Fixed Income

Special Report

Highlights We update our assumptions for the likely 10-15 year return for a wide range of different asset classes. Our methodology is basically unchanged from our last Return Assumptions report published in 2019, though we have refined our analysis and use of data in some areas. Returns over the next decade will be very low compared to history. We project that a standard global portfolio (50% equities, 30% bonds, and 20% alternatives) will return only 3.0% a year in nominal terms. That compares to a historic return of 6.3%. There are still some assets that will produce better returns, most notably small caps (4.9% a year in the US) and alternatives (6.2% for private equity, for example). But they also carry higher risk. Spreadsheets are available with detailed data. Introduction This is the third edition of our work on return assumptions. Since publishing the previous reports in November 2017 and June 2019, we have had many opportunities to discuss our methodologies with clients and in the Global Asset Allocation course at the BCA Academy. This has allowed us to test and, in many cases, refine our approach. We believe the methodologies we use have stood the test of time. We have always emphasized that this sort of capital markets assumptions (CMA) analysis is an art, not a precise science. We continue to prefer to project returns over a somewhat undefined 10-15 year period, since this allows us to think about the underlying trend of likely returns. Many other CMA papers use five (or even three) year time horizons which, in our view, are problematical since they rely heavily on a forecast of the timing, length, and severity of the next recession. Our approach is based on the concept that the return on the risk-free long-term government bond is the cornerstone to projecting asset returns, and that this return is rather predictable: It is approximately the current yield. Most other asset returns can be built up from that – the return on high-yield bonds, for example, by assuming that their historic spread over government bonds, and default and recovery rates will continue in the future. For equities, we continue to use six different methodologies, which are based on a mixture of valuation and projected earnings growth. This approach – that assumed returns can be built up from a combination of current yield plus forecast future growth in capital values – also works for most alternative asset classes, for example real estate. We have made a few minor changes to our methodology in this edition. We have, for example, made our use of historical data (for spreads, profit margins, growth relative to GDP, etc.) more consistent, using the 20-year average where possible. The biggest change this time is that clients can download here a spreadsheet with all the data in this report in order, for example, to use the data as inputs into their own optimizers. In addition, we have set up our detailed spreadsheet to allow clients to see the underlying inputs, the formulae behind our methodologies, and to input their own assumptions. This will also allow us to update the results of our analysis as often as needed. Please let us know here if you would like more details about this additional service. This Special Report is structured as follows. First, we analyze the overall results: What is the probable return from each asset class over the next 10-15 years, and how do these differ from historical returns. Next, we describe in detail the methodologies we use, for (1) economic growth, (2) fixed-income instruments, (3) equities, and (4) 12 different alternative asset classes. Then, we describe our way of forecasting currency returns, and show the return assumptions in different base currencies. Finally, we update the numbers for volatility and correlations, which many investors need as inputs into optimization programs. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in US dollars). The data is updated to end-April 2021 (except for some alternative asset classes where only quarterly data is available). Table 1BCA Assumed Returns Overall Results Returns over the coming decade are likely to be very disappointing compared to history. Our assumptions suggest a typical global portfolio, consisting of 50% large-cap equities, 30% bonds, and 20% alternatives, will produce an annual nominal return of only 3.0%, compared to an average of 6.3% over the past 20 years. A US-only portfolio with a similar composition is likely to produce only a 3.1% return, compared to 7% in history. The reason is simple: Valuations currently are very stretched in almost every asset class. The risk-free rate (the 10-year government bond yield) in the US is 1.6% (compared to a 20-year average of 3.1%). It is negative in the euro area (in nominal terms) and zero in Japan. These rates are the anchor for the returns of all other asset classes, which are theoretically priced off the risk-free rate plus a risk premium. We have long argued that valuations are not a good timing tool for investors. An asset can remain very expensive or very cheap for a considerable period. But all the evidence shows that the valuation at the starting point is a very powerful indicator of long-run returns. The yield on government bonds, for example, has a strong correlation with their 10-year return (Chart 1). In the equity market, the Shiller PE has historically had little correlation with the return over one or two years, but has a 90% correlation with the return over the subsequent 10 years (Chart 2). Chart 1Starting Yield Determines Bond Returns Chart 2Valuation Drive Long-Run Equtiy Returns     With valuations in equity markets now expensive relative to history (for example, forward PE for US stocks of 22x compared to a 20-year average of 16x, and 18x in the euro zone compared to 13x), investors should expect that equity market returns will be low relative to history. Our assumptions point to a 2.6% annual return from US stocks, 2.3% from the euro zone, and 1.6% from Japan (compared to 8.5%, 3.9%, and 3.5% over the past 20 years). Our assumptions are significantly lower than when we last published our analysis in 2019; then we projected 5.6% for US stocks, 4.7% for the euro zone, and 6.2% for Japan. The difference is that equity multiples have risen and risk-free rates have fallen significantly since then. So what should investors do? They have only two choices: Lower their return assumptions, or increase their weightings in riskier asset classes. Chart 3Hard To See How US Pension Funds Will Achieve Their Targets The average US public pension fund (Chart 3) still assumes a return of 7% a year, and private pension funds’ assumption is not much lower. And yet corporate pension funds have been pushed by their consultants in recent years to increase their weighting in bonds, to more closely match their liabilities (Chart 4). It is almost mathematically impossible to achieve their targets with that sort of portfolio. In other countries, such as Australia or Canada, pension funds’ return targets are typically inflation or cash plus 3-4 percentage points. But even those targets are challenging.   Chart 4...Especially With Over 50% In Bonds There are asset classes which will produce higher returns. For example, we project a return of 4.9% from US small-cap stocks – and 9.7% from UK small caps. US high-yield bonds should produce a return of 3.2% a year (even after defaults) and Emerging Markets local currency sovereign debt 2.7% (in USD terms) – not exactly exciting, but at least a pick-up over other fixed-income securities. The projected returns from illiquid alternative assets continue to look relatively attractive. An equal-weighted portfolio of the 12 alternatives we cover is projected to return 5.7% a year, not much lower than the forecast of 6.1% from our 2019 report (and compared to an average of 7.1% of the past 20 years). There are some alt assets where returns have started to trend down: Private equity, for instance, is projected to return 6.2% a year, compared to 11.1% in history, and hedge funds 4.5%, compared to 5.9%. But the illiquidity premium should not disappear completely, even if the move of alternative investments to become more mainstream has reduced it to a degree. So adding more risky assets to a portfolio is an answer, at least for those investors with a long enough time-horizon that allows them to bear the inevitable big drawdowns that come with having a more volatile portfolio. And, unfortunately, lower returns mean that the incremental return gained for each unit of risk taken has declined compared to the past 10 or 20 years (Chart 5) – the efficient frontier has flattened significantly. Chart 5You Need To Take More Risk To Produce Return How We Came Up With The Assumptions GDP Growth Several of our methodologies use assumptions (for example, in equity methods (2) and (3), based on projections of earnings growth, real-estate capital-value growth, and commodities prices) which require estimates of nominal GDP growth in each country and region. To make these forecasts, we assume that nominal GDP growth can be decomposed into: (1) growth of the working-age population, (2) productivity growth, and (3) inflation. This ignores capital intensity, but it has been relatively stable over history and is difficult to forecast. Table 2 shows the assumptions we use, and our forecasts for real and nominal GDP in each country and region. Table 2Calculations Of Trend GDP Growth For population growth we use the United Nations’ median forecast of annual growth in the population aged 25-54 between 2020 and 2040. This ranges from -1% in Japan to +1% in Emerging Markets – although note that the range of forecast population growth in EM varies widely from 1.2% in India to -1.1% in Korea (and in China, too, is negative at -0.7%). This estimate is reasonably reliable, although it does miss some possible factors, such as changes in the female participation rate, hours worked, and changing openness to immigration. Productivity is much harder to forecast. Over the past 10 to 20 years, productivity growth has trended down in most countries (Charts 6A & B). We take a slightly more optimistic view, assuming that productivity growth over the next 10-15 years will equal the 20-year average. We base this on the belief that part of the decline in productivity since the Global Financial Crisis is due to cyclical reasons which are now dissipating, and also to expectations that new technologies coming through (artificial intelligence, big data, automation, robotics etc) will boost productivity in the coming years. Others take a more pessimistic view. The Congressional Budget Office’s forecast of trend real US GDP growth in 2022-2031 of 1.8%, for example, is lower than our estimate of 2.2% mainly because of its more cautious estimate of productivity growth. Chart 6AProductivity Growth (I) Chart 6BProductivity Growth (II)   To derive nominal GDP growth, we assume that inflation over the next 10 years will be on average the same as over the past 20 years, for example 2% in the US, 1.6% in the euro area, 0.1% in Japan, and 3.9% in Emerging Markets (using a weighted average of EM by equity market cap). This estimate, too, has a high degree of uncertainty. One could imagine a scenario whereby inflation picks up significantly over the next decade due to excessively easy monetary policy, overly generous fiscal spending, growth in protectionism, rising labor pressure for wage increases, and the effects of a rising dependency ratio (the ratio of non-working people, especially retirees, to total population).1 But another scenario of continued “secular stagnation” and disinflation, caused by automation-driven job losses and a chronic lack of aggregate demand, is also conceivable. We think our middle-path forecast is the most sensible one to use in projecting likely asset returns, but investors might also want to plan based on these alternative scenarios too. Note that for Emerging Markets, we continue to show two different scenarios, which vary according to different projections of productivity growth. EM productivity growth has been declining steadily since around 2010, and in all major emerging economies, not just China. Our first scenario assumes that this decline ends and that, as in our assumption for developed economies, productivity growth reverts to the 20-year average. The more pessimistic (and, in our view, more likely) scenario assumes that the deterioration in productivity continues and that in 10 years’ time, EM productivity is the same as the average of developed economies. Which scenario will be correct depends on whether emerging economies, not least China, are able to implement structural reforms over the next decade, for example liberalizing the labor market, allowing a greater role for the private sector, improving corporate governance, and institutionalizing more orthodox fiscal and particularly monetary policy. Fixed Income Our anchor for calculating assumed returns is the return on long-term risk-free assets, specifically the 10-year government bond in the strongest countries. It is a reasonable assumption that an investor who buys, for example, a 10-year Treasury bond today and holds it for 10 years will make 1.6% a year in nominal US dollar terms. While this is not perfectly mathematically correct (since it ignores reinvested interest payments, for instance), empirically the return on government bonds has been very closely linked to the yield at the start-point in history (see Chart 1). From this starting-point in each country, we can easily build up the return for other fixed-income assets. These assumptions and the results are shown in Table 3. Table 3Fixed-Income Return Calculations Government bonds in most countries have an average duration of less than 10 years. Over the past five years, in the US it has averaged 6.4 years, and in the euro area 8.0 years. Only in the UK is the average over 10 years: 12.4 years to be precise. To calculate the return from the government bond index for each country we therefore assume that the shape of the yield curve (using the spread between 7-year and 10-year bonds) in future will be the same as the historic 20-year average. Cash. We assume that over the next 10 years the yield on cash will gradually revert to an equilibrium level. We calculate a market-implied real long-term neutral rate from the 10-year historical average of 5-year/5-year OIS implied forwards deflated by the 5-year/5-year implied CPI swap rate. This is a change from the methodology we used in 2019, when we based this off the neutral rate, r*, as calculated by the Holston Laubach-Williams model. But the New York Fed has temporarily stopped updating its calculation of this due to pandemic-induced volatility in the data, and anyway it was not available for every country. We turn the real cash rate into a total nominal return using our assumption for inflation described in detail in the GDP section above, the 20-year historical average of CPI. For inflation-linked securities, such as TIPS, we take the average yield over the past 10 years (a 20-year average was not available in many markets) and add the assumption for inflation described above. Corporate credit. We assume that spreads, and default and recovery rates, while highly volatile over the cycle, remain stable in the long run (Chart 7). We use 20-year averages for these, except that data for investment-grade default rates in Japan, the UK, Canada, and Australia are not available and so we use the average of the US and the euro zone. High-yield default rates are not available for the UK either, and so we do the same. Other bonds. For government-related debt (which is a big part of some bond indexes, 28% in the US for example) we assume that the 20-year historical average of the option-adjusted spread over government bonds will apply in the future too. We use the same methodology for securitized debt (for example, mortgage- and asset-based bonds): The 20-year average spread over the return on government bonds. Emerging Market debt. The assumptions and results for the three categories of EM debt (US dollar sovereign debt, US dollar corporate debt, and local currency sovereign debt) are shown in Table 4. We here assume that the 20-year average historical spread will continue in future. Default and recovery rates are a little harder to calculate, due to a lack of data. For USD sovereign debt (where defaults are rare and so hard to project), we use the rating-based default rate, calculated by Aswath Damodaran of NYU Stern School of Business.2 For USD-denominated EM corporate debt, we use the historical average, calculated by Moody's 2.5%.3 For local-currency debt, we use the same rating-based default rate as for USD sovereign debt. To translate the return into hard currency, we assume that currencies will move in line with the inflation differential between Emerging Markets and the US. For EM inflation we use an average of the IMF’s inflation forecasts for the nine largest emerging markets weighted by their weights in the J.P. Morgan GBI-EM Global Diversified local government bond index, and compare this to our US inflation forecast. This produces an EM inflation forecast of 2.9% a year, compared to 2.2% for the US, thus lowering the USD-based return from local EM debt by 0.7 percentage point. (See a more detailed discussion of forecasting long-term EM currency changes in the Currency section below). Index returns. Table 3 also shows the assumed return for the Bloomberg Barclays bond index for each country and for the global bond index, based on a weighted average of our assumption for each fixed-income asset class and country. Chart 7ACredit Spreads & Default Rates (I) Chart 7BCredit Spreads & Default Rates (II)   Table 4Emerging Market Debt   Equities The assumptions and detailed results for seven different equity markets are shown in Table 5. We have not made any substantial changes to our methodology for equities. We continue to use the average of six different methods to calculate the probable equity returns over the next 10-15 years. These are: Equity Risk Premium (ERP). The return from equities equals the yield on government bonds (we use 10-year bonds) plus an equity risk premium. For the US, we use an equity risk premium of 3.5%. This is based on work by Dimson, Marsh and Staunton4 showing that this is approximately the average excess return of equities over bonds in developed economies since 1900. We scale the equity risk premium for other countries using their average beta to the US market over the past 10 years. This varies from 0.66 for Japan (giving an ERP of 2.3%) and 1.2 in the euro area (ERP is 4.2%). Growth model. Here we assume that the return from equities equals the current dividend yield plus dividend growth. We need to adjust the dividend yield, however, to take into account that in some countries, particularly the US, it is more tax efficient for companies to do buybacks than to pay out dividends. We do this by adding equity withdrawals to the dividend yield. But this needs to be done on a net basis (taking into account equity issuance). We calculate this using the average annual change in the index divisor over the past 10 years. For the US, this is -0.8%, meaning there are more buybacks than new share issues. But in all other regions, the number is positive, and as high as 5.9% a year for Emerging Markets. This dilution is something that many calculations of assumed equity returns miss. For dividend growth, we assume that the dividend payout ratio remains stable, and that earnings growth is correlated with nominal GDP growth. However, history shows that earnings grow more slowly than GDP (logically so, when you consider that companies usually grow fastest before they list on a stock exchange). So we deduct 1% from nominal GDP growth to derive our earnings growth assumption. Note that for Emerging Markets, we use two different measures of dividend growth, depending on future productivity growth, as detailed above in our explanation of the GDP projections. Growth model (with reversion to mean). To take into account that valuations and profit margins typically revert to mean over the long run, we adjust the standard growth model (No. 2 above) by assuming that the current 12-month forward PE ratio and forward net profit margin for each country gradually revert over the next 10 years to their 20-year average. In the US, for example, that would mean that the current 12-month forward PE of 22.5x falls back to 16.0x, and profit margin of 12.5% falls to 10.7%. In every country and region, the profit margin is currently above the long-run average, and in all except the UK the PE is too. Note that we have changed from using the trailing PE and margin, because to use these now would be misleading given the big pandemic-driven decline in profits in 2020. Earnings yield. An intrinsically intuitive (and empirically demonstrable) way of estimating future returns is to use the earnings yield. This is based on the idea that an investor’s return from owning a stock comes either from the company paying a dividend, or from it investing retained earnings and paying a dividend in future. In the US, for example, a forward PE of 22.5x translates into an earnings yield of 4.4%. Again, here we switched this time to using 12-month forward forecast earnings yield, rather the trailing. Shiller PE. There is a strong correlation between valuation at the starting-point and the subsequent return from equities, at least over the long-run, although not over a period of less than 3-5 years (Chart 2). We regressed the Shiller PE (current price divided by average real earnings over the past 10 years) against the return from equities over the subsequent 10 years for each country and region. Composite valuation metric. The Shiller PE has its detractors. Using a fixed 10-year period does not reflect the different lengths of recessions and bull markets. It may say more about the mean-reverting nature of earnings than about whether the current price level is too high. So we also use the BCA Compositive Valuation Metric, which comprises eight indicators including, besides standard valuation measures such as price/sales and price/book, more esoteric ones such as market cap/GDP and Tobin’s Q. Again, we regress the metric against the subsequent 10-year return. Table 5Equity Return Calculations Alternative Assets Real Estate & REITs. We use the same basic methodology for both: The current yield (cap rate or dividend yield) plus projected capital value appreciation (linked to GDP growth). For US direct real estate, for example, we use the simple average cap rate of the five categories of commercial real estate (CRE), apartments, office, retail, industrial, and hotels in major cities: 6.1%. We also use the simple average of available city and category data for other countries. Cap rates are notoriously hard to estimate precisely; our data include a range of real estate, not just prime locations. We assume that capital values will grow in line with nominal GDP growth (using the same assumptions for this as we used for equities, 4.2%). We then deduct 0.5% for maintenance. This produces an expected return of 9.8% for the US. The only difference for REITs is that we do not deduct maintenance since this should already be reflected in the dividend yield. US REITs have a dividend yield currently of 3.5%, which produces an assumed return of 7.7% (Table 6). One risk with this methodology is that in the post-pandemic world, work and life practices might change. This will hurt office and residential real estate in major cities (which are overrepresented in investible CRE), though smaller cities and rural areas might benefit. As a result, capital values might fall. Table 6Alternatives Return Calculations Farmland & Timberland. Our methodology is similar to that for real estate: Current yield plus projected growth in capital values. For farmland, we use the farmland renter yield, sourced from the US Department of Agriculture. To estimate future land values, we take the gap between land value growth over the past 40 years (3.7%) and nominal growth of world GDP over that time (5.2%), assume that gap will continue and so deduct it from our estimate of global nominal GDP growth going forward (3.6%). This gives a result of 6.5%. For timberland, we assume that annualized returns in the future are the same as over the past 20 years. This produces a return assumption of 5.7%, which is (logically) moderately lower than our assumed return for farmland. Private Equity & Venture Capital. We project the return for private equity (PE) using the 30-year time-weighted average of the three-year rolling annualized return of PE over US large-cap equities, 3.6% (Chart 8). This produces an assumed return of 6.2%. For venture capital (VC), we use the same historical average for VC over PE (0.4%) to arrive at an assumed return of 6.6%. Hedge Funds. We use the 20-year time-weighted return of the Hedge Fund Composite Index over cash, 3.5% (Chart 9). This projects a future annual nominal return of 4.5%. Commodities. We previously used a methodology based on the idea that commodities’ bear markets in history have been rather fairly consistent, lasting on average 17 years, with an average decline of 50%, and that the current bear market began in 2012 (Chart 10). However, there are arguments that a new “commodities super-cycle” may be starting, driven by government infrastructure spending, and investment in alternative energy.5 We are agnostic for now on whether that will be the case, but it makes sense to switch to a neutral methodology, more in line with what we use for other assets classes: The return from commodities relative to GDP over the long run. Specifically, the CRB Raw Industrials Index has risen by an annualized 1.6% since 1951, during which time US nominal GDP growth averaged 6% (Chart 11). We assume that the differential will continue in future (although we calculate growth using global, not US, GDP), giving an annual return from commodities over the next 10-15 years of -0.9%. Gold. We calculate this using a regression of the gold price against nominal GDP growth and the annual change in the real 10-year yield over the past 40 years. For the forward-looking return assumption, we use a forecast of real rates (based on the equilibrium cash rate plus the average historical spread between the 10-year yield and cash) and a forecast of global nominal GDP growth. This produces an assumed return of 3.8%. Structured products. This asset class consists mainly of mortgage-backed and other asset-backed securitized instruments. In the US, these have historically returned 0.6% over US Treasurys. We assume that this premium continues, producing a total future return of 1.1% a year. Chart 8Private Equity Premium Chart 9Hedge Fund Return Over Cash     Chart 10Commodity Prices In History Chart 11Commodity Prices Vs. GDP Growth     Currencies Chart 12Currencies Tend To Revert To PPP To translate our local currency returns into an investor’s base currency, we need to arrive at some projections for FX movements over the next decade. Fortunately, for developed market currencies at least, it is relatively straightforward to use purchasing power parities (PPP) to do this since, over the long run, all the major currencies have tended to revert to PPP (Chart 12). We assume that in 10 years’ time all currencies will trade at PPP. We use the IMF’s estimate of today’s PPP for each currency to calculate the current under- or over-valuation. We assume that PPP will change in future years according to the relative inflation between each country and the US. The IMF provides five-year inflation forecasts and we assume that inflation will continue at this rate until 2031. For the euro zone, we calculate the PPP of the euro using the GDP-weighted PPPs of the five largest economies. The results (Table 7) suggest that the US dollar is currently overvalued and, given the forecast of higher inflation in the US than elsewhere in the future, will depreciate significantly against all major currencies except the Australian dollar. The USD is projected to depreciate by 1.7% a year against the euro and 1.1% against the yen over the next 10 years. It is likely to appreciate by 1.3% a year against the AUD, however. Table 7Currency Return Calculations Emerging Markets (Table 8) are more complicated. There is no evidence that EM currencies move towards PPP over time. All the major EM currencies are currently very cheap versus PPP (varying from 34% undervalued for the Chinese yuan to 67% for the Indonesian rupiah) but they were 10 years ago, too, and have not significantly moved towards PPP over that time. Table 8EM Currencies To calculate likely EM currency moves against the USD, therefore, we carry out a regression of the nine largest EM currencies against their relative CPI inflation rate to US inflation in history. We assume an intercept of zero. The regression coefficients vary from +0.5 for China to -1.7 for Malaysia. Apart from China, Malaysia, Poland and South Africa, the coefficients were negative, meaning that historically the USD has strengthened against the EM currency at least partly in line with relative inflation. To calculate likely future currency movements, we use the IMF’s five-year inflation forecasts and assume that the same rate of inflation will continue for our whole projection period. This methodology points to moderate annual depreciation of most EM currencies against the USD, varying from 0.8% a year for the Russian ruble to 0.1% for the Indonesia rupiah. The Chinese yuan and Taiwanese dollar are projected to appreciate moderately. We calculate the average EM currency movement using the weights of these nine large economies in the EM J.P. Morgan GBI-EM Global Diversified local-currency sovereign bond index. This produces a small (0.1%) a year appreciation. However, the IMF’s EM inflation forecasts may be too optimistic. It forecasts, for example, that Brazilian inflation will be only 3.3% a year in future, compared to an average of 6.1% over the past 20 years, and Russian inflation 4.0% versus a historical average of 9.3%. This suggests that EM currency performance could be worse than our projections. Table 9 shows the returns for the major asset classes expressed in local currency terms for six base currencies, based on the calculations explained above. Table 9Returns In Different Base Currencies Correlation And Volatility Below, in Table 10, we provide correlations for clients who need these inputs for their optimization calculations. Table 10Long-Run Correlation Matrix Returns can be calculated using the sort of forward-looking methodologies we have described above. For volatility, we think it is reasonable to use historical average data (Table 1, far right column), since volatility does not tend to trend over the long run (Chart 13). But correlation is a different matter. Correlations have varied significantly in history due to structural changes or regime shifts. The correlation of equities to bonds, it is well known, has moved from positive in the 1980s and 1990s, to negative since 2000 – probably because inflation disappeared as a factor moving bond prices (Chart 14). The correlation between equity market has risen as a result of the globalization of investment flows, though note that it fell back in 2010-2019. Chart 13Volatility Is Fairly Stable In The Long Run Chart 14Correlations Are Not Stable   So what correlations should investors use in an optimizer? Our recommendation would be to use the longest period of history available. A US investor, for example, might take the average correlation between Treasury bonds and large-cap US equities since 1945, 0.1%. Table 10 shows the correlation since 1973 of all the major asset classes for which data is available. Unfortunately, this misses some important asset classes such as high-yield bonds and Emerging Market equities, whose history does not go back that far. The results are intuitive – and prudent. From these numbers, it would seem sensible to use an assumption of a small positive correlation between US Treasurys and US equities, for example. US investment-grade debt has a correlation of 0.4 against equities. Global equity markets are all fairly highly correlated to each other, ranging mostly from 0.4 to 0.7. The most non-correlated asset class is commodities, especially gold.   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com   Footnotes 1 These are themes that BCA Research has been writing about for several years. See, for example, please see Global Investment Strategy, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; and " 1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. 2 Please see http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html 3 Annual Emerging Markets Default Study: Coronavirus Will Push Up Default Rates https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1214906 4 Please see, for example, https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-returns-yearbook-2021-summary-edition.pdf. 5 Please see Commodity & Energy Strategy, "Industrial Commodities Super-Cycle Or Bull Market?", dated March 4, 2021.

Highlights The Seventh National Population Census highlights the seriousness of China’s demographic deterioration; apart from a shrinking working-age population, the nation’s fertility and birth rates have dropped meaningfully. China’s urbanization rate will likely slow in the second half of this decade. The country’s urban population growth is only slightly positive, while the rural population is declining and aging. Demand for housing will experience a structural downshift, particularly in less developed regions.  Competition for labor will become fiercer among regions and sectors, and wage growth will continue to accelerate. However, the manufacturing sector will remain competitive regardless of wage inflation, thanks to the rising quality of China’s labor force and innovation. Interest rates will structurally shift to a lower range, providing some tailwind to Chinese equities and government bonds. Feature The Seventh Population Census, conducted by the National Bureau of Statistics every 10 years, reinforced the magnitude of China’s demographic challenge. The nation’s population is not only aging but is set to start shrinking due to extremely low birth and fertility rates. The main implication is that China’s urbanization rate will slow and property market will likely encounter a structural downshift, tied to declining demand from both its working-age (age 15 to 64) and total population. Demand for housing will increasingly concentrate in top-tier cities because these metropolitan areas have more advantages attracting labor. Secondly, manufacturing will likely maintain its share of GDP, despite China’s push for consumption and growth in the service sector. Importantly, interest rates will continue to shift downward along with a decelerating potential growth; waning interest rates will create a tailwind to China’s capital market in the long term.  Highlights From The Census The Census showed three meaningful shifts in China’s demographics in the past decade:  1.  China is getting old before getting rich. China is experiencing a worse demographic transition than Japan in the early 1990s, with a lower level of per capita wealth than Japan attained when its working-age population peaked (Chart 1). Over the past ten years China’s population has only expanded by 5.4%, the lowest rate since the first census in 1953. Moreover, the country’s oldest cohort rose from 8.9% in 2010 to 13.5% and the working-age population is falling more quickly than in Japan. China’s working-age population peaked in 2010 and then fell by 6.79 percentage points in the next 10 years. In contrast, Japan’s working-age population peaked in 1992 and fell by 2.18 percentage points in the subsequent decade (Chart 1, top panel). 2.  China’s total population is set to start declining in five years. Some demographers project that China’s total population will peak in 2027,1 but a high-level Chinese official recently predicted that the country’s population will start to trend down as early as in 2025.2 The relaxation of the one-child policy in 2015 helped to lift the birthrate (births per 1,000 people) briefly in 2016, before falling sharply again in 2017. The population’s natural growth rate, calculated as birthrate minus deathrate, is rapidly approaching zero (Chart 2). Chart 1China's Working Population Falling Faster Than Japan's In 1990s Chart 2China's Population Growth Will Turn Negative In Mid-2020s The birthrate is the main determinant of the population’s natural growth rate given that China’s deathrate has been steady for decades.  If the birthrate continues to fall at the current rate, then China will undoubtedly reach a population turning point and will join nations such as Japan, Germany and South Korea, which have negative population growth.  3.  A low fertility trap. Chart 3China's Alarmingly Low Fertility Rate Is Set To Decline Even Further... China’s extremely low fertility rate3 is a major contributor to its falling birthrate.  The current 1.3 reading is less than in many developed countries, such as Japan with 1.4 and the US with 1.6, and it is far below the fertility rate of 2.1 needed to stabilize a population, according to the United Nations (Chart 3). China’s fertility rate is set to dive even further in the coming years due to structural factors such as a dwindling number of childbearing-age women linked to the one-child policy implemented in the 1980s (Chart 4). China’s high female labor participation rate and low propensity among young people to get married, and the high cost of raising children in urban areas, all are long-standing socio-economic issues hindering the Chinese from having more babies (Chart 5). Chart 4…Due To Fewer Childbearing-Age Women And… Chart 5...Structural Issues That Curb Chinese Propensity To Produce Babies Bottom Line: These structural trends will take decades to reverse. China faces a dramatic plunge in its population in the very near future if the authorities do not enact significant and immediate policy changes.   Urbanization Pace Will Slow The Census indicates that rapid urbanization continued through 2020, with the rate hitting 64% of the population, up 14 percentage points from 2010. However, the headline number in the urbanization rate understates China’s progress in industrialization, i.e. the country’s rural-to-urban transition has entered a late stage and the current pace cannot be sustained in the future. Significantly, China’s underlying demographic shifts will likely lead to a passive increase in the urbanization rate in the second half of this decade. This trend will curb rather than boost demand in urban areas.  The experience of developed countries suggests that the pace of urbanization begins to slow when the rate reaches around 70% (Chart 6). Based on China’s current level, the country should reach the 70% threshold in just six to seven years. Meanwhile, China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85%, which means that 85% of jobs in China are in non-agricultural sectors (Chart 7). Chart 6Urbanization Progress Stabilizes When Reaching 70% Chart 7China Is Much More Industrialized Than Commonly Believed Furthermore, a higher urbanization reading may be the result of negative natural population growth. Given that the urbanization rate is calculated as a percentage of urban population in the total population, a decline in the absolute level of total population (the denominator) could lead to a passive increase in the numerator. Chart 8Japan Has Had A "Passive" Increase In Urbanization Since 2012 For example, Japan’s urbanization rate rose significantly during the 2000s, and maintained an upward momentum even as its total population peaked in 2010. However, its urban population growth rate dropped dramatically and turned negative in 2012 – suggesting the increase in the urbanization rate is due to a shrinking total population instead of expanding urbanities (Chart 8). The rising deathrate of the rural elderly population is another important reason for the accelerated increase in Japan's urbanization rate. China’s urban population growth is on a sharp down trend, although it is still slightly positive (Chart 9). However, the rural population has shrunk and aged, which limits future migration from rural to urban areas (Chart 10).  China’s rural population has shrunk by almost half from its peak in 1995 to 2020. The share of the rural population 50 years and older doubled in the same period. Chart 9China's Urban Population Growth Is On The Decline... Chart 10...While Rural Population Has Shrunk And Aged Thus, China’s rural-to-urban migration has slowed in the past decade (the trend turned negative last year due to the pandemic). The number of new migrant workers moving from the country to the city tumbled from 12.5 million a year to 2.5 million, and the number of younger migrants (50 years and younger) has contracted since 2017 (Chart 11). Chart 11The Number Of Young Migrant Workers Started Contracting In 2017 Bottom Line: Country-to-city migration will be smaller going forward based on a diminishing rural population, an increasing number of elders and a reduced proportion of young people in rural areas. When China’s population peaks, which is highly likely by 2025, its urbanization progress will turn passive and the aggregate population growth in urban areas may also turn negative. Aggregate Housing Demand Will Dwindle The demographic shifts described above will impact the demand for properties and accentuate regional divergences in housing demand and prices.   Historically, changes in the working-age population led residential home sales by five to six years. Home sales have fluctuated in a downward trend in the past five years along with a peak in the working-age population in 2015 (Chart 12). Moreover, the sharp deterioration in China’s birthrate means that home sales will be significantly reduced in the next 15-20 years. Chart 12Aggregate Demand For Housing Will Dwindle Along With Smaller Labor Force Chart 13Population Is An Important Driver For Urban Development The regional divergence in the demand for housing will also widen. Population, especially the labor force, is an important driver for urban development and housing (Chart 13 above). Population migration mainly occurs among 15-59-year-olds, and this cohort is also the main homeowner group. As China’s labor force increasingly flocks to developed areas, the economic development of less developed areas will face greater challenges (Chart 14). Those areas will encounter a combination of declining birthrate and outflow of labor force. This demographic shift is already evident in many two- and third-tier cities where housing prices have lagged far behind the tier-one cities (Chart 15). Chart 14Less Developed Regions Have Seen Net Population Losses In The Past Decade… Chart 15...And Softening Housing Prices Bottom Line: The drop in China’s birthrate and working-age population will lead to less demand for housing. However, China’s first-tier cities (and core metropolitan areas) will likely continue to outperform third- and fourth-tier cities in terms of labor growth, consumption and home prices. Labor Measures And Manufacturing Competitiveness Labor shortages in selected sectors and upward pressure on wages will likely intensify in the coming decade. While labor quantity will decrease, the quality of China’s labor force will remain competitive. From an aggregate economy perspective, improving labor productivity and automation can help to offset the smaller number of workers (Chart 16). Following two decades of rapid expansion in the industrial sector, China’s labor shortages began to multiply when the country’s urbanization ratio rose to between 50% and 60%. Looking at Japan and Korea, for example, a shortage in manufacturing labor emerged when the countries’ manufacturing/agricultural employment ratio climbed above one. China’s employment ratio likely have crossed this threshold in the mid-2010s, coinciding with a rollover in its working-age population and a massive jump in wage growth (Chart 17). Chart 16Improving Labor Quality To Offset Smaller Labor Quantity Chart 17Manufacturing Labor Shortage And Wage Pressure Intensified In Mid-2010s The manufacturing and service sectors will continue to compete with agriculture for labor. The wage gap between urban and rural areas is disappearing and there are signs of labor market tightness in urban settings (Chart 18).  While the demand for labor has been flat, labor supply peaked in 2013/14 and has been on the wane since that time, which has resulted in an ascending demand-to-supply ratio in China’s urban labor market (Chart 19). Chart 18Wage Gap Between Urban And Rural Areas Is Disappearing Chart 19Urban Labor Supply Can't Keep Up With Demand The bright side is that China’s labor shortage and escalating wages have not eroded the competitiveness of its manufacturing sector. Impressive labor productivity gains and progressively improving labor quality have trumped higher input costs (Chart 20). Consistent with improved productivity, China’s share of global trade continues to build regardless of higher wages, a stronger currency, and import tariffs from the US (Chart 21). The manufacturing sector has gradually climbed the value-added chain in recent years and mounting wage pressures will likely push the corporate sector, particularly in more developed coastal regions, to move further away from a labor-intensive model. Chart 20Rising Wages But Stable Unit Labor Costs Chart 21Chinese Exporters Have Maintained Their Global Market Share Despite Higher Costs The 14th Five-Year Plan outlined policymakers’ decision to maintain the share of manufacturing in GDP, which is around 30%. Labor productivity in the manufacturing sector is notably higher than in the service sector. In an environment of shrinking labor, keeping workers in a high-productivity sector may be a better way to stabilize potential growth. Bottom Line: The competition for labor between sectors will intensify. Meanwhile, manufacturing’s share of China’s economy will likely be sustained in this decade, which will help to mitigate the speed of the deceleration in China’s growth.  Implications On Policy Setting Chart 22AInterest Rates Drop With Aging Population The combination of a weak fertility/birthrate and a decline in the working-age population will weigh on consumption and investment growth, bringing deflationary headwinds to the economy. China’s interest rate regime will likely follow its Asian neighbors to downshift structurally (Chart 22). Despite moderating potential economic growth, a low interest rate environment may be positive for China’s financial asset prices.  Chart 22BInterest Rates Drop With Aging Population Chart 22CInterest Rates Drop With Aging Population Chart 23Support Ratios Are Declining Globally One could argue that a falling support ratio – measured by the number of workers relative to consumers – can lead to inflation (Chart 23). This could happen to the US where baby boomers retire but continue to spend particularly on healthcare, while production falls along with the available workers. As production falls in relation to consumption, inflation could rise. However, this is not the case in China where both production and consumption will fall. Demand from an aging population may increase pockets of inflationary pressures, such as healthcare and elderly care, but it is unlikely to fully offset weakening demand from a declining working-age population and total population. In other words, both the numerator (workers) and denominator (consumers) will be falling in China. While a weakening demographic profile is negative for economic growth, lower prices on capital will make corporate debt-servicing cheaper. Further industrial consolidation aimed at supply-side reforms will also improve corporate profitability. Cheaper capital, improving productivity and efficiency could provide tailwinds to Chinese stocks and government bonds in the long run.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1As of 2020, China’s total population is at 1411.78 million. 2"China faces an economic crisis as a population peak nears," South China Morning Post, April 18, 2021. 3The total fertility rate is based on the number of newborns by women in child-bearing years, which is ages 15-44 or 15-49 by international statistical standards.  Cyclical Investment Stance Equity Sector Recommendations

Highlights Monetary Policy: The Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. Duration: The overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Corporate Bonds: High and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds. Feature Recent inflationary trends are making the Fed’s job more difficult. Not only was April’s increase in core CPI the largest since 1981, but measures of long-term inflation expectations have also jumped. The 5-year/5-year TIPS breakeven inflation rate has quickly risen to levels that are consistent with the Fed’s 2% inflation target (Chart 1). What’s more, survey measures of inflation expectations have also moved up, in many cases to uncomfortably high levels (Chart 2). Chart 1Back To Target Chart 2Inflation Expectations Have Jumped All of this makes the Fed’s zero-lower-bound interest rate policy look increasingly untenable. Can the Fed really just sit on the sidelines as inflation and inflation expectations rise to above-target levels? Our expectation is that the Fed will ignore rising inflation until the labor market is fully recovered, but it may then need to move quickly to contain inflationary pressures. The result could very well be a rate hike cycle that takes a long time to start, but then proceeds at a rapid pace. The Fed’s Liftoff Criteria Are Different Than Its Criteria For Pace A crucial point about the Fed’s forward guidance is that the criteria that will determine the timing of the first rate hike are different than the criteria that will determine the post-liftoff pace of rate hikes. Liftoff Criteria Table 1A Checklist For Liftoff For liftoff, the Fed has been very explicit that three conditions must be met before it will raise rates off the zero bound (Table 1). Of the three conditions listed in Table 1, the timing of when the labor market will reach “maximum employment” is the most uncertain. We have written extensively about how the Fed defines “maximum employment” and about the pace of employment growth that’s necessary to achieve that goal by specific future dates.1 To summarize, we calculate that average monthly nonfarm payroll growth of at least 698k is required to reach “maximum employment” by the end of this year and average monthly payroll growth of at least 412k is required to hit that target by the end of 2022 (Chart 3). Chart 3Employment Growth Chart 4Labor Demand Is Strong Our assessment is that “maximum employment” will be achieved in time for the Fed to lift rates in 2022, largely because employment growth must rise quickly in order to catch up with skyrocketing indicators of labor demand (Chart 4). The risk, of course, is that inflation continues to run hot as the Fed waits for its “maximum employment” condition to be met. If this occurs, we believe that the Fed will stick to its current forward guidance. It will ignore rising inflation until its liftoff criteria are met. Only then, will Fed policy turn toward containing inflation. Pace Criteria In a recent speech, Fed Vice-Chair Richard Clarida laid out three indicators that he will track to guide the pace of policy tightening post Fed liftoff.2 First, he pointed to inflation expectations. In particular, the Fed’s index of Common Inflation Expectations (CIE):3 Other things being equal, my desired pace of policy normalization post-liftoff to return inflation to 2 percent […] would be somewhat slower than otherwise if the CIE index is, at time of liftoff, below the pre-ELB level. [ELB = effective lower bound]. Chart 2 shows that the CIE index has already broken above its 2018 peak. It stands to reason that, all else equal, an elevated CIE index would speed up the post-liftoff pace of rate hikes. Chart 5Inflation Since August 2020 Second, Clarida noted that: Another factor I will consider in calibrating the pace of policy normalization post-liftoff is the average rate of PCE inflation since the new framework was adopted in August 2020. The annualized rate of change in core PCE since August 2020 is almost at the Fed’s 2% target already, and it will certainly rise to above-target levels when the April data are released, as was the case with core CPI (Chart 5). Finally, Clarida offered up a detailed Taylor-type monetary policy rule that he says he will consult once the conditions for liftoff are met: Consistent with our new framework, the relevant policy rule benchmark I will consult once the conditions for liftoff have been met is an inertial Taylor-type rule with a coefficient of zero on the unemployment gap, a coefficient of 1.5 on the gap between core PCE inflation and the 2 percent longer-run goal, and a neutral real policy rate equal to my SEP forecast of long-run r*. Chart 6Balanced Approach (Shortfalls) Rule* Recommendations Chart 6 shows the results of a very similar policy rule using median FOMC estimates for r*, NAIRU and the path of inflation. We use a slightly more pessimistic forecast for the unemployment rate and assume that it reaches 4.5% by the end of 2022 and 4% by the end of 2023. Even with those conservative assumptions, the rule still recommends a policy rate of 1.5% by the end of 2022 and 2.65% by the end of 2023. This is not to say that the Fed will immediately lift rates to those levels once it is ready to hike, only that the Fed will have a strong incentive to pursue a rapid pace of rate hikes once it finally lifts rates off the zero bound. Investment Implications For investors, the bottom line is that the Fed will not immediately change its policy stance in response to rising inflation and inflation expectations. Rather, it will follow its current forward guidance and only lift rates off zero once the labor market has reached “maximum employment”. However, once the first rate hike has occurred, the Fed will shift its focus toward inflation and inflation expectations. If inflation and inflation expectations rise further, or even remain sticky near current levels, the Fed will lift rates more quickly than many anticipate. At present, the overnight index swap curve is priced for a total of 77 bps of rate hikes by the end of 2023. We see strong odds that more hikes will be delivered and therefore continue to recommend a below-benchmark portfolio duration stance. Is Inflation A Risk For Spread Product? Yes it is, but not just yet. In past reports, we’ve often pointed to 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5% as a reason to turn more cautious on spread product (see Chart 1), and the recent rise in inflation expectations certainly does set off some alarm bells. High inflation expectations pose a risk to credit spreads because of what they signal about the future course of Fed policy. If the Fed responds to high inflation expectations by tightening policy into restrictive territory, then economic growth and credit spreads are at risk. All this remains true, but the Fed’s willingness to ignore rising inflation expectations – at least until “maximum employment” and fed funds liftoff are achieved – gives spread product a little more runway than usual. One way to illustrate this dynamic is with the slope of the yield curve (Chart 7). Historically, corporate bond (both investment grade and junk) excess returns are strong at least until the 3-year/10-year Treasury slope flattens to below 50 bps (Table 2). Currently, the 3-year/10-year Treasury slope is well above 100 bps and has shown few signs of rolling over. If the Fed was still following its old forward-looking policy framework, then the yield curve would likely be much flatter today. That is, the curve would be pricing-in some policy tightening in response to high and rising inflation expectations. However, as discussed above, inflation expectations are not currently the Fed’s primary concern and they will only become the Fed’s primary concern once “maximum employment” has been achieved and the funds rate has been lifted off the zero bound. Chart 7Spread Product Returns Are Strong When The Curve Is Steep Table 2Corporate Bond Performance In Different Phases Of The Cycle All in all, we are concerned that, if inflation expectations remain elevated, the Fed may quickly ramp up its post-liftoff pace of rate hikes, sending credit spreads wider. But we are reluctant to position for that outcome when we are still many months away from Fed liftoff and the slope of the yield curve remains so steep. Chart 8Low Expected Returns In IG Another factor to consider is that value in spread product is extremely tight. In fact, our measure of the 12-month breakeven spread for the quality-adjusted investment grade corporate bond index is almost at its most expensive level since 1995 (Chart 8). This doesn’t change our assessment of when restrictive Fed policy will cause spreads to widen, but it does reduce our return expectations in the interim. All else equal, since the rewards from being overweight spread product versus Treasuries are low, we will be quicker to reduce our recommended spread product allocation when our indicators start to point toward the end of the credit cycle. Though, at the very least, we will still want to see the 3-year/10-year Treasury slope start to flatten and approach 50 bps before we get too pessimistic on spread product. The bottom line is that high and rising inflation expectations will eventually pose a risk to credit spreads, but only once the Fed tightens policy in response. For now, we remain overweight spread product versus Treasuries, though we maintain a preference for high-yield corporates, USD-denominated EM Sovereigns and municipal bonds over investment grade corporate bonds.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021. 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm 3 The CIE is a composite measure of different market-based and survey-based indicators of inflation expectations. https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm  Fixed Income Sector Performance Recommended Portfolio Specification

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 Chart I-14The Dollar Usually Weakens In H2 The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years Chart 10NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 19 at 10:00 AM EDT, 3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Special Report

Highlights The ECB is not repressing interest rates and penalizing savers. The Eurozone shows none of the symptoms associated with financial repression. Global excess savings are keeping US rates depressed. If US rates are low, then European rates must be lower because of structural problems in the region’s economy, independent of the ECB’s preferences. Structurally, there is still no case for European yields to rise meaningfully compared to the rest of the world. Despite positive forces over the next year or two, European financials will remain long-term underperformers. European utilities will outperform US ones. The euro is transforming into a safe haven like the yen and the Swiss franc. Feature By maintaining negative short rates, the European Central Bank is conducting severe financial repression, which distorts rates of return and penalizes savers. This is a common refrain among many insurers and pension plan managers investing in Europe and among a large number of the region’s politicians. Chart 1The ECB's Financial Repression? At first glance, this criticism is apt. For the past five years, negative policy rates have forced safe-haven Bund yields to trade well below the Euro Area’s nominal GDP growth (Chart 1). Moreover, the real ECB deposit rate remains well below the Holston, Laubach-Williams estimate of R-star (the real neutral rate of interest). If we go beyond these superficial observations, it is far from clear that the ECB is conducting financial repression or distorting market rates any more than other major global central banks. Is It Financial Repression? The ECB is not conducting financial repression; rather, it is responding to powerful economic forces in Europe and beyond that are depressing interest rates. The definition of financial repression is crucial to this assessment. Financial repression involves monetary authorities actively suppressing interest rates to the advantage of the borrowers and users of capital at the expense of the savers, whose risk-free investments then provide subpar rates of returns. Following this definition, financial repression shows these clear symptoms: A low savings rate. Suppressed interest rates do not adequately compensate savers to forgo consumption. Thus, they are less likely to put money aside. A significant build-up of debt. Real interest rates are below fair market value, which subsidizes borrowing. A significant expansion of the money supply. Money supply expands rapidly in response to strong credit demand in the economy. Plentiful capital expenditures. Savers must take on more financial risk to make appropriate returns on their assets, which compresses risk premia. Depressed internal rates of return boost the net present value of investment projects and thus cause investments to account for a large share of output. A current account deficit. A nation’s current account balance equals its savings minus its investments. By depressing savings and stimulating investments, financial repression results in a current account deficit or a sharply deteriorating current account balance. Above-trend GDP growth. By depressing savings and boosting investments, financial repression lifts cyclical spending and forces the GDP to rise above its potential. The problem for commentators who argue that the ECB is conducting financial repression is that the Euro Area meets none of these criteria. First, Eurozone money and credit growth has run well below that of the US ever since the euro crisis, despite ECB policy rates that are constantly lower than the Fed Funds rate. Moreover, since the ECB cut rates to zero, the pace of money and credit creation has decelerated significantly compared to their pre-crisis trends (Chart 2). Second, the Euro Area’s real GDP per capita, nominal GDP per capita, and the GDP deflator have also fallen 4.6%, 5.2% and 5%, respectively, behind those of the US, since the ECB has cut interest rates to zero (Chart 3). Moreover, the growth of these variables has also decelerated significantly over this period, which is consistent with depressed credit demand. Additionally, despite the inferior performance of European activity metrics compared to those of the US since the introduction of the common currency, European government bonds have performed exactly in line with those of the US (Chart 3, bottom panel) and have therefore outperformed in real terms. This is inconsistent with financial repression by the ECB. Chart 2Europe's Money And Credit Trends Are Too Tame... Chart 3... So Are Output Volume And Price Trends Finally, the Euro Area runs a current account surplus of 2.3% of GDP, which has grown by 4.1% of GDP since late 2008. This is the clearest sign that Eurozone savings have become excessive relative to investment, despite the surge in government deficits in the wake of the COVID-19 pandemic. Excess savings are not typically associated with central banks artificially distorting interest rates. Bottom Line: The economic developments in the Euro Area do not correspond to what would be anticipated if the ECB were repressing interest rates. The growth rate of money and credit has structurally slowed both in absolute terms and compared to that of the US. The same deceleration is evident in both real and nominal output per person, as well as in price levels. Finally, the Eurozone’s current account surplus has widened, which highlights that savings have grown in excess of investments. The Eurozone Needs Lower Interest Rates Than The US The ECB must set appropriately low interest rates, if US yields are low across the curve. In a way, the case that the Federal Reserve is conducting financial repression is stronger than the case against the ECB. Over the past twelve years, nominal and real output per capita have grown more robustly in the US, while money as well as credit expansion and inflation have also been stronger. The US runs a persistent current account deficit of 3.1% of GDP, which also indicates that it is not awash in excess domestic savings. Chart 4Maybe The Fed Is Repressing Interest Rates We could even argue that the case for the Fed repressing interest rates is growing stronger. The federal budget deficit has expanded to 19% of GDP, even as the unemployment rate tumbles (Chart 4). Moreover, US quarterly GDP growth has averaged 8.5% since the fourth quarter of 2020 and, according to Bloomberg consensus estimates, is anticipated to average 6.3% for the remainder of the year. US inflation is also strong. Annual core CPI Inflation hit 3% in April; monthly core inflation was 0.92%, or an annualized rate of 11.6%, the strongest reading in almost 40 years. Yet, even in the US, the argument that the Fed is repressing interest rates is ultimately weak, despite the aforementioned economic strength. The Fed is accommodating global market pressures that are greater than those of the US economy. In other words, even if the Fed did not set short rates, US interest rates would be low across the curve because of global excess savings. Chart 5Too Much Savings, Everywhere Excess savings around the world constitute an exceptionally strong gravitational force that anchor global rates at low levels. As Chart 5 shows, since the early 1990s, global private savings have outpaced investments by a cumulative 163% of GDP. Accumulated government deficit, which has accounted for 99% of global GDP, has been far too small to absorb fully this surplus of savings. The resulting imbalance places downward pressure on global inflation (a consequence of demand falling short of supply) and real interest rates, which means it depresses nominal interest rates across the curve. US interest rates also feel the yield-compressing effect of these excess global savings, even if the US economy does not generate excess savings itself (it runs a current account deficit). The major DM central banks are removing a greater proportion of the float of safe-haven from their jurisdictions than the Fed (Chart 6). The resulting scarcity of safe-haven securities means that US fixed-income products remain the natural outlet for global investors seeking safety and liquidity. Thus, despite the US lack of excess savings, Treasury yields have traded below nominal GDP growth 55% of the time over the past 30 years, no matter how strong US activity is or how wide federal deficits become. If the Fed has little choice but to accept low US interest rates, then the Eurozone must accept even lower interest rates because of its large excess savings. As Chart 7 illustrates, the 2-year and 10-year interest rate spreads (both in nominal and real terms) between the Eurozone and the US track the gap between the US current account deficit and the Europe’s current account surplus. Chart 6Treasurys Are The World Only Plentiful Safe-Haven Chart 7Europe's Excess Savings Justify Lower Rates Across The Curve The Eurozone lower rate of return on capital is another force depressing rates relative to the US (Chart 8). This lower return on capital reflects the following structural problems with the European economies: Excess capital stock. The Eurozone peripheral nations have abnormally large capital stocks in relation to their GDPs (Chart 9). As we previously argued, this feature means that Europe suffers from large amounts of misallocated capital, which hurt the return on capital. Chart 8Capital Is Not Rewarded In Europe Chart 9Too Much Capital! Ageing capital stock. Not only is the Eurozone capital stock too large relative to the size of its economy, it is also older than that of the US (Chart 10). An ageing capital stock, especially in a world where ICT spending is one of the key sources of innovation and growth, further hurts the Euro Area’s return on capital. Lower incremental output-to-capital ratio (Chart 11). The Euro Area generates significantly less output per unit of investment than the US. This confirms the notion that capital is misallocated and that it is used less productively than in the US. Chart 10Europe's Capital Is Ageing Too Chart 11Poor Capital Utilization Chart 12Europe's Inferior Productivity Problem The final force limiting European interest rates compared to the US is the Euro Area’s inferior potential growth rate. The Eurozone’s population is ageing, and it will start to contract in 2030. Moreover, multifactor productivity growth is weaker than in the US (Chart 12). A lower potential GDP growth accentuates the discount in the Euro Area neutral rate of interest compared to the US. Bottom Line: Despite the relative economic vigor of the US, global excess savings lower US rates across the curve. The ECB has no choice but to accept even lower European rates, because the European economy suffers from greater excess savings than the US: its return on capital is inferior, and its neutral rate of interest is hampered by its lower potential GDP growth. Investment Conclusions For European rates to avoid the fate of Japan and to circumvent suffering many more decades wedged near zero, some important changes must take place. First, at the global level, excess savings must recede. This will allow global interest rates to increase, especially those of the US. Even if Eurozone rates continue to trade at a discount to the US, safe-haven yields in Europe would nonetheless climb in absolute terms. The fall in the global ratio of workers relative to dependent people, most notably in China where the 2020 population census has just highlighted the trend, is one factor pointing toward a potential gradual decline in global savings. For the moment, absorbing excess savings means that global fiscal policy must remain accommodative. Although fiscal authorities around the world continue to display greater profligacy than they did in the wake of the Great Financial Crisis, there is no guarantee that they will not revert to their old ways. In fact, BCA’s Global Investment Strategy service recently showed that the US fiscal policy is set to become more of a constraint on growth next year than it has been in 2020 and 2021 (Chart 13).  One factor to monitor is the international shift in voters’ preferences toward left-wing economic policies, which often results in more generous fiscal spending. If this trend persists, then global fiscal deficits will close more slowly than the private sector savings will decline. This process will both be inflationary over the long run and impose upward pressure on real interest rates worldwide. But the fiscal excesses of the current moment may force opposition parties to restrain spending whenever they come into power. Chart 13Will Global Fiscal Policy Morph Into a Headwind? Second, to narrow the spread between the Eurozone and US interest rates, the Euro Area must tackle its low rate of return on capital. Practically, this means that much of the excess capital stock weighing on European rates of returns must be written down. Doing so will require more cross border mergers and acquisitions within sectors in the Eurozone. However, the loss-recognition process on nonviable capital will be deflationary. Thus, to facilitate these asset write-downs, the region’s fiscal policy and monetary policy must first remain extremely accommodative. It is far from certain that European authorities will resist reverting to their old ways. A structural underweight on European financial equities remains appropriate. Even if the Eurozone enacts the reforms necessary to invite the peripheral asset write-downs required to boost rates of return in the long-run, in the interim, these reforms will be deflationary. Consequently, no matter what, Eurozone yields will remain well below the US for years to come. Moreover, European credit demand is unlikely to outperform the rest of the world for the coming few years. In this context, the RoE of European banks will remain low. Therefore, our current recommendation to overweight this sector is only valid as a near-term play on the global economic recovery and is not a strategic recommendation. By contrast, European utilities will structurally outperform their US counterparts. European utilities offer higher RoE than US ones and have healthier leverage (Chart 14). Moreover, European utilities trade at discounts to US firms on a price-to-book, price-to-cash flow, price-to-sales and dividend yield basis (Chart 15). Additionally, as yield plays, structurally lower European yields relative to those of the US will advantage European utilities on a long-term basis. Chart 14European Utilities Offer More Appealing Operating Metrics... Chart 15... And Are More Attractively Priced Than US Ones Finally, the euro will increasingly trade as a safe-haven currency like the yen and the Swiss franc. First, after a decade of trial by fire, EU integration and solidarity have gained rather than lost momentum and the EU break-up risk has proved to be limited to Brexit. Second, although the Eurozone economy is pro-cyclical, so are the Swiss and Japanese economies. Instead, the Euro Area’s structurally elevated savings rate and current account balance are transforming this economy into a net creditor, with a positive net international investment position equal to -0.1% of GDP. Moreover, the bloc’s low inflation will continue to put upward pressure on the euro’s long-term fair value. If we add the Euro Area’s low interest rates to the mix, then the euro is likely to behave increasingly as a funding currency. Thus, while the euro will benefit from the USD’s weakness forecasted by our Foreign Exchange Strategists, it will underperformed more pro-cyclical currencies such as the SEK, the NOK, or the GBP, which do not suffer from the same ills as the Eurozone.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com