Economy

Executive Summary Don’t Try Catching Falling Euros The euro is inexorably moving toward parity. However, many positives could still save EUR/USD, a cheap currency that will benefit if the fears of a global recession recede and if European inflation peaks by the fall. Nonetheless, many fundamental risks still weigh on the euro, including the dollar’s momentum and the continuing ructions in the European energy market. Moreover, technical vulnerabilities are likely to amplify the potential weakness in the euro. There is greater than a 30% chance that EUR/USD will fall to 0.9 or below. As a result, it is preferable to stay on the sidelines and opt for a neutral stance on the EUR/USD. Selling EUR/JPY offers a more attractive reward-to-risk ratio than EUR/USD. The GBP remains under threat. Bottom Line: Don’t be a hero. At this juncture, the EUR/USD outlook remains particularly uncertain. While EUR/USD possesses ample upside over the coming 12 months, there is roughly a 1/3 chance that it will plunge to 0.9 by the winter. Investors should sell EUR/JPY instead.   The euro’s race toward parity continues. From May 12 to July 1, EUR/USD attempted to form a triple bottom at 1.0375 that could have marked the end of this year’s decline. Alas, the euro did not hold that floor and now traders are inexorably pushing the common currency lower. The outlook for the euro is complex. At current levels, it is inexpensive and discounts many negative developments affecting both the global and European economies. However, the EUR/USD’s weakness is also a story of dollar strength, and the deteriorating global economic momentum remains the Greenback’s best friend, to the euro’s detriment. For now, we stick to our mantra of the past few months: don’t be a hero. The euro may soon bottom, but enough risks lie ahead that a move below 0.9 against the dollar should not be discarded. The risk-reward from bottom fishing is therefore poor. Instead, investors should sell EUR/JPY, for which downside remains ample. What We Like About The Euro… Despite the pervasive negativity engulfing the euro, there are plenty of positives that will soon help EUR/USD form a bottom. First, the euro is cheap on most metrics. The Purchasing Power Parity (PPP) model developed by BCA’s Foreign Exchange Strategists adjust for the different consumption baskets in the Eurozone and the US. It currently shows that EUR/USD trades 25% below fair value, its deepest discount since 2001. This degree of undervaluation is associated with a high probability of strong long-term returns for the euro (Chart 1). Based on interest rate parity and risk aversion, the euro also trades well below its fair value. Steep discounts are often followed by an imminent rebound in the currency (Chart 2). However, the euro hit a similar discount in January, but failed to rally because of the problems in the energy markets prompted by Russia’s invasion of Ukraine. Chart 1Strong Long-Term Returns based on PPP Chart 2Oversold on Many Metrics Second, the euro is oversold. Both BCA’s Intermediate-Term Technical Indicator and the Citi FX Euro PAIN Index are very depressed, which indicates pervasive negative sentiment toward the euro (Chart 2, bottom two panels). This kind of extremes in momentum are often followed by a euro rally. Chart 3Global Recession Fears Hurt EUR/USD Third, global economic pessimism is widespread. EUR/USD is a pro-cyclical pair, which mostly reflects the counter-cyclicality of the dollar and the great liquidity of the euro. It is therefore not surprising that spikes in global recession concerns are associated with a weakening EUR/USD (Chart 3). The recent wave of depreciation happened contemporaneously with a spike in Google searches for the word “recession.” If these fears, which reached extreme levels, subside further in the months ahead, the euro may benefit greatly. Fourth, pessimism toward China may ease, which would lift the euro in the process. Last week, it was announced that Beijing is considering allowing local governments to sell RMB1.5 trillion of special government bonds in the second half of the year to fund infrastructure spending. The news caused a rebound in the AUD, Brazilian assets, and copper. Europe too would benefit from greater activity in China. Chart 4Chinese Salvation? Chinese monetary conditions are also easing, which historically supports industrial activity in Europe relative to the US (Chart 4, top panel). The change in approach in the implementation of the zero-COVID policy is helping Chinese PMIs rebound, which will eventually translate into higher European shipments to China. Moreover, the rate of change of the performance of real estate stocks relative to the broad market has turned the corner, which may facilitate a stabilization of Chinese real estate transactions (Chart 4, second panel). Ultimately, the expanding excess reserves in the Chinese banking system point toward a stabilization of the performance of EUR/USD later this year (Chart 4, bottom panel). Fifth, our expectation that European inflation will peak by the autumn will prove the greatest help to the euro. The EUR/USD’s weakness over the past twelve months has coincided with a surge in European inflation surprises (Chart 5, top panel). This relationship reflects the negative impact on European real rates of both stronger realized and expected inflation (Chart 5, second panel). Investors understand that Europe’s inflation crisis is driven by a relative price shock in the energy market that greatly hurts economic activity in the Eurozone. Hence, even if they expect the ECB to increase interest rates, they believe policy rates will lag inflation because of Europe’s poor growth outlook. This is particularly true when compared to the US Fed. As a result, European real rates continue to lag far behind US ones and the European yield curve is steeper than that of the US, because traders foresee easier policy on the Eastern shores of the Atlantic (Chart 5, panel three and four). Chart 5Inflation Hurts the Euro Chart 6Declining Inflation Expectations? Declining Inflation Expectations? This situation is fluid and inflation expectations have begun to decrease. The recent easing in energy prices has contributed to a decline in long-term inflation expectations (Chart 6). We argued last week that the energy inflation is arithmetically set to decrease over the coming twelve months, which suggests further downside in inflation expectations is likely. Moreover, four of the five largest weights in the Eurozone HICP are running hot, but all are linked to commodity inflation, which confirms our bias that European inflation will soon peak (Chart 7). A top in both headline and core inflation will drag short- and long-term inflation expectations lower, which will help European real rates (Chart 8). Meanwhile, lower imported energy inflation will limit the damage to European economic activity, allowing the ECB to increase rates anyway.   Chart 7Key HICP Components Chart 8A durable Decline In Expected Inflation Depends On Realized Inflation Chart 9Balance Of Payment Support Bottom Line: The euro benefits from important tailwinds that suggest EUR/USD will be higher 12 to 18 months from now. It is cheap and oversold and the pervasive gloom among investors about the state of the global economy indicates that many negatives are already embedded in its pricing. Moreover, the Chinese economy could stabilize in the second half of 2022 and into 2023, which will hurt the dollar and boost the euro. Crucially, a peak in European inflation will allow European real rates to recover and curtail the handicap keeping EUR/USD under pressure, especially as the basic balance of payment remains in the euro’s favor (Chart 9).   … And What We Don’t EUR/USD may benefit from some important tailwinds, but it is still burdened by massive handicaps. The first problem that will place downward pressure on the euro is that its weakness is not unique and that it reflects broad-based dollar strength (Chart 10). This is a problem for the euro because the dollar (and the yen) is the foremost momentum currency in the G10. Its strength begets further strength, and the momentum signal from moving average crossovers remains dollar-bullish.  This headwind for the euro could even intensify in the coming months. JP Morgan EM FX Index is breaking down to new lows, which points to further tightening in EM financial conditions. Historically, tighter EM FCIs translate in both weaker Eurozone stock prices and a weaker EUR/USD, which reflects the closer link between the Euro Area and EM economies than between the US and EM (Chart 11). Chart 10The Dollar's Strength Is Broad-Based Chart 11More Trouble In Store This phenomenon is exacerbated by the underlying weakness in global economic activity. Arthur Budaghyan, BCA’s EM Chief Strategist, often reminds us that Asian exports remain soft. Additionally, the deterioration in US economic activity is likely to continue, as suggested by the weakness in the ISM new orders-to-inventories ratio and by the poor readings from the Regional Fed Surveys. Slowing US growth will generate a further decline in the business-sales-to-inventory ratio, which often coincides in a strong dollar and a weak euro. Chart 12Past Chinese Weaknesses Linger The second problem for EUR/USD is that China’s economic outlook may be improving in the future, but, for now, the impact of the recent Chinese slowdown continues to hamper Europe. More specifically, the recent decline in Chinese import volumes is consistent with a euro-bearish backdrop for the remainder of this year (Chart 12, top panel). In fact, even if the CNY remains stable against the USD, this does not guarantee a positive outcome for the euro as the past weakness in Chinese import volumes is also consistent with a depreciating EUR/CNY (Chart 12, bottom panel) The third euro-negative force is the natural gas market. As we showed last week, Dutch natural gas prices must settle between EUR500-600/MWh this upcoming winter to have the same inflationary impact as they did over the past 18 months. This is unlikely to happen, even according to the direst forecasts of BCA’s Commodity and Energy strategists. However, there is a greater than 30% chance that Europe must ration electricity this winter, which would cause a violent output contraction. As a result, any fluctuation in natural gas flows in Europe will cause the market-based odds of a European recession to swing widely. Consequently, the negative correlation between EUR/USD and TTF prices observed over the past twelve months is likely to remain intact (Chart 13). Related Report  European Investment StrategyQuestions From The Road The fourth issue hurting the euro is the US’s comparative isolation from the energy market’s travails. The US is a haven of relative economic stability today. Yes, its growth will slow further, but it is nonetheless set to outperform the Eurozone. The US is not under threat of rationing energy this winter. Moreover, the US terms of trades benefit from rising energy prices, unlike Europe (Chart 14). Furthermore, the US output gap is closing faster than that of in the Eurozone (Chart 14, bottom panel). As a result, the odds of dovish surprises by the ECB are much greater than those by the Fed. Chart 13Neutral Gas Is Still A Drag Chart 14The US As A Haven Of Stability The US’s relative resilience might also impact equity flows over the next few months in a euro-bearish fashion. US EPS have been stable relative to Euro Area ones, even in local currency terms. Interestingly, because relative EPS reflect broader economic forces, EUR/USD follows them (Chart 15). Thus, if the European economic outlook deteriorates further relative to that of the US, chances are high that Eurozone EPS estimates will be revised down relative to the US, which will coincide with a lower EUR/USD. In fact, the recent underperformance of Eurozone small-cap stocks (which are domestically focused) relative to European large-cap equities (which derive a greater proportion of their sales abroad) and US small-cap shares also confirms the worsening relative economic outlook between Europe and the US, and thus portend significant near-term risks to EUR/USD (Chart 16). Chart 15Follow Earnings Estimates Chart 16Small Caps Indicate More EUR Selling Chart 17An ECB Bungle Would Burden The Euro The last major fundamental risk weighing on EUR/USD is the significant probability that the ECB will disappoint markets with respect to its anti-fragmentation tool to be announced in July. Investor expectations are lofty. However, internal divisions within the ECB Governing Council remain, and, most importantly, the ECB is hamstrung by previous ECJ and German Constitutional Court rulings on bond purchases. Thus, our base case remains that the development of an appropriate bond purchase program will be an iterative process resulting from a back-and-forth between market tensions and ECB responses. As a result, there are risks of further widening in Italian spreads as well as European corporate bond spreads. These developments would further hurt the euro (Chart 17). Chart 18Much Selling To Be Unleashed Sentiment Could Get More Negative These fundamental problems with EUR/USD do not guarantee that the euro will punch below parity. After all, there are also plenty of positives with this currency. However, the risk of a violent selloff is elevated, at around 30%, because of underlying technical vulnerabilities. Global market liquidity has deteriorated in recent years, and this phenomenon is also impacting FX markets, resulting in sudden jumps being more frequent. Most crucially, the odds are high that automatic selling will be triggered if the euro tests parity, which would result in a cascading decline for a euro entering territory that has not been charted for the past 20 years. Specifically, speculators are marginally short the euro (Chart 18, top panel) and 1-month and 3-month risk reversals in the option markets are not yet at a capitulation point (Chart 18, bottom panel). Thus, if panic sets in, the euro could easily fall below 0.9, where the strongest supports lie. In essence, we worry that a sudden crash in the euro is becoming a growing threat. Bottom Line: The combination of the dollar’s momentum, the lagging impact of China’s economic woes, the risks to Europe’s energy supplies, the relative stability of the US economy, and the heightened chance that the ECB underdelivers with respect to its anti-fragmentation tool later next week all point to significant risks to the euro in the coming months. Moreover, the technical vulnerabilities present in the FX market suggest that, if further downside takes place, it will not only be large but also rapid. Investment Conclusions The dilemma between views and strategy is greatest with the euro today. There are many positives highlighted in this report that suggest that the euro has upside on a 12-month basis. However, the risks are abundant, and the potential downside in the coming six months not only carries a large probability, it is also likely to be pronounced if it takes place. As a result of this configuration, we fall back to the strategy we had adopted for European equities earlier this year: don’t be a hero. Even if the euro bottoms tomorrow, the risks are such that capital preservation remains paramount. Consequently, we recommend that investors stay on the sideline and maintain a neutral stance on EUR/USD. It is just as risky to try to bottom fish this pair as it is to chase it lower from current levels. Chart 19Sell EUR/JPY Instead, we follow BCA’s Foreign Exchange Strategists recommendation to go short EUR/JPY as a bet with a lower risk-reward ratio. Global recession worries and weakening commodity inflation are likely to allow for greater downside in global yields, which often results in a lower EUR/JPY (Chart 19). Additionally, investors do not expect much out of the BoJ this year, but if recession risks intensify in Europe because of energy rationing this winter, there is room to curtail the interest rate pricing for the ECB embedded in the €STR curve. Furthermore, the JPY is the cheapest currency in the G10. Finally, investors wanting to build greater exposure to European currencies should do so via the Swiss franc. We argued three weeks ago that the CHF enjoys significant structural tailwinds because of the Swiss economy’s strong productivity. Additionally, the SNB is no longer intervening to limit the CHF upside, as demonstrated by the decline in its current deposits. Instead, a stronger Swiss franc is the most potent weapon in the SNB’s arsenal to combat inflation. Moreover, the CHF offers a hedge against both recession risks in the Eurozone and further widening in European spreads. Bottom Line: Don’t be a hero. EUR/USD’s outlook is uniquely uncertain now. While many factors point to positive returns on a 12-to-18 month basis, if the euro hits parity in response to the many clouds still hanging over Europe, technical factors could plunge this currency to EUR/USD 0.9 into a steep decline. Instead, the clearer call is to sell EUR/JPY. Investors who want to assume a European FX exposure today should do so through the Swiss franc, not the euro. A Few Words On The UK Last week, Prime Minister Boris Johnson resigned. The initial response of the pound was to rebound. This reaction should fade. BCA Geopolitical strategists argue that, even though the person sitting at 10 Downing Street is about to change, the fundamental problems with the UK remain the same. The Labour Party is ascending, but it will still have to deal with the Brexit aftermath, rising populism, and popular discontent across the country. The economy is still fragile and engulfed in an inflationary spiral. Meanwhile, the risks created by a looming Scottish independence referendum are much more significant than was the case in 2014. As a result, the pound is likely to remain under stress over the coming quarters.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Economic growth is decelerating and recession talk is unavoidable, but the data series the business cycle dating committee tracks suggest the expansion is still alive and kicking. Despite unacceptably high inflation readings and a wildly swinging near-term outlook, intermediate- and long-term inflation expectations have remained well anchored all year. Market-based measures have been remarkably well behaved and the preliminary reading from the University of Michigan consumer survey that spooked the Fed was revised down to a more comfortable level. The FOMC minutes for June left no doubt that the committee is prepared to accept a recession as the price of subduing inflation, but markets already discounted that in their June swoon. The swiftness with which financial conditions have tightened in response to the beginning of the Fed’s rate-hiking campaign is unprecedented. It may have the effect of reducing the lag between FOMC actions and economic impacts while front-loading the pain from the inevitable slowdown. It Won't Be Easy To Get Worse Bottom Line: The domestic economic backdrop is challenging and international uncertainties could make things worse, but a severe recession and bear market are not inevitable. The consensus is underestimating the potential for upside surprises that could lead equities to outperform fixed income and cash over the next three-to-twelve months. Feature Feed a cold, starve a fever is a simple prescription with an obvious read-through for monetary policymakers. If growth is sluggish, a central bank can stimulate its economy by lowering interest rates to encourage consumption and investment. If the economy is overheating, it can raise interest rates to cool household and business spending and dial back activity to a more sustainable level. Related Report  US Investment StrategyA Difference Of Opinion Things get hairy when it’s a sluggish economy that needs to be slowed. The specter of stagflation – stagnant growth and high inflation – has been haunting financial markets as consumer prices have increased by at least 7% year-over-year every month since December amidst a clear deceleration in growth. Economic activity contracted in the first quarter, in terms of real GDP, and the Atlanta Fed’s GDPNow model projects that it did so again in the second quarter. According to the definition every introductory economics student learns, two consecutive quarters of contraction make a recession. Financial markets are a forward discounting mechanism and stocks’ and bonds’ ugly first-half performances may have foreshadowed the expansion's demise. We suspect the immediate future might not be as bad as financial market performance would imply, though we acknowledge that the risks to our comparatively constructive view have risen. We do not think that everything is hunky-dory; as we’ve previously noted, inflation will likely ease to 4% of its own accord, but getting it back down to the 2% target will require the Fed to squash the economy. That will bring about the definitive end to the expansion and risk assets’ extended romp. Our best guess is that the policy day of reckoning will not become apparent until 2024 and that the S&P 500 can recover a meaningful amount of ground between now and next July. We therefore remain overweight equities over the twelve-month cyclical timeframe, in contrast to the neutral house view. Recession Already? Probably Not Chart 1The Expansion Looks Sound Despite the Econ 101 rule of thumb, business cycles are defined by the National Bureau of Economic Research’s Business Cycle Dating Committee, not the ups and downs of real GDP. The committee considers a broad range of activity measures when determining economic peaks and troughs, with employment (Chart 1, top panel), income and consumption (Chart 1, second panel), industrial production (Chart 1, third panel) and real manufacturing and trade sales (Chart 1, bottom panel) drawing particular attention. Those series do not warn of a recession now, and neither does still-positive real final domestic demand growth (Chart 2), which backs inventory adjustments and net exports out of GDP to provide a better read on the domestic economy. Per its dual mandate, the Fed is charged with maintaining price stability and full employment. Now that inflation is unacceptably high and growth is slowing, several clients have remarked on the incompatibility of the individual mandates. The Fed can choose price stability and kill the economy, a la Volcker in the early eighties, or it can protect employment at the cost of inflation. We have limited faith in central bankers’ ability to fine-tune economic outcomes with the blunt tools at their disposal, but there is room for the labor market to cool without denting the economy too terribly. Chair Powell has cited the ratio of job openings to unemployed workers as a metric that’s well beyond full-employment levels and has mused that it might offer an avenue for the Fed to engineer a soft landing. It eased a bit in May, as per the JOLTS job openings data released last week, and the labor market would presumably remain robust if it fell to a level at or around 1 (Chart 3). Getting the ratio to settle in the desired range is easier said than done, of course, but if a meaningful share of the working-age Americans who remain AWOL come back to the work force, it will be possible for payrolls to continue to expand even as the unemployment rate rises to the Fed’s estimated long-run full employment level of 4.1%. Chart 2Real Final Domestic Demand Is Still Growing​​​​​ Chart 3The Job Market Can Cool Without Shrinking​​​​​ Inflation Expectations Remain Contained We view longer-run inflation expectations as an important driver of economic participants’ actions. If households, businesses and investors expect that inflation will not be an issue over the long run, they will not alter their behavior to protect themselves from it. If they begin to believe that high inflation will linger for an extended period, they will take actions that serve to entrench it. The evolution of long-run inflation expectations, then, can provide advance warning that a vicious circle in which high prices beget higher prices is brewing. They also offer insight into the course of monetary policy. Chair Powell regularly cites inflation expectations as an important driver of the Fed’s actions, and the prospect that inflation expectations could become unanchored would prompt Volcker-like moves that would surely throttle financial markets and the economy. Powell explicitly cited the 3.3% preliminary long-run inflation expectation reading from the University of Michigan consumer sentiment survey as a catalyst for the FOMC’s eleventh-hour decision to hike the fed funds rate by 75 basis points in June. The final reading was revised down to a less noteworthy 3.1%, but the episode showed that the Fed responds to any suggestion that inflation expectations are at risk of breaking out. We monitor the CPI swaps market, and the TIPS and nominal Treasury markets, to get a read on investors’ and businesses’ intermediate- and long-term inflation expectations. Despite wild swings in 2-year expectations, which made a run at 5% in late March before setting (Chart 4, top panel) or approaching (Chart 5, top panel) new 2022 lows last week, 3-to-5- and 6-to-10-year expectations have been remarkably well behaved. TIPS break-evens imply intermediate- (Chart 4, middle panel) and long-term (Chart 4, bottom panel) inflation expectations that are 20 basis points (bps) below the 2.3-2.5% range consistent with the Fed’s 2% inflation target. Intermediate- and long-term expectations derived from the CPI swaps curve sit about 30 bps higher, but their path has been similar, with the former making a new year-to-date low last week (Chart 5, middle panel) and the latter nearing one (Chart 5, middle panel). Chart 4Investors' Longer-Run Expectations Remain Well-Anchored, ...​​​​​ Chart 5... And Businesses' Do, Too​​​​​​ The bottom line is that investors and the Fed should take some comfort from how well anchored inflation expectations have remained all year. They will not remain that way indefinitely if real-time inflation does not head convincingly lower soon, but apparently no longer-run damage has been done yet. For all the things that have turned out worse than expected this year, longer-run inflation expectations have been a meaningfully positive surprise. The Fed’s Next Moves Chart 6Act On The Rumor, Ignore The News While watching Chair Powell’s press conference following the June FOMC meeting, we were struck by how doggedly he stuck to the theme that price stability was the committee’s foremost concern. In a performance that must have warmed the heart of anyone who’s ever worked as a behind-the-scenes aide, he unwaveringly hammered the primary talking point he’d been coached to hit. Last week’s release of the June meeting’s minutes revealed that he was speaking for the full committee when he emphasized that nothing could dissuade it from restoring inflation to its target level. Though FOMC members’ hawkish/dovish leanings occupy a broad spectrum, the minutes painted a picture of a committee unified by its concern about inflation. Although the minutes made it clear that the committee is willing to sacrifice growth to gain control over inflation, and media coverage trumpeted that theme, they didn’t tell us anything new. They may have been a bit outdated, now that the Michigan survey’s final inflation expectations turned out not to be a big deal, and subsequent price action in real and financial asset markets suggest inflation pressures are easing, but markets already discounted the consequences of the Fed’s hawkish pivot when the committee let it be known that it was considering a 75-bps hike. The S&P 500 fell 12% in just seven sessions, culminating in its year-to-date closing low the day after the meeting concluded, 23.5% below its all-time closing high set at the beginning of January (Chart 6, top panel). Treasuries had embarked on a wild ride ahead of the meeting, as well, with the 10-year yield rising 45 bps in three sessions to 3.49% on the first day of the two-day meeting before bottoming for the time being at 2.82% last week (Chart 6, bottom panel). The minutes underlined members’ understanding of the tradeoff involved in crushing inflation and their resolve to enter into it. “Most [participants] agreed that risks to inflation were skewed to the upside … [while assessing] that the risks to … growth were skewed to the downside.” Despite the stagflation risks, “[p]articipants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.” We have no doubt that the Fed will induce a recession if it proceeds along the course it has charted, but that doesn’t mean that it will be a severe one, or that it will begin imminently, leaving room for equities and credit to rally in the interim. About That Monetary Policy Lag Chart 7It's Hard To Keep Missing A Progressively Lower Target Our contention that risk assets have a path to rally over the next twelve months underpins our recommendation to overweight equities within a multi-asset portfolio over that timeframe. We are not saying that skies are blue and everything is great; we simply think that the gloom has gone too far and the equity selloff is overdone. As the saying goes, more money is made owning stocks from terrible to bad than it is from good to great. Judging by the economic surprise index, the bar for getting more terrible has been set pretty high (Chart 7). The unprecedentedly rapid tightening of financial conditions at the outset of a rate-hiking campaign also raises questions. It is widely assumed that Fed actions take around twelve months to filter their way through the economy. While the prime rate moves higher immediately after the FOMC meeting, rates impacting households can be slow to reset, and it typically takes some time to reverse spending and investing momentum. If households and businesses foresee an extended series of rate hikes, the first ones may be stimulative in the near term as they line up to deploy their consumption and investment capital while they can obtain it on relatively favorable terms. Chart 8No Lag This Time Financial conditions do not typically become maximally tight until a couple of years after the Fed completes its rate hike campaigns (Chart 8). The swiftness with which financial conditions have tightened this time has us wondering if they have already reached peak tightness or are about to do so. If activity troughs around the time the financial conditions index peaks, is it possible that the worst of the downturn isn’t far away? The conditions that have attended this cycle are unique, and all we can say for sure is that Treasury yields, corporate bond spreads, equity indexes and the dollar have combined to tighten financial conditions to the tune of about two-and-a-half percentage points of real GDP1 solely on anticipation. Financial markets’ proactive moves may have been hasty. We are closely monitoring the ongoing flow of data to determine if it will vindicate or discredit our thesis, but we remain more open to positive surprises than the consensus.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Goldman Sachs’ Financial Conditions Index is calibrated such that a one-point move in the index is meant to be equivalent to a one-percentage-point move in real GDP.

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Caught In Risk-Off Selling Weak Chinese and European economies are suppressing copper demand and helping to temper prices in a market that remains fundamentally tight. Weaker US GDP growth could put the three largest economies in the world in or close to recession in 2H22/1H23, which would contribute to demand-side weakness in copper markets. The odds manufacturing and base-metals refining will be curtailed in Europe are rising. Although a strike in Norway has been averted by government intervention, maintenance on Russia’s Nord Stream 1 pipeline scheduled to begin next week likely will serve as a pretext for longer and deeper natgas supply cuts to the EU. Bottom Line: Despite fundamental tightness in global copper markets, prices are being restrained by fears weaker Chinese and European economic performance will lead to a global recession. Early reads of US GDP pointing to negative growth in 2Q22 stoke these fears. Heightened economic policy uncertainty globally exacerbates them. We remain fundamentally bullish copper and will re-establish our long SPDR S&P Metals & Mining ETF (XME) – down ~ 40% from its highs in April – at tonight’s close. In addition, we went long the XOP oil and gas ETF at Tuesday’s close, after prompt Brent breached the buy-trigger we set last week of $105/bbl during this week’s crude-oil sell-off.   Feature   Lower GDP growth expectations in China and the EU – along with a wobbly US economy being flagged by an Atlanta Fed GDPNow forecast pointing to negative growth in 2Q22 – are stoking fears of a global manufacturing and industrial recession. This prompted a rout in industrial commodities – base metals and oil – this week, which still has markets on edge. This slow-down in the world’s three largest economies – accounting for almost 50% of global GDP expressed in purchasing-power terms – is the only thing keeping the level of global copper demand close to supply at present (Chart 1).1 At least for the time being, this is keeping the threat of sharply higher copper prices, which would be more in line with the low levels of supplies and inventories globally, at bay (Chart 2). As of the week ended May 27th, global copper stocks stood at just above 562k tons, which is ~ 31% lower y/y. Chart 1World’s Biggest Economies Slowing Chart 2Copper Prices Disconnect From Fundamentals   Uncertainty Weakens Copper Prices Energy and metals markets remain extremely tight on a fundamental supply-demand basis.2 The sharp sell-off this week in oil and metals prices is, in our view, evidence industrial-commodity prices have decoupled from fundamentals.  This makes traders – hedgers and speculators – extremely risk-averse, which reduces liquidity and increases volatility. On the back of these concerns, markets exhibit the sort of volatility associated with economic collapse, despite still-strong underlying fundamentals. Chart 3Rising Global Policy Uncertainty Volatility is on the rise due to increasing economic uncertainty in these markets. This makes it extremely difficult to assign probabilities to different price outcomes (i.e., true uncertainty). The BBD Global Economic Policy Uncertainty is approaching levels seen during the early pandemic (Chart 3).  We put this rising uncertainty down to poor policy and communication from central banks and governments; a pig’s breakfast of energy policy globally that increasingly adds nothing but confusion to markets; and a muddled public-health policy in China, which produces random shut-downs in global supply chains as covid infections randomly crop up in important port cities.  Lastly, the East and West are moving toward a new Cold War, which already is having profound effects on all markets, trade flows and capital availability in the short- and medium-term. This keeps markets on edge and forces them to parse every geopolitical development that hits the tape.3 Re-forging supply chains, re-building basic industrial infrastructure as the West moves away from outsourcing to China and other EM states will be costly and volatile, especially as embargoes and sanctions increase between these blocs.    This political and economic evolution will require increased investment in base metals production and exploration, along with similar commitments to oil and gas. Low and volatile prices will not support this, as they disincentivize investment, and set markets up for continued shortage and scarcity going forward. In the metals markets, years of underinvestment by major mining companies will keep copper supplies and inventories tight going forward (Chart 4). This will hinder and delay the global renewable-energy transition, which cannot be realized without higher base-metals supplies.  Chart 4Structural Underinvestment In Mining Fundamentally Bullish Copper Recession Fears Haunt Metals Globally … The proximate causes of the persistent weakening of copper prices is the demand destruction arising from the lockdown in China, and an increasing concern over the economic prospects of the EU as it prepares for a possible shut-off of Russian natgas exports. Should Russian supplies be cut off, the EU will be pushed into recession as natural-gas rationing – and the attendant prioritization of human needs going into winter – will constrict economic activity, particularly in manufacturing.  This leaves two of the three largest economies in the world either in recession or not growing at all. Added to this is the fear of a wobbly US economy, which has been slowed by higher energy prices and the Fed’s hawkish tightening of monetary policy. The Atlanta Fed’s GDPNow forecast for 2Q22 estimates a 2.1% contraction in US GDP. This would be the second consecutive quarter of negative growth and would meet a widely held rule-of-thumb indicator or recession.4  In our modelling, we estimate the income elasticity of copper demand in DM economies like the EU and US (1.39) and EM-ex-China (0.87) states is higher than that of China (0.37). This means that a 1% contraction in p.a. Chinese real GDP would translate to a 0.37% p.a. fall in copper demand, all else equal. A contraction of real incomes – i.e., real GDP – in the EU and EM-ex-China will cause a larger relative adjustment in copper demand than in China, even though the level of copper demand in China is far greater in absolute terms (Chart 5).  A recession in the EU will reduce import demand for China’s manufactured output in these markets (Chart 6). As China’s trade volumes fall, Chinese manufacturing PMIs will contract. Similarly, exports to China from the EU will weaken as manufacturing weakens and real GDP moves lower. We believe this will put more pressure on the Chinese government to provide fiscal and monetary stimulus to counter such a downdraft.  Chart 5Copper Demand Sensitive to Real GDP (Income) Chart 6Trade Channel Effects Follow GDP Weakness … But China Worries Dominate The Chinese economy is showing signs of further slowing.5 Weakness in credit levels, infrastructure investment, manufacturing, the property sector, and exports all indicate the covid-policy lockdowns, high commodity prices, and parsimonious credit and fiscal policies have produced a dramatic slowing in economic activity. In our modelling, we find evidence that each of these components exhibits a long-run inverse relationship with Chinese copper inventories, which in turn exhibits a long-run inverse relationship with COMEX copper prices.  Roughly 10 days after the initial Shanghai lockdown, copper prices went into contango (Chart 7). This occurred despite continuous declines in Chinese copper inventories during the lockdown months (Chart 8). Such anomalous behavior – i.e., as inventories fall markets become more backwardated – makes it difficult to connect prices and supply-demand-inventory fundamentals. Chart 7Copper In Contango For Most Of China’s Lockdown Chart 8Chinese Copper Inventories Continue To Draw In Lockdown BCA’s China Investment Strategy expects a muted 2H22 recovery for the Chinese economy. Rolling lockdowns due to China’s COVID policy will reduce the potency of fiscal and monetary stimulus. The stop-start nature of economic activity will stymie growth in disposable income and job creation, which in turn will translate to weaker aggregate demand. The knock-on effect of weaker business activity due to the lockdown earlier this year has been a higher propensity to save by households (Chart 9). Household surveys conducted by the PBoC show that, since 2017, household savings have been increasing, suggesting a precautionary sentiment (Chart 10). Chart 9Chinese Economic Slowdown Reduced Credit Demand Chart 10Rising Precautionary Savings... Chart 11...Will Impact Domestic Property Market We do not expect the property market to recover in a manner similar to what occurred following China’s re-opening after the first wave of the COVID-19 pandemic. Depressed household purchasing power will keep housing demand subdued, while the “three red lines” policy, which limits the amount property developers can borrow, will keep supply low (Chart 11).6 Housing accounts for ~ 30% of copper consumption in China, which means weak property markets will remain a drag on copper demand. Investment Implications Continued weakness in China’s economy and a potentially deep recession in the EU will continue to restrain demand for copper globally. In addition, with the US economy looking wobbly, the third global pillar of economic strength also will be weakening going into 2H22. These fundamental demand-side effects will lower pressure on tight copper inventories and keep prices subdued, in our view. This does not, however, signal an all-clear for copper supply or inventory tightness. Weaker demand is the only thing keeping prices from rising sharply, given the tight supply and inventory position of global copper markets. On the supply side, governance issues in copper-rich Latin American states, which are in the process of revising their social contracts with copper producers and consumers, will increase mining costs for companies, disincentivizing long-term and large-scale investments in new mines.7 These costs ultimately will be borne by consumers as supply shortages mount and the need to increase capex grows. Ultimately, this will feed into longer-term inflation and inflation expectations. Chart 12Caught In Risk-Off Selling We remain long-term bullish copper, as fundamentals remain tight and will get tighter. That said, over the short term, aggregate-demand weakness in the three major economic pillars in the world makes us leery of getting long copper futures, particularly as prompt COMEX prices test support (Chart 12).  Persistently weak copper prices will disincentivize the needed investment in new supply the world will need to effect a transition to renewable energy in coming decades. For this reason, we are comfortable re-establishing our long XME metals and mining ETF at tonight’s close, as copper prices are down 40% from their April highs. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish. A strike by Norwegian energy-sector workers that would have hit the natural gas market in Europe particularly hard was averted earlier this week.8 This still leaves the EU and UK (Europe) at risk of additional losses of Russian natgas exports beginning next week when Nord Stream 1 (NS1) maintenance is due to start. These threats have pushed Dutch Title Transfer Facility (TTF) natural gas prices up close to 93% since 1 June, and close to 400% y/y as of Tuesday. For the first five months of this year, Europe’s been importing just under 15 Bcf/d of LNG, with ~ 8.5 Bcf/d of those volumes coming from the US, based on EIA data. The EIA expects US LNG exports to average ~ 11.9 Bcf/d this year and 12 Bcf/d in 2023. Europe accounted for just under 75% of US exports in January – April of this year, and we expect that to continue going forward. The IEA expects Russia to supply 25% of EU demand this year, the lowest in 20 years. Last year, Russian imports covered ~ 40% (~ 7 TCF) of EU demand. Base Metals: Zinc stocks are depleted but prices are dropping on recession fears (Chart 13). Smelting operations were hit last year following the power-supply crunches in China and Europe. While China has recovered its energy security, Europe, which accounts for ~15% of global refined zinc supply, has not. Reduced natgas supply from Russia will make the smelting shortage in Europe even more acute, especially if power and fuel rationing occur. In April, China was a net exporter of zinc for the first time since 2014, as low demand in the state and low European zinc supply incentivized Chinese smelters to ship metal to the West despite high outbound tariffs. Precious Metals: Markets switched from inflation to growth fears, as central banks, notably the Fed began hiking interest rates aggressively to curb inflation. Investors have been flocking to the USD, which hit a 20-year high on recession fears this week (Chart 14). This has happened at the expense of the yellow metal, which, since breaking through the USD 1800/oz mark last week, has continued to drop, hitting an 8-month low as of yesterday's close. Chart 13Global Copper Inventories Remain Tight Chart 14   Footnotes 1     Please see China, US and EU are the largest economies in the world, which was published by Eurostat 19 May 2020. 2     For additional discussion of oil-market fundamentals, please see Recession Unlikely To Batter Oil Prices, which covers our expectation for global oil balances and prices. It was published 16 June 2022. 3    Please see Hypo-Globalization (A GeoRisk Update) published by BCA Research’s Geopolitical Strategy 30 July 2021. See also Commodities' Watershed Moment, which we published 22 March 2022.  4    Please see GDPNow, published by the Federal Reserve Bank of Atlanta 1 July 2022. 5    Please see Third Quarter Geopolitical Outlook: Thunder And Lightning, published by BCA’s Geopolitical Strategy 24 June 2022. This report notes, “China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect … . Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively.” 6    In August 2020, the Ministry of Housing and Urban-Rural Development and the People’s Bank of China proposed to implement a policy which kept a ceiling on companies’ asset to liability ratio at 70%, net debt to equity ratio at 100%, and cash to short-term borrowings ratio at 1. Developers whose liabilities are within these requirements may increase their liabilities by less than 15%. These were known as the “three red lines.” Per that policy, if one or more of these ceilings are surpassed, maximum liabilities growth is capped at a lower percentage. 7     Please see Add Local Politics To Copper Supply Risks, which we published 25 November 2021. It is available at ces.bcaresearch.com. See also Chile sticks to plan for new mining profit tax up to 32% linked to copper price, published by reuters.com via mining.com 1 July 2022. 8    Please see Norway’s government halts oil and gas strike published by ft.com 5 July 2022. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed In 2022

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now)​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes Table 3BEstimated Government Bond Yield Betas To US Treasuries For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 18Risk Factor Assumptions For The Scenario Analysis​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations*