Economy

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs Chart 12Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. Stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, we expect the 10-year Treasury yield to reach a range of 2% to 2.25% by the end of 2022 when the Fed is ready to lift rates. Maintain below-benchmark portfolio duration. Employment: The static unemployment rate and sub-50 readings from ISM employment indexes will prove to be short-lived phenomena driven by labor supply constraints. These constraints will vanish in the fall when schools re-open and expanded unemployment benefits lapse. Yield Curve: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Feature Last week was another dramatic one in the bond market. Bond yields fell sharply as doubts emerged about the pace of economic recovery and the economy’s progress back to full employment. The 10-year Treasury yield started the week at 1.44% before hitting an intra-day low of 1.25% on Thursday. It then rebounded somewhat to end the week at 1.36%. One catalyst for the move was Tuesday morning’s ISM Non-Manufacturing report that printed at 60.1, below consensus expectations of 63.5. But in truth, economic momentum had already been slowing for several months before that release. The 10-year Treasury yield peaked at 1.74% on March 31st, right around the same time that the New York Fed’s Weekly Economic Index and both the ISM Manufacturing and Non-Manufacturing indexes leveled-off (Chart 1). Last week simply saw the “slowing growth” narrative pick up steam. One noteworthy feature of last week’s market action is that the Treasury curve flattened as yields fell. While the 10-year yield is now at its lowest since February, the 2-year yield remains higher than it was just prior to the June FOMC meeting (Chart 2). This suggests that part of the drop in long-maturity bond yields is due to a fear that the Fed will over-tighten in the face of slowing growth. This fear likely stems from the Fed’s apparent hawkish pivot at the June FOMC meeting.1 Chart 1"Peak Growth" Hits The Bond Market Chart 2A Flatter Curve Since March   It’s also worth mentioning that the bulk of last week’s drop in yields was concentrated in long-maturity real yields (Chart 2, bottom 2 panels). TIPS breakeven inflation rates have fallen somewhat since the end of March. But, at 2.3% and 2.23% respectively, the 10-year and 30-year TIPS breakeven inflation rates are not that far below the Fed’s 2.3% - 2.5% target range. Chart 3Bond Rally Not Confirmed By Commodities Finally, many have suggested that “technical factors” are responsible for last week’s bond market strength. That is, factors related to the supply and demand for bonds but unrelated to economic fundamentals conspired to push yields lower. This is a difficult thesis to prove or disprove, but we will point out that the 10-year Treasury yield has diverged significantly from the CRB Raw Industrials / Gold ratio (Chart 3). The 10-year yield and the CRB/Gold ratio tend to track each other very closely but, in contrast to yields, the CRB/Gold ratio has actually increased since March 31st. This lends some credence to the argument that last week’s drop in yields is not purely a reflection of economic weakness, and it could be an overreaction to weaker-than-expected data that was exacerbated by extreme short positioning in the market (Chart 3, bottom panel). Three Reasons Why The Decline In Treasury Yields Is Overdone We do in fact think that the recent decline in Treasury yields is overdone, and we continue to see the 10-year Treasury yield reaching a range of 2% - 2.25% by the end of next year when the Fed is ready to lift rates. We present three reasons why the recent drop in Treasury yields is overdone. First, the bond market is making too much of the “slowing growth” narrative. Yes, it’s certainly true that the economic indicators shown in Chart 1 are no longer accelerating, but in level terms they remain consistent with a robust economic recovery where GDP growth is well above trend. This sort of growth environment is consistent with a falling unemployment rate that will eventually bring Fed rate hikes into play. Bond yields will move higher as this tightening cycle approaches. Second, it is not just the pace of economic growth that matters for bond yields. The output gap matters as well.2 That is, the same rate of economic growth will coincide with higher bond yields when the unemployment rate is 5% than it will when the unemployment rate is 10%. With that in mind, we observe that the output gap has closed significantly during the past year. The prime-age employment-to-population ratio is 77%, up from a 2020 low of 70%. Similarly, capacity utilization is 75%, up from a 2020 low of 64% (Chart 4). Unless we expect economic growth to slow enough for progress on these two fronts to reverse, then we should see significantly higher bond yields this year compared to last year. This makes it difficult to see how Treasury yields can fall much further from current levels. Another way to conceptualize the relationship between the output gap and long-maturity bond yields is to look at how long-dated yields move relative to short-dated yields. Since the Fed moves the funds rate in response to changes in the output gap, we can model the 10-year Treasury yield relative to the fed funds rate and expectations for near-term changes in the fed funds rate to get a sense of how well the output gap explains changes in long-maturity bond yields. Chart 5 presents a simple model of the 10-year Treasury yield relative to the fed funds rate and the 24-month fed funds discounter. It shows that last week’s decline in the 10-year yield caused it to diverge significantly from the model’s fair value. Chart 4The Output Gap Matters Chart 5Long-Maturity Yields Are Too Low   Third, the Fed’s pledge to keep rates at the zero-lower-bound at least until the labor market reaches “maximum employment” means that the labor market outlook is critical for bond yields. Our view is that the labor market is on the cusp of a rapid recovery that will cause the Fed to lift rates before the end of 2022. However, recent labor market data have been mixed and there is considerable uncertainty in the market about the future pace of employment gains. The next section delves deeper into the outlook for the labor market. Making Sense Of The Employment Data Chart 6ISM Employment Below 50 ... Overall, it seems safe to say that the labor market data have been disappointing in recent months. Yes, nonfarm payroll growth has averaged a robust +543k this year, but the minutes of the June FOMC meeting revealed that “some participants” viewed employment gains as “weaker than they had expected”. The recent dips in the employment components of both the ISM Manufacturing and Non-Manufacturing indexes to below the 50 boom/bust line only add to the sense of pessimism about the labor market. Historically, sub-50 readings from the ISM employment indices (particularly from the non-manufacturing ISM) have coincided with slowing employment growth (Chart 6). This time, however, we don’t see the ISM employment indexes staying below 50 for very long. The more demand-focused components of the ISM indexes – production, new orders and backlog of orders – remain elevated (Chart 7). This tells us that demand is strong and that hiring is only weak because of labor supply constraints, a topic we have covered repeatedly in this publication.3 Our view is that by September, once schools re-open and expanded unemployment benefits lapse, we will see a surge in hiring and a jump in the ISM employment components as people are enticed back into the workforce. A clearer picture of the labor market will then emerge, and it will catalyze a jump in bond yields. It’s not just weak ISM employment readings that are giving investors doubts about the labor market. The unemployment rate’s decline has also slowed markedly in recent months (Chart 8). Our adjusted measure of the U3 unemployment rate currently sits at 6.1%, above the headline U3 measure of 5.9% and significantly above the range of 3.5% to 4.5% that the Fed estimates is consistent with full employment. Chart 7... But Demand Indicators Are Elevated Chart 8Slow Progress On Unemployment Chart 9Labor Supply Is The Problem We adjust the U3 unemployment rate to include a number of people that are currently being classified as “employed but absent from work” when they should be classified as “temporarily unemployed”. The number of people describing themselves as “employed but absent from work” jumped sharply in March 2020 and has remained elevated. This is the result of workers that were placed on temporary furlough during the pandemic and who should be counted as unemployed. We make our adjustment by taking the difference between the number of people that are “employed but absent from work for other reasons” each month and a baseline calculated as that month’s average between 2015 and 2019. We then add this excess amount to the number of temporarily unemployed. This gives us adjusted readings for both the U3 unemployment rate and the temporary unemployment rate (Chart 8, top 2 panels). The Appendix of this report updates our scenarios for the average monthly nonfarm payroll growth required to reach “maximum employment” to consider both this new adjustment and June’s employment figures. Technical adjustments aside, the main takeaway for investors is that progress toward “maximum employment” has been relatively slow during the past few months. This is particularly true if we look at the unemployment rate excluding those on temporary furlough (Chart 8, panel 3) and the labor force participation rate (Chart 8, bottom panel). This slow progress toward “maximum employment” is undoubtedly a reason why bond yields remain low. But, once again, we think it’s only a matter of time before labor supply constraints ease and the unemployment rate falls rapidly, catching up to indicators of labor demand that have already surpassed pre-COVID levels (Chart 9). Bottom Line: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. The labor market also continues to make progress toward maximum employment (and Fed rate hikes) though that progress has slowed during the past few months. We anticipate that stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, the economy will reach full employment in time for the Fed to lift rates in 2022. We expect that the 10-year Treasury yield will be in a range of 2% to 2.25% by then. Maintain below-benchmark portfolio duration. A Quick Note On The Yield Curve Chart 105y5y Still Close To Fair Value While we view the recent drop in the level of bond yields as an overreaction, we are less inclined to view recent curve flattening as temporary. To see why, let’s look at the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate. We like to think of the 5-year/5-year forward Treasury yield as a market proxy for the long-run neutral fed funds rate, so a range of estimates of that rate is a logical fair value target. The 5-year/5-year forward Treasury yield has fallen a lot during the past few weeks. But, at 2%, it is still within the range of neutral rate estimates from the New York Fed’s Survey of Market Participants and only just outside of the same range from the Survey of Primary Dealers (Chart 10). The fact that the 5-year/5-year yield remains relatively close to its fair value range tells us that there is very limited scope for curve steepening. Recent periods of significant curve steepening have tended to coincide with one of the following two developments: The Fed is cutting rates (coincides with a bull-steepening) The 5-year/5-year forward Treasury yield moves into its fair value range after starting out well below it (coincides with a bear-steepening) This second sort of curve steepening occurred during the 2013 taper tantrum, after the 2016 presidential election and again after the 2020 presidential election. It’s conceivable that the yield curve could re-steepen somewhat during the next few months, if the 5-year/5-year forward yield moves back to its prior highs. But we expect the next major move in the Treasury market to be a bear-flattening as the rest of the yield curve catches up to the 5-year/5-year. This is the sort of curve flattening that occurred in 2017 and 2018 when the Fed was lifting rates (Chart 10, bottom 2 panels). A bear-flattening of the yield curve is also the most likely outcome if we start to see significant positive employment surprises later this year, as we anticipate. These employment surprises would bring forward the timing and pace of rate hikes but wouldn’t necessarily cause investors to question their views about the long-run neutral fed funds rate. Bottom Line: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +484k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart helps us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 For a description of the five macro factors that determine bond yields please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019. 3 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021.   Fixed Income Sector Performance Recommended Portfolio Specification

Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Chart 2...Leads To Greater Activity   … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Chart 4...And China's Credit Slowdown Matter   Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Chart 6...Will Improve Further   Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Chart 8...Later This Year   … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now   A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro   The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell   Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Chart 16...Reflects Profitability Problems   …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Chart 18...And So Does Global Growth   Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Chart 20...And Are Less Risky   A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons.  Chart 21Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away   Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance