategic Petroleum Reserve The Strategic Petroleum Reserve (SPR) originated in the wake of the Arab oil embargo to protect the US from supply shocks. Faced with “severe petroleum supply interruptions” the president can authorize a maximum drawdown of 396 million barrels over 90 days, which begin reaching the market roughly 13 days after the decision. The current inventory is 570 million barrels of sweet and sour crude, which could last 92 days of crude imports and 72 days of crude and petroleum product imports (Chart 8). Unlike during the 1970s, today the US is the world’s largest oil and refined products producer. It is a net exporter as well. However, it is still vulnerable to external shocks. It imports 6.3 million barrels per day and has already cut off 283 thousand barrels per day of imports from Russia (Chart 9). Global price shocks still affect the US prices at the pump, as Chart 6 above shows in the relationship between domestic gasoline prices and Brent crude. Chart 8SPR Can Be Tapped For Six-To-Nine Months Easily SPR Can Be Tapped For Six-To-Nine Months Easily SPR Can Be Tapped For Six-To-Nine Months Easily Chart 9US Energy Independent But Still Vulnerable To Shocks US Energy Independent But Still Vulnerable To Shocks US Energy Independent But Still Vulnerable To Shocks The Ukraine crisis is just the sort of geopolitical crisis that the SPR was invented to address – but the magnitude of Biden’s action is larger than normal. The SPR was tapped for 21 million barrels in 1990-91, during the Iraqi invasion of Kuwait, and for 30 million barrels in 2011, when Libyan production fell to zero amid the revolution. However, because of US net exporter status, Biden has much more room for maneuver. The SPR would be tapped for 180 million barrels if Biden’s current plan is fully implemented. The SPR can be released at a rate of 4.4 million barrels per day for about 90 days, though after that the drawdown rate begins to decline for technical reasons (e.g. contaminants). Biden’s 180 days would end in early October, a month before the midterm election. If the SPR has at least 282 million barrels left (90 days of US net crude imports in 2021), the president can continue to release oil from it. The minimum storage level is 282 million barrels of crude. Thus at the end of Biden’s current order, he would have 390 million barrels left and would still be able to release 1 million barrels per day for 108 days.  There are various interpretations of Biden’s decision to tap the SPR today: Currently the Russians and Europeans are in a standoff over energy flows. Russia is demanding payment in rubles and Europe is rejecting Russia’s demands while threatening to ban Russian coal imports. Since crude oil is generally interchangeable, an EU-Russia breakdown in crude trade would not prevent Russian barrels from reaching global markets eventually (Chart 10). In short Biden did not tap the SPR in anticipation of a breakdown. Biden could have tapped the SPR because of difficulties convincing the core OPEC states to increase production. Saudi Arabia, the UAE, and Kuwait are rapidly increasing production already, though their 90-day spare capacity enables them to bring out as much as 3.5 million additional barrels per day. But on March 31 they ruled out any massive near-term adjustments. Their relations with the US under the Biden administration have been strained, namely as Biden is still trying to rejoin the 2015 Iranian nuclear deal. If the US and Iran rejoin the 2015 deal, the US would lift sanctions and Iran could quickly bring about 1.3 million barrels per day back to global markets. Biden’s SPR release is roughly equal to this amount, which means it could be insurance for a failure to do a deal (Chart 11). Chart 10Russian Oil Exports To Europe And World War Not Helping Biden So Far War Not Helping Biden So Far An Iran deal on top of the SPR release would add 2.3 million barrels per day in positive supply surprises, while reducing the short-term risk of a military conflict in the Persian Gulf. This would have a significant short-term negative impact on oil prices this year. Chart 11Biden Struggles For Help From OPEC Biden Struggles For Help From OPEC Biden Struggles For Help From OPEC What is clear is that our Geopolitical Strategy’s base case of a failure of US-Iran talks would imply a significantly higher risk of oil disruptions in the Middle East over the short and long run. In that case the OPEC states would need to change their position and increase production or else a new supply shock would be added on top of the Russian shock. Biden’s SPR release would make up for production bottled up in Iran but regional supply disruptions would intensify and Iran would threaten the Strait of Hormuz. Biden’s executive action to tap the SPR removes one option from the table. The ultimate impact of this move depends on whether Biden also uses executive action to do a deal with Iran. We cannot rule it out, because Biden has the authority to lift sanctions unilaterally, but we would not bet on it. Bottom Line: Market fundamentals suggest that Brent prices will fall from their current $105 per barrel toward their likely average of $93 per barrel this year and in 2023. Quant Model Points To Republican Senate Last week we highlighted that our Senate election model flipped from predicting the status quo to predicting a Republican victory, in line with our subjective view of the situation. The latest model findings, using data from the state coincident economic indicators released on April 5, suggests that Republicans have a 51.6% chance of gaining control of the Senate (Chart 12). Democrats only need to lose a single seat to slip from 50 to 49 seats and thus yield the majority. The model suggests they will lose two seats, in Arizona and Georgia. The result is a Republican majority of 52-48 seats. Chart 12Senate Election Model Flips To Republicans War Not Helping Biden So Far War Not Helping Biden So Far Our presidential election model still shows Democrats holding onto the White House in 2024 with 308 electoral college votes but their chances are declining. Specifically Democrats’ odds of retaining the White House have fallen from 54.9% to 54.7% now that the March data is taken into account (Chart 13). North Carolina is still considered a toss-up state, with a 45% probability that Democrats win it, but that means that a single percentage point drop puts it firmly in the Republican camp, along with Arizona and Georgia. Democrats’ odds are falling in Florida, Pennsylvania, and Nevada especially, although they are improving in Wisconsin and Minnesota. Chart 13Presidential Election Model Still Slightly Favors Democrats War Not Helping Biden So Far War Not Helping Biden So Far Florida presents an interesting difference between the two models: the Senate model gives Florida to the Republicans, while the presidential model gives it to the Democrats. This requires some explanation: The incumbent advantage plays a role. Biden did not win Florida in 2020 but that does not stop the model from ascribing Democrats a good chance of winning Florida given that they are the incumbent party. Incumbency would be punished if Democrats held the White House for eight years due to the variable that accounts for the public sentiment that it is “time for change.” The Senate model works differently. The model only helps the party that controls a state Senate seat by means of the partisan leaning of the state in recent elections. This is helpful for Republicans in the model’s 2022 prediction. Meanwhile the model only punishes an incumbent party if it has held control of the US Senate for three or more terms, which is not the case today. Our sample periods across the two election models are the same (1984-2020), but in this period, Democrats only held Senate seats for three out of nine changes. There have been nine different senators from Florida since 1989, three of which have been Democrats. The last Democratic senator was Bill Nelson but he was beaten by Republican Rick Scott in 2018. The other Senate seat has been held by a Republican since around 2004, most recently Marco Rubio, who is up for re-election in 2022. So the model will “lean” more Republican based on total outcomes and how recently recurring they were. Finally, a caveat: we should be careful about explicitly comparing the two election models. Although they are both Probit models, the variables are not all the same. Some are shared but their interaction with one another and the election outcome (dependent variable) should not be assumed to be exactly the same. There can be little doubt in the model’s outlook for the Florida Senate race. Senator Marco Rubio is a young incumbent, has strong name recognition, and is up for re-election in a favorable year for Republicans. As of February he was leading his top Democratic opponent Val Demings by 12 percentage points in opinion polls. Confirming the state’s Republican leaning, Governor Ron DeSantis was leading his Democratic opponent Charlie Crist by 21 percentage points in February polls, with over 50% favoring DeSantis. (Other than former President Trump, DeSantis is currently the favored Republican nominee for 2024.) Moreover the presidential model is catching up to the Senate model, with the odds of a Democratic win in Florida dropping from 59% to 55% over the past month alone. If the odds fall beneath 50% then the model naturally awards all of Florida’s 29 electoral votes to the Republicans. This would leave Democrats hanging by a thread at 279 votes. What is clear is that the 2024 election is a long way off. Democrats benefit from an incumbent advantage as a political party, aside from whether President Biden runs again. Yet the quantitative model suggests that the US will experience another hotly contested presidential election. Bottom Line: Republicans are now tipped to take the Senate in our quantitative model as well as our subjective judgment. Meanwhile Democrats are still favored to win the 2024 election but only slightly, and their odds are falling. These views support the market consensus but in general US investors will remain risk averse ahead of the midterm election.  Investment Takeaways Stay tactically long the US dollar and defensive stocks like in the health care sector. Russia is threatening to cut off energy exports to Europe, which is considering a ban on Russian coal. Until this dispute is resolved, risk appetite will suffer, the euro will be limited, and the dollar will stay strong. Stay long renewable energy, cyber security stocks, infrastructure stocks, defense stocks, oil and gas distribution, and small cap energy stocks (Chart 14). Chart 14Investment Takeaways Investment Takeaways Investment Takeaways Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst guyr@bcaresearch.com   Footnotes 1     See White House, “FACT SHEET: President Biden’s Plan to Respond to Putin’s Price Hike at the Pump,” March 31, 2022, whitehouse.gov; Department of Energy, “Strategic Petroleum Reserve: Providing Energy Security For America,” March 28, 2022, energy.gov; and Heather L. Greenley, “The Strategic Petroleum Reserve: Background, Authorities, and Considerations,” Congressional Research Service, R46355, May 13, 2020, crsreports.congress.gov.   Appendix Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix War Not Helping Biden So Far War Not Helping Biden So Far Table A3US Political Capital Index War Not Helping Biden So Far War Not Helping Biden So Far Chart A1Presidential Election Model War Not Helping Biden So Far War Not Helping Biden So Far Chart A2Senate Election Model War Not Helping Biden So Far War Not Helping Biden So Far Table A4APolitical Capital: White House And Congress War Not Helping Biden So Far War Not Helping Biden So Far Table A4BPolitical Capital: Household And Business Sentiment War Not Helping Biden So Far War Not Helping Biden So Far Table A4CPolitical Capital: The Economy And Markets War Not Helping Biden So Far War Not Helping Biden So Far  

Executive Summary Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone ​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral ​​​​​ Chart 8No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels ​​​​​​ Chart 12Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US ​​​​​​ Chart 14Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations ​​​​​​ Chart 15Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 18Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​​ Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase  

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Listen to a short summary of this report.       Executive Summary Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively.  Tighter financial conditions augur badly for growth (see Chart).  We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious   Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Supply Chains Remain Disrupted Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Chart 6Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Will PMIs Fall Below 50? Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13).   Chart 11China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken European Data Starting To Weaken European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much.  Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Risks To Our View Chart 17Fed Feedback Loop Back In Action? Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending ...And So May Keep On Spending ...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months.     How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components.  Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3).   Chart 23AOPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries... ...Unlike Other Countries... ...Unlike Other Countries... Chart 23CTo Restore A Balanced But Tight Market To Restore A Balanced But Tight Market To Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price.   Chart 24Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound?  Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1).  Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3).  Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth.  As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US.   Global Economy Chart 25Global Growth Remains Robust... Global Growth Remains Robust... Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months.   Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system.  Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1).  In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2).  Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched.    Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation.   Corporate Bonds Chart 30Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis.   Commodities Chart 31Risks To Oil Price Are To The Upside Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4).   Currencies Chart 32Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months.   Alternatives Chart 33Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4).   Footnotes 1   Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary The Dollar And The Yield Curve The Dollar And The Yield Curve The Dollar And The Yield Curve The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s. Beyond that timeframe, the path of the dollar has depended on what other central banks are doing, and/or which stage of the business cycle we are in. The flattening yield curve in the US is coinciding with a strong dollar (Feature chart), but the historical evidence is that this relationship is very fickle. While the dollar tends to rise during recessions, the average business cycle over the last 40 years has also lasted 90 months, making a recession in the next year possible, but not probable. The dollar has usually followed a long boom/bust cycle of 10 years. If the Fed stays behind the inflation curve, we could be entering a period of weakness akin to the pre-Volcker years in the 70s. The greenback has also tended to be seasonally strong in H1 and weaker in H2. The yen has generally been the best-performing currency shortly after a Fed rate hike. Go short USD/JPY if it touches 124. RECOMMENDATION INCEPTION LEVEL inception date RETURN Short USD/JPY 124 2022-04-01 - Bottom Line: Our bias remains that the DXY index does not have much upside above 100. Our 12-month target remains 90. Feature Chart I-1Dollar Action Before Curve Inversions Is Mixed Dollar Action Before Curve Inversions Is Mixed Dollar Action Before Curve Inversions Is Mixed Rudi Dornbusch was one of the pioneers behind the theory that currency markets tend to overreact. His observation was as simple as it was brilliant. Currency markets are fluid, while prices tend to be sticky. Therefore, a monetary response to an inflation overshoot will initially cause a knee-jerk reaction in the currency before it settles back towards equilibrium. While we have oversimplified Dornbusch’s overshooting model, it is hard to ignore the fact that today’s currency and bond markets could potentially be overreacting. The 10-year/2-year US Treasury spread briefly turned negative this week, as the short end catapulted higher. Historically, that has been a precursor to an impending recession. This is important because the dollar has usually done well during recessions, even though its performance ahead of doomsday has been mixed over a 40-year period (Chart I-1). Given this backdrop, this report attempts to answer a few questions. How has the dollar performed over prior Federal Reserve tightening cycles? What drives the relationship between the dollar and the yield curve? Are the Fed rate hikes currently priced in the short end of the curve credible? Which currencies have historically excelled or suffered once the Fed begins to tighten policy? And finally, what is the roadmap investors should use to gauge the path of the dollar going forward? The Dollar And The Yield Curve Chart I-2A Rising Dollar Has Tracked A Flattening Curve A Rising Dollar Has Tracked A Flattening Curve A Rising Dollar Has Tracked A Flattening Curve The relationship between the dollar and the yield curve has been tight over the last three years. A flattening curve throughout most of 2018 signaled US policy was getting too restrictive relative to underlying economic conditions. The dollar was also rising (Chart I-2). The Federal Reserve eventually responded by cutting rates, which allowed the curve to steepen again, eventually putting a top in the greenback. Our Chief US Bond Strategist, Ryan Swift, has characterized this cycle as the dollar/bond feedback loop (Chart I-3).    Chart I-3The Dollar/Bond Feedback Loop Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes In retrospect, this feedback loop works through two channels. First, almost 90% of global transactions are conducted in US dollars, which means the cost of doing business (paying for imports, reconciling accounts payables, servicing debt, and so on) rises for foreigners as the dollar appreciates. This puts a break on economic activity abroad. Second, as a counter-cyclical currency, the dollar tends to attract capital when growth in the rest of the world is slowing, reinforcing this loop. Eventually, a strong dollar and rising domestic bond yields put a break on US economic activity, which causes the Fed to back off. Investors with a high-conviction view that we are close to a recession should be buying the dollar on weakness. In our view, many central banks are becoming too hawkish at the exact moment global growth is set to slow. That said, not unlike the Dornbusch analogy at the start of this text, currency markets have overreacted. Specifically: Over the last 40 years, the average business cycle has lasted 90 months. An inverted yield curve does not corroborate this fact, considering the recession in 2020. It is well known that there are previous episodes of the yield curve inverting, without an impending recession. This time around, rate hike expectations have been heavily priced at the front end of the curve, while being underpriced at the long end. The inference is that the market thinks the Fed is about to make a policy mistake. With policy rates in the US still at 25-50 bps, those near-term rate expectations will turn out to be wrong if US economic growth does indeed slow, forcing the Fed to pivot. The term premium in the US (and globally) is very low, and could rise as quantitative easing is wound down, and yield-curve control is relaxed in bond markets such as Japan. That could help lift longer-term bond yields. Global yield curves have tended to move in unison, with the UK curve historically being the first to invert ahead of a recession. That has not yet happened. Elsewhere, Japanese, and German yield curves are steep (Chart I-4). Chart I-4Global Yield Curves Tend To Move In Unison Global Yield Curves Tend To Move In Unison Global Yield Curves Tend To Move In Unison Historically, the relationship between the yield curve and the dollar has not been consistent (Chart I-5). In the early 80s, the dollar initially rose with a steepening yield curve. In retrospect, rising real rates at the long end of the Treasury curve drove the initial dollar rally. The backdrop was Federal Reserve Chairman Paul Volcker’s resolve to crack down on inflation. Thereafter, rising trade imbalances on the back of a strong dollar eventually led to the Plaza Accord in 1985, which weakened the dollar despite a curve that remained steep. In the 1990s, the dollar rose along with a flattening curve and a productivity boom in the US. In both the latter half of the 2000s and 2010s, the curve flattened, but the performances of the dollar in each case were opposites - weakness in the 2000s, but strength over the last decade. Chart I-5No Consistent Relationship Between The Dollar And The Yield Curve No Consistent Relationship Between The Dollar And The Yield Curve No Consistent Relationship Between The Dollar And The Yield Curve The bottom line is that the dollar tends to do well during recessions, which historically has happened after the yield curve inverts. Prior to that, the performance of the dollar is mixed. Dollar Performance Over Prior Tightening Cycles Chart I-6The Dollar Falls After The First Fed Rate Hike The Dollar Falls After The First Fed Rate Hike The Dollar Falls After The First Fed Rate Hike The dollar has tended to decline 3-to-6 months after the Fed starts hiking interest rates. This has been true since the mid-1990s (Chart I-6). The average decline after six months has been 5.3%. This will pin the DXY at around 95 or so by late summer. As the Appendix  shows, while this relationship has been consistent for the dollar, it has been inconclusive for the hiking cycles of other central banks. The exceptions are the CAD, GBP, and SEK which tend to rally three months after their respective central banks raise rates. The AUD initially stalls but performs well one year after the Reserve Bank of Australia lifts interest rates. There is a rationale as to why the dollar performs well ahead of interest rate increases by the Fed, and falters shortly after. Historically, the Fed has usually been the first to start the process of hiking interest rates globally. It has also been the central bank that has lifted rates by the most (Chart I-7). This history of credibility has nudged forward markets to grow accustomed to anticipating the Federal Reserve to be ahead of the curve. As of now, US policy rates stand at 0.25% but the two-year yield is at 2.4%. This divergence could be viewed as vote of credibility akin to during the Volcker years (Chart I-8). Chart I-7The Fed Has Usually Led The Hiking Cycle The Fed Has Usually Led The Hiking Cycle The Fed Has Usually Led The Hiking Cycle Chart I-8The 2-Year/3-Month Treasury Spread Is Very Wide The 2-year/3-month Treasury Spread Is Very Wide The 2-year/3-month Treasury Spread Is Very Wide Beyond a 3-to-6-month timeframe, the path of the dollar has depended on what other central banks are doing (Table I-1). The BoE, BoC, Norges Bank, and RBNZ all raised rates before the Fed. The Riksbank and RBA ended QE ahead of the Fed. The BoJ’s balance sheet has been flat-to-shrinking since 2021. The US dollar has tended to do well when US interest rates are in the top decile amongst the G10 countries (Chart I-9).  While that was true before the Covid-19 crisis, it is no longer the case today. This suggests the onus is on the Fed to meet market expectations and keep the dollar strong. Table I-1The Performance Of Currencies Is Mixed When Their Resident Central Bank Hikes Rates Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-9The Fed Is Lagging Other G10 Central Banks The Fed Is Lagging Other G10 Central Banks The Fed Is Lagging Other G10 Central Banks Interestingly, the yen has generally done very well around Fed rate hikes (Chart I-10), followed by commodity currencies (Table I-2). It also happens to be incredibly cheap today (Chart I-11). Our bias is that should inflation pick up faster in Japan, the yen will rally ahead of any anticipated changes to monetary policy. Chart I-10G10 Currencies Around The First Fed ##br##Rate Hike G10 Currencies Around The First Fed Rate Hike G10 Currencies Around The First Fed Rate Hike Table 2Most Currencies Appreciate Shortly After The First Fed Rate Hike Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-11The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Are Fed Rate Hikes Sustainable? There is a case to be made that the Federal Reserve could indeed hike interest rates faster than other economies. The 3-month rate-of-change in the dollar has closely followed the mini-growth oscillations between the US and other G10 economies (Chart I-12). US growth is now relatively strong (as measured by relative PMIs or relative economic surprise indices). Barring a global recession, the Fed has more scope to raise interest rates. Related Report  Foreign Exchange StrategyThe Yen In 2022 On the flip side, financial conditions in the US are tightening quickly as mortgage rates rise, and the dollar soars. This is happening at a time when growth is weak in China and the PBoC is on an easing path. Chinese long bond yields (a proxy for Chinese growth) tend to rise when the PBoC stimulates growth. (Chart I-13). When the number of Covid-19 cases in China rolls over, there will be a case for growth to firmly bottom. Chart I-12Economic Growth Is Relatively Strong In The US Economic Growth Is Relatively Strong In The US Economic Growth Is Relatively Strong In The US Chart I-13The Chinese Economy Is Soft The Chinese Economy Is Soft The Chinese Economy Is Soft This is important since most Asian economies are very dependent on China to close their output gaps and reach escape velocity in economic growth. Take the example of Japan. Tourist arrivals (mainly from Asia) generally represent 25% of the overall Japanese population but today, that number remains near zero. As a result, consumption outlays in Japan are well below the pre-pandemic trend (Chart I-14). As growth recovers, the Japanese economy should be one of the best candidates for generating non-inflationary growth. This is a bullish backdrop for the currency. Chart I-14Japanese Consumption Is Well Below Trend Japanese Consumption Is Well Below Trend Japanese Consumption Is Well Below Trend Finally, real interest rates in the US remain very low. Empirically, currencies react more to the path of relative real rates (Chart I-15). Chart I-15US Real Rates Are Very Low US Real Rates Are Very Low US Real Rates Are Very Low Seasonality: Friend Or Foe? Coincidentally, the dollar also usually weakens in the second half of the year (Chart I-16). This dovetails with our bias that the dollar also underperforms after the first Fed interest rate hike. This has been especially true over the last decade (Chart I-17). Chart I-16The Dollar Is Seasonally Weak In H2 Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chart I-17The Dollar Is Seasonally Weak In H2 The Dollar Is Seasonally Weak In H2 The Dollar Is Seasonally Weak In H2 The dollar has already priced in that the Fed will lead the interest rate hiking cycle. However, as we have been highlighting in recent reports, rising inflation is a global problem and not one that is exclusive to the US. The hawks in the ECB are very uncomfortable with this week’s HICP (harmonized index of consumer prices) release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. As a comparison, headline inflation in the US is 7.9%. A weak euro will only fan the inflationary flame in the eurozone.  The Japanese economy could be next in unleashing inflationary surprises, especially on the back of a very cheap yen (Chart I-11). This will raise the probability that the Bank of Japan eases yield curve control. In short, the potential for upside surprises in interest rates is highest outside the US. Concluding Thoughts The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. The BIS report on the topic concludes that short maturity bonds have had the strongest FX impact.1 Moreover, near the effective lower bound, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. As FX becomes the axle of adjustment at lower interest rates, a strong dollar and weaker euro and yen are likely to grease the wheels of an economic rebound in these latter economies. For now, economic momentum in the US is stronger, which indicates that the Fed will initially deliver the bulk of rate hikes priced in the OIS curve this year. Beyond then, if growth picks up faster outside the US, especially in the euro area and Japan, then the USD could enter a consolidation phase. Finally, the yen has tended to be the best-performing currency after a Fed rate hike. Go short USD/JPY if it touches 124. Appendix: Currency Performance Around Interest Rate Hikes United States Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes United States Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Euro Area Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Japan Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes United Kingdom Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Canada Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes   Australia Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes New Zealand Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Switzerland Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Norway Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Sweden Lessons From Fed Interest Rate Hikes Lessons From Fed Interest Rate Hikes Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. 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