Developed Countries

Highlights Monetary Policy: Last week’s numerous central bank meetings across the world confirmed that the overall direction for global monetary policy is shifting in a more hawkish direction. The main reason: growing fears that elevated inflation will persist for much longer than expected, even with global growth having lost some momentum. Country Allocation: The relative degrees of central banker hawkishness support our current government bond country allocation strategy. Stay underweight the US, UK, Canada, New Zealand and Norway where markets are discounting a path for future policy rates over the next two years that is too flat. Remain overweight countries where there is less need for a more aggressive tightening response: the euro area (both the core and periphery), Australia, Sweden and Japan. Still The Only Game In Town Last week was a busy one for global bond markets, with no fewer than 14 central banks within both the developed markets (DM) and emerging markets (EM) holding policy meetings. The results were eventful: Within EM, Brazil and Hungary lifted policy rates. Norway followed suit to become the first G-10 central bank to hike during the COVID era. The Fed teed up a formal announcement on tapering asset purchases at the next FOMC meeting in November. The Bank of England (BoE) gave strong hints that rate hikes could come sooner than expected, perhaps even before year-end. Chart of the WeekMonetary Policy Backdrop Turning More Bond-Bearish Global bond yields in the developed markets took notice of the change in central bank guidance, especially from the Fed and BoE. The benchmark 10-year US Treasury yield rose from a pre-FOMC low of 1.30% to an intraday high of 1.57% yesterday – a level last seen late June. Longer-dated yields in the UK also rose significantly, with the 30-year Gilt yield rising from a pre-BoE meeting low of 1.11% to an intraday high of 1.40% yesterday – also the highest level since June. The pull on yields extended to other countries, as well, with 10-year yields in Germany, Canada and Australia climbing to three-month highs. The overall message from all of those policy meetings was one of an incremental shift toward less accommodative policies, even as the pace of global economic growth has slowed in recent months. Policymakers are growing more concerned that higher inflation could linger for longer (Chart of the Week). At the same time, loose policy settings have fueled a boom in asset markets that supports growth through easy financial conditions, but also raises future stability risks that worry the central banks. The number of countries seeing actual rate hikes is growing. Our Global Monetary Policy Tightening Indicator shows that just over one-quarter of G-10 and EM central banks have lifted rates over the past three months (Chart 2). All but one (Norway) are in EM, where policymakers have had to act more mechanistically in response to high inflation, even with softening economic growth momentum. While the slower pace of growth is more visible in EM relative to DM, when looking at cyclical indicators like manufacturing PMIs, inflation rates are simply too high around the world for inflation-targeting central banks to ignore (Chart 3). Chart 2Our Global Monetary Policy Indicator Shows A More Hawkish Turn Chart 3Global CBs Growing More Worried About Inflation Risks Within the major DM countries, there has been a notable shift in interest rate expectations in a more hawkish direction. Interest rate markets are, for the most part, still underestimating the potential for tighter monetary policies over the next couple of years. This is the main reason why we continue to recommend an overall below-benchmark strategic stance on global duration exposure. However, the relative expected pace of rate hikes also informs our views on country allocation. In Table 1, we show expectations for the timing of the next rate hike, as well as the cumulative amount of rate increases to the end of 2024, that are currently discounted in DM overnight index swap (OIS) curves. We present the latest level for both, as well as the reading from earlier this month to see how expectations have changed. Table 1Markets Still Pricing Very Modest Tightening Cycles The so-called “liftoff date” for the first rate hike has been most notably pulled forward in the UK from January 2023 to May 2022, while other countries have seen more modest shifts in the timing of the next rate increase. More importantly, the discounted pace of rate hikes to end-2024 for all countries shown in the table has increased since early September (including Norway, factoring in last week’s tightening move by the Norges Bank). In our view, the biggest driver of relative government bond market yield movements and returns over the next 6-12 months will be the relative adjustments in the expected pace of rate hikes. On that front, the biggest shift higher in cumulative tightening has occurred in countries where we are more pessimistic on government bond performance on a relative basis to the global benchmark: the US, Canada, the UK and Norway. The smaller increases in the pace of hikes have occurred in our more preferred markets – Australia, Sweden, the euro area, and Japan. Assessing Our Two Biggest Government Bond Underweights: The US & UK For last week’s Fed meeting, a new set of economic and interest rate projections from the FOMC members (“the dots”) were presented (Chart 4). Compared to the forecasts from the June meeting, US real GDP growth expectations for 2021 were revised down (5.9% vs 7.6%) but were boosted for 2022 (3.8% vs 3.3%) and 2023 (2.5% vs 2.4%). A new forecast for 2024 was added, coming in at 2.0%. Importantly, none of those growth forecasts was below the median FOMC estimate of the longer-run real GDP growth rate of 1.8% (top panel). In other words, the Fed is not anticipating below-trend growth anytime in the next three years. Chart 4The Fed’s Rate Projections Look Too Low The same conclusion goes for the US unemployment rate (second panel), with the median FOMC projection for 2022 (3.8%), 2023 (3.5%) and 2024 (3.5%) all below the median longer-run “full employment” estimate of 4.0%. The forecasts for US inflation (third panel) reflect that persistent low level of unemployment. Headline PCE inflation is expected to end 2021 at 4.2%, to be followed by a somewhat slower pace – but still above the 2% Fed inflation target – in 2022 (2.2%), 2023 (2.2%) and 2024 (2.1%). Yet despite these forecasts that show US growth and inflation exceeding its longer-run estimates for the next few years, the FOMC is projecting a relatively slow upward path for interest rates. The median dot now calls for the Fed to hike the funds rate once in 2022 and three more times in both 2023 and 2024. This would bring the funds rate to 1.75% by the end of 2024 – still 75bps below the Fed’s estimate of the longer-run “neutral” funds rate of 2.5% (bottom panel). That projected path for the funds rate is higher than the June dots, which only called for 75bps of cumulative hikes to the end of 2023. There is a wide divergence of opinions on the future path of rates within the FOMC, but the hawks appear to be winning the internal battle (Chart 5). There is now a 9-9 split of FOMC members who are calling for a rate hike in 2022, compared to a 7-11 split back in June, while the number of those projecting a funds rate above 1% in 2023 rose from 5 to 9. Chart 5A Wide Dispersion Of FOMC Interest Rate Views For 2023/24 One area where there does appear to be a consensus is on the timing and pace of tapering. Fed Chair Powell noted at his post-FOMC press conference that an announcement on the reduction of Fed asset purchases could come as soon as the next FOMC meeting on November 6. Powell also signaled that there was general agreement on the FOMC that the taper should end by mid-2022, barring any economic setbacks. That would likely open the door to a rate hike in the latter half of next year, given the Fed’s longstanding view that lifting the funds rate should only occur after tapering is complete, to avoid sending conflicting signals about the Fed’s policy bias. It is clear that the Fed’s policy guidance has shifted incrementally in a more hawkish direction, and confirms our long-held expectation that tapering would be announced by year-end, with rate hikes to begin in late 2022. This dovetails with our recommended investment positioning in the US Treasury market for the next 12-18 months. Maintain a below-benchmark US duration exposure, with a curve-flattening bias, while staying underweight US Treasuries in global (USD-hedged) fixed income portfolios (Chart 6). Our other high-conviction underweight government bond call is in the UK. The BoE’s recent messaging has turned more hawkish in a very short period of time, justifying our decision to downgrade our recommended UK Gilt exposure to underweight last month.1 The BoE Monetary Policy Committee had already sharply upgraded its inflation forecast for the end of 2021 to just above 4% at the last policy meeting in August. That was categorized as just a temporary surge due to rising energy prices and goods prices elevated by shorter-term global supply chain bottlenecks. At last week’s meeting, however, the MPC noted that +4% UK inflation could persist into Q2 2022 because of the current surge in wholesale natural gas prices that has driven many UK gas suppliers out of business (Chart 7). Chart 6Our Recommended Strategy For US Treasuries Chart 7BoE Growing More Worried About Inflation Chart 8Our Recommended Strategy For UK Gilts The official view of the BoE has been like that of other central banks, that much of the current high inflation is supply driven and, hence, will not last. Yet within the MPC, there is clearly some growing nervousness about high realized inflation becoming more embedded in longer-term inflation expectations, which are moving higher. BoE Governor Andrew Bailey has noted in recent speeches that there was a growing case for interest rate hikes because of stubbornly higher inflation. Two members of the MPC even voted last week to reduce the size of the BoE’s QE program that is already set to end in just three months. The markets have begun to heed the more hawkish signals from the BoE. Our 24-month UK discounter, measuring the amount of rate hikes priced into the UK OIS curve, has jumped 24bps since September 7 (Chart 8). Over that same period, UK Gilts have underperformed the Bloomberg Barclays Global Treasury index by 108bps (on a USD-hedged and duration-matched basis). We are sticking with our underweight recommendation on UK Gilts, as there are still too few rate hikes priced into the UK curve relative to the BoE’s guidance and upside inflation risks. What About The BoJ? Same Old, Same Old Chart 9Reasons Why JGBs Will Outperform Lost amid the hawkish din from the Fed and BoE meetings last week was the Bank of Japan (BoJ) meeting. The message from policymakers in Tokyo was predictably dovish, as Japan has not seen anything resembling the high inflation that has pushed central bankers elsewhere in a more hawkish direction. Japanese growth has also not seen the same magnitude of recovery from the pandemic shock as the other major developed markets, despite suffering comparable losses during the 2020 recession (Chart 9). One of the main reasons has been that Japan’s vaccine rollouts were much slower than those of other major countries. This forced an extension of emergency lockdowns and other economic restrictions that depressed domestic demand and delayed a return to normal economic activity (second panel). COVID outbreaks even cost Japan the one-time economic windfall from hosting an Olympics, with the Tokyo Games first delayed by a year and then taking place with no fans. Japan has also not suffered any of the higher inflation rates witnessed elsewhere over the past year, despite presumably facing many of the same inflationary forces from global supply chain disruption (third panel). Both headline and core CPI inflation are now in deflation. Governor Haruhiko Kuroda stated last week that it will take longer for Japan to see inflation return back to its 2% target than other developed countries, with the official BoJ forecast calling for that level to be reached by 2023 – a forecast that appears too optimistic. We continue to view Japanese government bonds (JGBs) as a relative safe haven during the period of rising global bond yields that we expect over the next 6-12 months. The BoJ is nowhere close to seeing the conditions necessary to begin exiting its Yield Curve Control and negative interest rate policies, both of which have crushed JGB volatility and kept longer-term bond yields hovering near 0%. We continue to recommend a moderate overweight stance on Japan in global government bond portfolios, particularly on a USD-hedged basis to make the yields more attractive. The Scandinavian Policy Divergence Last week, the Norges Bank raised its benchmark interest rate from 0% to 0.25% (Chart 10), stating that a normalizing economy requires a gradual normalization in monetary policy. The bank’s decision reflects idiosyncratic factors unique to the Norwegian economy, but also some of the same broader themes that are forcing other central banks in a more hawkish direction.   As a small economy driven heavily by oil exports, both the Norwegian krone and the price of oil weigh heavily on the policy decisions of the Norges Bank. On that front, the rise in energy prices since the crisis has outpaced the appreciation in the krone (Chart 10, top panel). With this relative weakness in the krone comes higher import price inflation and increased export competitiveness, both of which mean that the Norges Bank must pull forward its path of rate hikes to compensate. As opposed to other G10 central banks, the Norges Bank clearly believes a pre-emptive move on rates is necessary to nip future inflation risk in the bud. The bank expects that increased capacity utilization and wage growth will help push up underlying inflation to approximately 1.9% by the end of 2024, with the ongoing supply chain disruptions creating additional upside risk to that forecast. Like other G10 banks, however, the Norges Bank is concerned about increasing financial imbalances. The Norwegian house price-to-disposable income ratio is now at all-time highs and the Norges Bank expects it to remain elevated to the end of its forecast horizon (Chart 10, bottom panel). With the growth in house prices substantially outpacing income growth during the pandemic, housing market vulnerabilities have increased as households have taken on greater leverage to enter the market. In contrast to the Norges Bank, the other major Scandinavian central bank, Sweden’s Riksbank, has hewed more closely to the prevailing global monetary policy orthodoxy – avoiding pre-emptive policy tightening in order to boost inflation. The central bank chose to hold its repo rate at 0% at last week’s policy meeting, even with a Swedish economy that has recovered the 2020 pandemic losses and is projected to return to pre-COVID growth rates in 2022 (Chart 11). In its decision, the Riksbank mirrored rhetoric from the Fed and ECB, citing that high inflation was driven by rising energy prices and supply logjams, both factors which are expected to subside over the coming year (Chart 11, middle panel). Both headline and core versions of the bank’s favored CPI-F (CPI with Fixed Interest Rate) measure are projected by the Riksbank to remain below target in 2022, reaching 2% only in 2024. Chart 10The Norges Bank Isn't Waiting Around... Chart 11...But The Riksbank Will Remain Patient Chart 12The Central Bank Story Will Further Widen The Norway-Sweden Spread The Riksbank is less willing than the Norges Bank to respond to temporarily higher inflation because of the former’s growing reluctance to return to negative nominal interest rates in response to an economic shock. The Riksbank would likely be more comfortable in lifting nominal rates only when real rates were significantly lower than current levels, which requires higher inflation. In contrast to the neighboring Norges Bank, the Riksbank has an additional tool which it can use to express shifts in monetary policy—the size of its balance sheet. The bank forecasts that holdings of securities will remain unchanged in 2022 (Chart 11, bottom panel), implying that purchases, net of redemptions, will be drawn down roughly to zero. However, the bank does believe that the existing stock of purchases will continue to support financial conditions. Chart 12 shows the impact of the Norges Bank’s relatively hawkish reaction function. Despite relatively similar underlying growth and inflation profiles, sovereign debt from Norway has markedly underperformed Swedish counterparts, a dynamic that has been even more obvious since the pandemic. On the currency side, the NOK/SEK cross has recovered much of the losses from 2020, and will likely rally further as Norway-Sweden rate differentials will turn even more favorable for the NOK. Relative to the global benchmark on a currency-hedged and duration-matched basis, Norwegian government debt has underperformed much more than Sweden following the pandemic. We see these tends continuing over the next 6-12 months, with the Norges Bank likely to remain far more hawkish than the Riksbank. Our bias is to favor Swedish sovereign debt over Norwegian government bonds.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy/European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 2 Appendix