Economy

Highlights Chart of the WeekThe Bond Bear Mantle Being Passed To Canada? US Treasuries: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remains bond bearish and the Fed is likely to begin preparing the market later this year for a tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk of the Bank of Canada shifting to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying – perhaps even before the Fed does the same (Chart of the Week). Downgrade Canadian government bonds to underweight in global fixed income portfolios. US Treasuries: The Pause That Refreshes Chart 2UST Yield Uptrend Has Paused After leading the global government bond market selloff over the past several months, US Treasury yields have calmed down of late. The 10-year Treasury yield is down 14bps from the most recent peak of 1.74% reached March 31, while the 30-year Treasury yield is down 16bps from the peak of 2.45% reached on March 18. These moves have been concentrated in the real yield component, with inflation breakevens stable, as the 10yr and 30yr TIPS yields are down -15bps and -20bps, respectively, since the dates of those peaks in nominal yields (Chart 2). The drift lower in US yields has occurred in the face of an explosive surge in US economic data. Retail sales rose +9.8% in March compared to February and a staggering +27.7% on a year-over-year basis. The Fed’s regional manufacturing surveys showed very robust results for April, with the New York Empire State index hitting the highest level since October 2017 and the Philadelphia Fed headline index surging to a level last seen in 1973. This follows the very strong payrolls and ISM data for March that came out in early April. Yet the US economic data is not unanimously positive. The latest readings from the University of Michigan consumer confidence and NFIB small business optimism surveys both remained well below pre-pandemic peaks (Chart 3). Annual core CPI inflation only inched up 0.2 percentage points in March to 1.6%, a tepid move compared to the base effect driven surge that took year-over-year headline CPI inflation from 1.7% in February to 2.6%. Chart 3Some Mixed Messages From Recent US Data Chart 4Fewer Positive US Data Surprises The overall flow of US economic data has been disappointing versus elevated expectations, as evidenced by the almost uninterrupted decline in the Citigroup US data surprise index since peaking in July of 2020 (Chart 4). This indicator reliably correlated to the momentum of US Treasury yields prior to the COVID-19 outbreak and now, given the bullish growth combination of vaccine optimism and fiscal stimulus, the bond market’s focus is returning to how US data evolves versus expectations - and what that means for the Fed’s future moves on monetary policy. The most senior leadership at the Fed continues to send a consistent message on policy, with no rate hikes expected before 2024 and no hints at when the tapering of quantitative easing (QE) could begin. Yet some Fed officials have started to be a bit more vocal about their comfort level with the current accommodative policy stance and the associated risks to financial stability and inflation. Last week, Dallas Fed President Robert Kaplan noted that he would like to see the Fed begin to withdraw its support for the economy “at the earliest opportunity”. St. Louis Fed President James Bullard was even more specific, noting that once the share of vaccinated Americans reaches “herd immunity” levels of 75-80%, it will be time for the Fed to debate tapering QE. At the moment, however, there is no need for the Fed to move preemptively. Our Fed Monitor - comprised of economic, inflation and financial market data that would signal pressure for the Fed to ease or tighten policy – is at a neutral level (Chart 5). Our 12-month Fed discounter, which measures the change in interest rates over the next year that is priced into the US overnight index swap (OIS) curve, is at 7bps, consistent with a stand-pat Fed. The latest read this month from the New York Fed’s Survey of Primary Dealers (and Survey of Market Participants) showed no change in the median longer-run expectation for the fed funds rate of 2.25% that has prevailed over the past year (middle panel) – despite a sharp recovery in US growth expectations. Chart 5UST Valuations A Bit Stretched The market pricing of the Fed’s next move is still relatively benign, with liftoff not expected until February 2023. This suggests that a pause in the trend of rising Treasury yields was essentially the market getting a bit ahead of itself in pricing in higher longer-term yields. This can be seen by looking at various valuation measures. For example, the 5-year/5-year forward Treasury yield now sits at 2.4%, which is at the high end of the range of longer-run fed funds rate expectations from the Primary Dealer survey. Also, various measures of the term premium on 10-year Treasury yields have returned to the above-zero levels last seen during the Fed’s 2016-2018 rate hiking cycle – even with the Fed not signaling any need to tighten policy in response to rising inflation expectations. Despite these signs of stretched near-term UST valuation, there is still no sign of major global bond investors being comfortable with increasing exposure to Treasuries. For example, despite yields on 10-year Treasuries (hedged into euros and yen) looking historically attractive compared to the near-zero yields on JGBs and sub-zero yields on German Bunds, the US Treasury’s capital flow data shows that foreign investors remain net sellers of Treasuries (Chart 6). It is possible that those foreign buyers need more evidence of a sustained decrease in US bond volatility before moving money into US Treasuries, where duration losses from higher US yields could wipe out the yield pickup from moving into US bonds. While valuations are a bit stretched for Treasuries, technicals appear very oversold. Both the deviation of the 10-year Treasury yield from its 200-day moving average, and the 6-month rate of change of the Bloomberg Barclays US Treasury total return index, are at levels seen only four previous times since 2010 (Chart 7). The JP Morgan client duration positioning surveys and the Market Vane Treasury sentiment index are also approaching post-2010 bearish extremes. It should be noted that both of those measures reached even more bearish extremes during the latter half of the Fed’s 2026-2018 tightening cycle, so there is potential for Treasury sentiment to become even more bearish once the Fed starts to tighten monetary policy – a scenario looking increasingly likely over the next 6-12 months. Chart 6No Foreign Bid For USTs (Yet) Chart 7USTs Are Technically Oversold We continue to expect a robust US economy and rising inflation to force the Fed to begin preparing the market in the latter half of 2021 for QE tapering in 2022, with the first rate hike of the next tightening cycle coming in late 2022. As that outcome appears largely consistent with current market pricing, amid oversold technicals, it is likely that Treasury yields will continue to move sideways over at least the next few weeks. Yet there is little to suggest that yields have peaked and are about to enter a new downtrend, given the accelerating pace of US vaccinations that is boosting optimism on an eventual end to the US leg of the pandemic. Stay defensive on US Treasury exposure, as the cyclical rise in yields is not over yet. Bottom Line: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remain bond bearish and the Fed is likely to begin preparing the market later this year for tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: Downgrade To Underweight In a Special Report published back in February along with our colleagues at BCA Foreign Exchange Strategy, we outlined the case for placing Canadian government debt on “downgrade watch” in global fixed income portfolios.1 We expected Canadian bond yields to continue rising along with the rise in global bond yields and, hence, we maintained our below-benchmark recommended duration exposure within Canada. Chart 8Canada: A High Beta Bond Market Once Again However, we concluded that it was too soon to shift to a full-blown underweight stance on Canadian government bonds with COVID-19 cases still raging through the country, the vaccination program off to a very slow start, and the Bank of Canada (BoC)’s QE program preventing Canadian bonds from returning to their usual “high-beta” status within developed economy bond markets. It now appears that we were too cautious on that front. Canadian government bonds have been one of the worst performing markets year-to-date within the Bloomberg Barclays Global Government bond index, delivering a local currency return of –4.1% - worse than the -3.5% return earned on US Treasuries so far in 2021.2 It is clear that the Canadian government bonds are once again a market more sensitive to global interest rate moves (Chart 8). In that February Special Report, we laid out three factors that could prompt the BoC to move to a less dovish, and more bond bearish, monetary policy stance faster than we expected. Much of that list has already started to come to fruition. 1) Good News On The Vaccine Rollout Sadly, Canada is suffering a third wave of COVID-19 cases that has resulted in the nation’s most populous province, Ontario, implementing the harshest lockdown yet seen during the pandemic. Yet the pace of vaccinations has also been rising with the share of Canadians receiving at least one jab is now 21% (Chart 9) - higher than that of the overall European Union (EU). Canada is now administering more daily vaccinations than both the UK and EU. The quickening pace of vaccinations is already providing a major lift to Canadian economic confidence. The Bloomberg Nanos consumer confidence index is at an all-time high (Chart 10), while the BoC’s Business Outlook Survey for the spring of 2021 was incredibly solid. Two-thirds of firms in that survey expect sales to exceed pre-pandemic levels, even with the latest upturn in COVID-19 cases. Chart 9Canadian Vaccine Rollout Improving Chart 10Booming Optimism The BoC’s Q1/2021 Consumer Survey showed similar levels of optimism. 74% of Canadians surveyed aged 25-54 are planning to engage in levels of social and economic activities equal to, or greater than, those seen prior to the pandemic once the majority is vaccinated (Chart 11). A net majority (18%) of those surveyed plan to spend more on the types of “high-touch” service spending unavailable during the pandemic, like travel, movies and dining in restaurants, once a majority is vaccinated (Chart 12). Chart 11Canadians Are Ready To Have Fun Once Again All of the Canadian survey data is sending a clear message: a faster vaccine rollout will leader to much faster spending by consumers and businesses. 2) Signs Of Financial Stability Risks Highly-indebted Canadians' love affair with real estate has always concerned the BoC. While a combination of cutting policy interest rates to zero and ramping up QE helped stabilize Canadian financial markets during the 2020 pandemic shock, it has also set off a new surge of housing speculation. According to the Bloomberg Nanos consumer survey, 67% of Canadians now expect house prices to appreciate. The demand for homes has given a lift to the Canadian economy through a surge in new housing starts (residential investment is 8% of Canadian real GDP), while pushing national house price inflation back above 10% (Chart 13). Chart 12A Surge In "High-Touch" Spending Awaits Canadian Herd Immunity As already indebted Canadian households pile on more debt to partake in another national home-buying party, the BoC must now concern itself with the potential financial stability risks from a too-rapid rise in housing values. Chart 13Yet Another Canadian Housing Boom In a recent speech, BoC Deputy Governor Toni Gravelle noted that the BoC had to introduce QE in 2020 to help fight COVID-related dysfunction across a variety of Canadian financial markets, including government bonds where liquidity dried up.3 Gravelle also noted that the BoC would begin to dial back QE once it was clear that financial markets no longer needed the support from QE. With Canadian equities booming and Canadian corporate bond spreads near the lowest levels of the past decade (Chart 14), it seems clear that the BoC can begin dialing back its government bond purchase program if it is no longer necessary and likely fueling another housing bubble. 3) Additional Large Fiscal Stimulus The governing Canadian Liberal government of Prime Minister Justin Trudeau delivered a massive amount of fiscal stimulus to the pandemic-stricken Canadian economy in 2020. In the 2021/22 federal budget announced yesterday, another huge burst of spending was introduced, equal to C$101bn or 4.2% of Canadian GDP over the next three years. The spending was described as another COVID relief package, but included many long-term programs like national child care, raising the minimum wage and boosting green investments. According to the projections from the latest IMF World Fiscal Monitor, the “fiscal thrust” for Canada – the change in the cyclically-adjusted primary budget balance as a share of GDP - was projected to turn from a stimulus of +9% in 2020 to a drag of -2% in 2021 (Chart 15). The spending announced in the latest budget will effectively eliminate that drag for the next three years. This will provide a major lift to an economy already likely to see booming post-pandemic growth. Chart 14BoC QE No Longer Necessary Chart 15No Fiscal Drag Now Expected In 2021 Chart 16Canadian Real Yields Are Too Low Given the combination of expanding vaccinations, surging confidence, a renewed housing boom and soaring financial markets, it will be difficult for the BoC to maintain its current policy settings for much longer. This is a central bank that engaged in QE reluctantly last year and numerous BoC officials have stated – even in the worst days of the global pandemic - that they would begin to remove accommodation once it was no longer needed. Interest rate markets have already moved to price in a full-blown BoC tightening cycle. The Canadian OIS curve now discounts “liftoff” (a full 25bp rate hike) in October 2022, with 163bps of rate hikes priced in to the end of 2024 (Chart 16). The projected path of rates is below the BoC’s inflation forecasts to 2023. Thus, the implied Canadian real policy rate is expected to remain negative over the next two years – even though the BoC estimates that the neutral policy rate range is 1.75% to 2.75%, or -0.25% to +0.75% in real terms after subtracting the midpoint of the BoC’s 1-3% inflation target band. In other words, Canadian interest rate markets are vulnerable to any BoC shift in a less dovish direction, as seems increasingly likely sometime in the next few months. Our BoC Monitor is rapidly moving out of the “easier policy required” zone (Chart 17), and the rapid improvement in the Canadian employment situation suggests the BoC will be under more pressure to begin signaling a path towards withdrawing policy accommodation. This will start with an announced tapering of QE purchases, perhaps even ahead of any signals from the Fed that it is doing the same (Chart 18). This justifies a more cautious stance on Canadian fixed income exposure. Chart 17Downgrade Canadian Government Bonds To Underweight Chart 18Could The BoC Start Tapering Before The Fed? While a BoC tapering announcement before the Fed would likely put upward pressure on the Canadian dollar versus the US dollar, that would be something the BoC could live with if the economy was rapidly gaining strength – especially as our currency strategists believe the “loonie” to be undervalued. Thus, we are formally downgrading our strategic recommended allocation to Canadian government bonds to underweight (2 out of 5, see table on page 16). We are also maintaining our recommended below-benchmark duration exposure within dedicated Canadian bond portfolios. We are also cutting the allocation to Canada to underweight in our model bond portfolio and placing the proceeds in both, the US and core Europe (see pages 14-15). Bottom Line: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk that the Bank of Canada shifts to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying. Downgrade Canadian government bonds to underweight in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com and gfis.bcaresearch.com. 2 That Canadian return is virtually the same after hedging into US dollars, hence that local currency return can be compared to the US dollar denominated Treasury market return. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Rising demand for packaging materials, increasing industry pricing power along with compelling relative valuations signal that ignored containers and packaging stocks are a hidden gem within the S&P materials sector. Stay overweight. Softening industry activity coupled with an absence of an export relief valve at a time when the economy is on track to fire on all cylinders, compel us to put the S&P soft drinks index on our downgrade watch list.            Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equity market euphoria has taken over with the SPX vaulting to fresh all-time highs on numerous occasions over the past two weeks. An easy Fed and ultra-loose fiscal policies remain the key macro drivers of this bull market. While the economy is on track to boom in 2021, leading economic indicators will soon be running into trouble and will have to come off the boil. The ISM manufacturing and services readings are at nose bleed levels, raising some eyebrows of how much further they can rise (Chart 1). The looming $2.4tn infrastructure bill following on the heels of the $900bn and $1.9tn fiscal easing packages since late-December are also likely fully reflected in the exuberant equity prices. As we showed two weeks ago, already more than two Fed hikes are priced in the OIS market over the next 24 months, and four by the end of 2023 (Chart 2)! Chart 1As Good As It Gets Chart 2Explaining US Dollar Strength S&P 500 twelve-month and five-year forward EPS estimates have crested and so have net earnings revisions (Chart 3). The SPX’s annual rate of change cannot go any higher for the remainder of the year (second panel, Chart 1) and breadth is as good as it gets with both SPX percent of stocks trading above their 50 and 200 day moving averages closing in on 100% (Chart 4).   Chart 3Cresting Euphoria? Chart 4Extended Breadth? The VIX recently melted below 16, junk yields hit all-time lows and the high-yield option adjusted spread multi-year lows (Chart 5). With regard to market internals, looking underneath the SPX hood is revealing. We recently booked handsome gains of 17% in our cyclicals/defensives portfolio bent and moved to the sidelines. This ratio has since ticked down, and so has the small/large ratio. As a reminder, we cemented gains north of 16% early in the year on the size bias and have been neutral since January 12, 2021. Even our long “Back-To-Work”/short “COVID-19 Winners” pair trade has hit a wall and we recently set a 5% rolling stop in order to protect profits of over 20% since our second inception in early February (Chart 6). Chart 5Complacency Reigns Supreme Chart 6Running Out Of Steam Finally, a number of key macro indicators we track are keeping us alert and make us uneasy with the recent stampede into stocks. EURUSD was the first to peak early in January, then gold bullion stalled and finally the South Korean Kospi index peaked. Tack on the recent relative EM stock market underperformance and the risk is that these growth hypersensitive indicators are sniffing out some trouble, potentially an ex-US economic soft-patch. Thus, some caution is warranted until all of these key indicators break out of their recent funk (Charts 7 & 8). Chart 7Three Macro Assets To Closely Monitor Chart 8Running Out Of Stimulus This week we update our SPX dividend discount model (DDM) for the fifth year running, along with the SPX EPS/multiple sensitivity analysis and the SPX forward equity risk premium (ERP). All three ways point to an SPX fair value near 4,050. As a reminder, we have been, and remain, very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2026 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 9). Our 8.2% discount rate mirrors the corporate junk bond yield historical average.  First off, remarkably, the SPX full year 2020 dividend went up 4 cents/share on a year-over-year basis, and blew out even the most optimistic estimates we had last April! While financials chopped their dividends following the Fed’s guidance, the S&P energy sector maintained their dividends as we predicted last spring. Impressively, we posited that XOM and CVX would sustain their dividend aristocrats status (i.e. minimum of 25 consecutive years of rising dividend payouts), which was controversial at the time, and subsequently these two US oil majors diverged from their European peers. Moreover, while a lot of pundits used the GFC as a close parallel, the 9/11 accelerated recession proved the most accurate historical episode from a dividend perspective (bottom panel, Chart 9), and we would not be surprised if a jump in dividend growth similar to the post 9/11 recession takes root. Chart 9Resilient SPX Dividends Continuing from last year, this year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. Tables 2 & 3 summarize the results. Table 2SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Table 3SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Table 4SPX EPS & Multiple Sensitivity Our own dividend growth estimates result in an SPX 4,050 fair value target (Table 2). Our assumptions are not as pessimistic as the SPX dividend futures, which result in an SPX 2,900 fair value (Table 3, please click here if you would like to receive our DDM and insert your own assumptions). Table 5Forward Equity Risk Premium Analysis In order to complement our SPX 4,050 fair value estimate, Tables 4 & 5 highlight our sensitivity analysis and forward ERP fair value estimates. Our starting point is the Street’s $203.1 EPS estimate for calendar 2022 and the backed out SPX forward P/E of 20.3. Similarly, for the forward ERP analysis we use the sell-side’s 2022 EPS estimate along with a forward 10-year US Treasury yield of 2% and an equilibrium ERP near 300bps on the back of: the Fed’s commitment to stay extremely accommodative, melting volatility, collapsing policy uncertainty and soaring ISM manufacturing (Charts 10 & 11). Chart 10Booming Economy… Chart 11…Translates Into Melting ERP This dual analysis corroborates the SPX DDM model’s 4,050 fair value and suggests that the SPX is fully valued at the current juncture, leaving little, if any, wiggle room for any mishaps. Our two key macro risks for the remainder of the year remain China’s looming slowdown and the Fed’s tapering, warning that some near-term caution is warranted. This week we update a niche materials subsector and set a downgrade on a consumer staples consumer goods subgroup. Stick With Containers And Packaging Containers and packaging stocks now comprise roughly 13% of the S&P materials index, represent a niche group within a niche sector and were we not already overweight we would not hesitate to commit capital to this index. In a nutshell, Chart 12 captures the attractiveness of container and packaging stocks. These neglected materials stocks are a play on rising pricing power due to insatiable demand for containerboard and other packaging materials. Tack on executives cost discipline and a profit margin expansion story will surprise analysts and investors alike and serve as a catalyst for a durable rerating phase (bottom panel, Chart 12). In more detail, packaged food exports coupled with consumer outlays on food and beverages are soaring. Expanding food manufacturing shipments corroborate this upbeat demand backdrop and signal that the path of least resistance is higher for ultra-pessimistic sell-side analysts’ top and bottom line growth estimates (Chart 13). Chart 12What’s Not To Like? Chart 13Upbeat Demand… Booming intermodal rail carloads gauging the retail industry’s demand also underpin container and packaging manufacturers’ profits (middle panel, Chart 14). Similarly the CASS freight index that tracks the health of different US freight industries is surging and confirms that relative profits will rebound in the back half of the year (bottom panel, Chart 14). Beyond the vigorous recovery in food manufacturing as per the Fed’s latest IP release that is a boon for packaging producers (bottom panel, Chart 15), COVID-19 ramifications also represent a rising source of demand for the industry. COVID-19 has served as an accelerant to the ongoing trend of non-store retail sales grabbing an ever increasing share of total retail sales. As internet sales garner a larger slice of the overall pie, the implication is that demand for boxes and other packaging materials like bubble wrap is increasing at a healthy clip (second panel, Chart 15). Chart 14...Everywhere… Chart 15…One Looks Finally, from a world perspective, global export volumes have vaulted to fresh all-time highs (third panel, Chart 15) and global readings of manufacturing PMIs have reached escape velocity. The upshot is that as trade picks up steam and bottlenecks and shortages get resolved likely in the back half of 2021, export volumes will remain buoyant further boosting the allure of container and packaging equities. Netting it all out, rising demand for packaging materials, increasing industry pricing power along with compelling relative valuations signal that ignored containers and packaging stocks are a hidden gem within the S&P materials sector. Bottom Line: Stay overweight the S&P containers and packaging index. The ticker symbols for the stocks in this index are: BLBG: S5CONP– WRK, SEE, IP, AVY, BLL, PKG, AMCR. Put Soft Drinks On Downgrade Alert Soft drinks have taken a beating recently and we are on the lookout for an oversold bounce before we go underweight this consumer goods sub group, thus today we set a downgrade alert. While PEP’s earnings were on the bright side, leading macro indicators signal that investors will be better off to avoid this defensive consumer staples sub-index. Importantly, safe-haven soft drink stocks that tend to be very stable cash flow generators both in good times and in bad, fare worse during the early stages of an economic expansion. As growth transitions from scarcity to abundance, investors start to shed staples exposure including soft drinks (ISM shown inverted, middle panel, Chart 16). Similarly on the operating front, our Beverage Industry Activity Proxy has crested of late and warns that sinking relative profits growth estimates will likely prove accurate (bottom panel, Chart 16). True, sell-side analysts appear to have thrown in the towel on this consumer goods subgroup with both 12-month and five-year forward profit growth estimates plunging to multi-year lows (middle panel, Chart 17). But, relative valuations have followed down the path of this EPS drubbing, and the relative forward P/E ratio is trading 14% below the historical mean (bottom panel, Chart 17). Chart 16Some Yellow Flags Chart 17De-rating Blues Actual profits and revenues have made a full circle owing to the sizable jump during the pandemic induced stay-at-home bonanza, however, such a stellar growth repeat remains elusive for 2021. This is especially true if the export relief valve remains firmly closed for the industry. Already there is a sizable gap between the smart rebound in the Asian currency index, but industry exports are still trying to achieve positive year-over-year momentum (Chart 18). The relative tick down in soft drink industrial production (IP), according to the Fed’s latest IP release, corroborates our view that there is an element of stealing demand from the future due to COVID-19, and top line growth will likely surprise to the down side, especially given the soaring reading from the ISM manufacturing survey (ISM shown inverted, bottom panel, Chart 19). Chart 18Export Valve is Blocked Chart 19Roaring Economy Weighs On Defensives Nevertheless, we are patient before pulling the trigger and downgrading to a below benchmark allocation, as not only technicals are washed out, but also three additional indicators keep us on the sidelines, at least, for now: First, if there is even a mild economic relapse, the 10-year US Treasury yield will be the first to sniff it out and the recent pause in the bond market’s selloff is cause for minor concern (top panel, Chart 20). Second, industry shipments, while a lagging indicator remain resilient (middle panel, Chart 20). Finally, soft drinks pricing power is also robust and there is tentative evidence that beverage producers have been successful in passing on at least part of their rising input costs – mostly commodity related inflation (bottom panel, Chart 20). Netting it all out, softening industry activity coupled with an absence of an export relief valve at a time when the economy is on track to fire on all cylinders, compel us to put the S&P soft drinks index on our downgrade watch list. Bottom Line: Set a downgrade alert on the S&P soft drinks index. The ticker symbols for the stocks in this index are: BLBG: S5SOFD – KO, PEP, MNST. Chart 20But There Are Some Substantial Offsets   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Highlights The five largest banks released a sizable chunk of their pandemic loan-loss reserves, signaling that the credit storm has passed: Excepting Wells Fargo, which is managing its credit loss allowance far more cautiously than its peers, the big banks released about a third of their pandemic reserves and only retain about half of them. Households are in fine fettle and the banks expect they’ll consume avidly as the year progresses: Aggregate debit and credit card spending recovered to pre-pandemic levels in the first quarter and even the ailing travel and entertainment categories showed signs of life. Businesses are not borrowing now, but they will have to if economic growth matches lofty expectations: The biggest companies have met their funding needs amidst the bond issuance bonanza, but businesses will not be able to satisfy the looming demand rush without taking out loans. Banks are ready and eager to lend: Management comments on earnings calls point strongly to easier standards in the coming first quarter senior loan officer survey. Lender willingness will hold down defaults and extend the virtuous phase of the credit cycle. The good times won’t last forever, but the end is not yet in sight. What The Big Banks See Through The Window The first quarter reporting season has begun with last week’s releases from the big banks. We have once again reviewed the SIFI1 banks’ (BAC, C, JPM and WFC) and USB’s earnings calls and financial statements for insight into the broad macro backdrop as revealed by the actions and intentions of their household and business customers, borrower performance, lender willingness and the overall condition of the financial system. As one might expect when economic growth appears to be on the cusp of a major inflection, the banks’ perceptions were nearly uniformly consistent. Table 1Taking Away The Sandbags Chart 1Quick Fed Action Brought Down Credit Spreads ... Chart 2... And Easing Credit Standards Should Help Hold Them In Place Everyone’s depositors are flush with cash. Households have just begun to spend it at their pre-pandemic pace and appear to be eager to get back to activities that have been largely off-limits for the last year. Businesses are holding onto their cash for now but they will have to replenish inventories and make other investments to meet the looming crush of demand. The banks themselves are drowning in deposits and pine for a revival of loan demand to provide a productive outlet for them. Credit performance has been vastly better than expected in the first stages of the pandemic and the banks and their auditors are finally convinced that it’s not a mirage. In the first quarter the biggest banks, ex-Wells Fargo, which is taking a markedly more conservative approach than its peers, released roughly a third of the loan-loss reserve bulwarks they built up last year (Table 1). Much of the remaining half of their pandemic reserves are subject to release in subsequent quarters if benign employment and economic trends continue in line with consensus expectations. Ongoing reserve releases are good for the economy on several counts. They demonstrate that the worst-case pandemic scenarios have not come to pass and validate the narrowing of credit spreads (Chart 1). They encourage banks and other lenders to ease their lending standards (Chart 2), ensuring that credit availability will help reinforce the boom. They also promote rising financial asset prices, supporting consumption at the margin via the wealth effect. Investors and regulators may eventually come to rue the layering of pro-cyclical reinforcement but it is highly supportive of risk assets over our default one-year investment horizon. What The Big Banks See In The Mirror In the January edition of the Big Bank Beige Book, we noted that the banks and their investors were grappling with two major pandemic uncertainties. The first – How badly will the value of loan portfolios be impaired? – was largely addressed with the first quarter’s big reserve releases. Assuming that the US is well on its way to subduing COVID by the summer, impairment of legacy loans will be considerably less than expected, though the easing standards currently taking root will eventually give rise to a new wave of credit losses. The latter has nothing to do with the pandemic; it is a natural cyclical ebb and flow first observed at least 5,000 years ago in Ecclesiastes 3:1-8, set to music by Pete Seeger in the early sixties and made ubiquitous on AM and FM radio by The Byrds’ subsequent cover. Chart 3The SIFI Banks Have Had A Great Vaccine Run The second question is of passing interest to the overall economy but essential to banks’ near-term earnings prospects: When will loan demand revive? Banks already find their net interest income hemmed in by the tight net interest margins that are part and parcel of zero interest rate policy. Sharply reduced lending volumes make matters worse and parking the excess cash in Treasuries and agency securities is an unappealing option when rates are set to rise over the next couple years. It is possible that the SIFI banks are due for a breather relative to their outperformance versus the overall market (Chart 3, top panel), though they may well have further room to run against pure-play banks that are more dependent on taking deposits and making loans (Chart 3, bottom panel). 1Q21 Big Bank Beige Book Household Borrowing (Chart 4) And Spending (Chart 5) Chart 4Consumer Borrowing Is Still In The Doldrums ... Chart 5... But Spending May Already Be Breaking Out March was a record month of spending by Bank of America consumers and led to the highest- ever quarter of consumer spending. … [O]ur … customers’ … spending is not only much higher than the prior year when payments began to decline but notably is much higher this year to date than year-to-date 2019. (Moynihan, BAC CEO) [L]ast I saw 30%-odd of the stimulus money has been spent. [T]he other 70% sitting in people’s accounts … [has] to be spent [before outstanding credit card balances can rise]. … You’re starting to see the [card] purchase numbers go up and the [card] payments rate went way up. [Once those numbers become] more constant … [as] you’d expect … the usage rate will go up and start to drive some balance growth. (Moynihan, BAC) Consumer sentiment has returned to more normalized levels, reflecting increased optimism. We’ve seen debit and credit card spend return to pre-pandemic levels, up 9% year-on-year and 14% versus 1Q19, despite T&E [travel and entertainment] remaining significantly lower. That said, we are seeing strong momentum in T&E with spend up more than 50% in March compared to February. (Piepszak, JPM CFO) [W]e do expect there to be significant economic activity in the second half and so [consumer re-leveraging] could come quite naturally but it could come a little bit later given the amount of the deleveraging we’ve seen. But the fact that we already see spend above pre-COVID levels [while] we still have restrictions in place, particularly around [consumers’] T&E, we think that we’ll see spend tick even higher. And that will be a point where perhaps we’ll start to see that re-levering. (Piepszak, JPM) [W]hile we are still seeing the impact of the pandemic and high payment rates on [our own] revenues, consumer spending continues to improve and credit remains healthy, pointing to a recovery as we move through the year. … [Card] purchase[s] are improving slightly faster than our prior expectations and with the vaccine rollout this should support a further recovery in discretionary spend. (Mason, C CFO) Weekly debit card spend was up every week compared to a year ago during the first quarter. ... We are seeing increased consumer spending activity in both travel and restaurants, two categories that have been particularly suppressed since the onset of COVID-19. … Consumer credit card weekly spend continued to strengthen over the course of the first quarter as well and ended the quarter … up 8% compared to the same week in 2019. (Scharf, WFC CEO) Improved economic activity is driving better consumer and business spending trends, which in turn is translating into improving payments volume. In each of our payments businesses, volumes, excluding COVID-impacted travel, hospitality and entertainment sectors, exceeded first quarter 2019 pre-pandemic levels. (Cecere, USB CEO) Our auto lending has been very strong. And I would expect that will continue to be strong. … [T]he encouraging thing is we are seeing a lot of nice green shoots and as consumer spend starts to expand and grow, I think that consumer lending will come back as well. (Dolan, USB CFO) Bank Capacity (Chart 6) And Willingness/Desperation To Lend (Chart 7) Chart 6Drowning In Liquidity Chart 7More Lenders Than Borrowers In terms of the commercial side, there are still the affected industries that we’re watching carefully, but everywhere else we’re back to pre-pandemic [underwriting criteria] and in light of the size of our company, in light of the need for loan growth, I think we’ve relaxed a little bit on some hold levels [Ed. Note – “Hold level” appears to be an internal BAC guideline limiting the share of an originated loan that the company will retain on its own balance sheet.], particularly in global markets where they have more of a moving-and-storage mentality around loans and what they [provide to] customers. We’re just taking a few maybe bigger positions than we might have otherwise taken pre-pandemic. But it’s no real change in the underwriting standards, the company is bigger, we have more liquidity, we have more capital, so we think all of this is appropriate. (Donofrio, BAC CFO) It’s a shame [all the effort that is directed to] … managing around capital constraints. This is not the way to run a railroad. We’re spending time on this call on CECL [the new loan-loss reserve standard that was implemented at the beginning of 2020] and SLR [supplemental leverage ratios] and it’s a shame and it distracts from growing the American economy. I’ve mentioned over and over, we have $2.2 trillion of deposits, $1 trillion of loans, $1.5 trillion of cash and marketable securities, much of which cannot be deployed to intermediate or lend. How conservative do you want to get? (Dimon, JPM CEO) Our [consumer] credit portfolio is proving to be quite resilient. We are now focused on loan and revenue recovery, through driving spend activity, re-entering the market for new account acquisitions and investing in lending capabilities and new value propositions. (Mason, C). We’ve got dry powder to put liquidity to work and we’ve [captured some increased share of our institutional clients’ wallets] but we have more dry powder to do [more of it]. (Mason, C) With the improving economic forecast, we are gradually returning to pre-pandemic underwriting policies. (Santomassimo, WFC CFO) Ultimately, … the fact is our card propositions are not competitive [versus] what is available today in the marketplace or where people are going. … [W]e think we have opportunities to make … our products far more attractive for those that currently have them so it becomes their primary product, but also more attractive for the customers that we currently touch [that don’t have our cards]. (Scharf, WFC) The Coming Business Spending Revival [T]hink about the flywheel that we have in the company as a production engine that had to be slowed down in the crisis with 15% unemployment and final demand being crushed in the second quarter last year. Then [think about] turning that crank back up and just watch that flywheel start to take off. That’s why we have good confidence in terms of getting right back on [a solid pace of] loan growth. (Moynihan, BAC) The projected economic growth should [spur] companies to borrow, build inventory, increase hiring and invest and do what they do in their businesses. Global banking loans, after falling in January, appear to have stabilized again in March. We’ll have to see how this plays out, but March was a good sign. (Moynihan, BAC) In order for the economy to expand 7% this year [per our economists’ projections], at some point companies have to access capital to meet that final demand and you [will] see [credit line] usage come up. (Moynihan, BAC) [I]n the commercial bank, given the level of support, the amount of liquidity in the markets, as well as the amount of cash on balance sheets, loan growth has been muted and probably will be for some time, but that’s incredibly healthy ultimately for the recovery. Whether we see [corporate borrowing] pick up later this year or next year remains to be seen, but [any delay] is [attributable to the economy’s underlying strength]. (Piepszak, JPM) Businesses remain strong as well. Most clients still have strong cash positions and [credit] line utilization remains low. Demand for consumer products is high and dealer inventory levels are meaningfully lower versus historical levels. After declining during the second half of the year, commercial loan balances seem to have stabilized. And if the economy continues to pick up, we would expect to see increased loan demand from our commercial customers in the second half of the year. (Scharf, WFC) [T]here are things [businesses] will need to do in order to be able to meet that [expected increase in] consumer demand … in the form of continuing to build their inventories and make some capital investments which they, just like many of us, have been holding off. [T]he timing of that … is probably [going to be] a little bit more subdued simply because of the fact that there is a fair amount of liquidity and deposit balances that exist. They need to burn through that. … So what we’re first going to see is utilizing those deposit balances and then more robust loan growth. And that’s why we think it’s really probably more the second half of the year before that starts to happen. (Dolan, USB) [B]usinesses are becoming much more optimistic, they’re thinking about inventory build and they’re thinking about their capital expenditures. And I think that those are all really good signs. I would also just say, probably more for the second half of the year, that we do see and believe that M&A activity is going to start to strengthen and that will have positive implications with respect to C&I loans. (Dolan, USB) Investment Implications We frankly acknowledge our discomfort with current valuation levels. The S&P 500 is expensive at nearly 23 times forward four-quarter earnings; at a yield of around 1.6%, the 10-year Treasury note is likely to produce a negative real return if held to maturity; and credit spreads are tight enough that they’re beginning to squeak. The current pace of growth is quite robust, however, and it appears nearly certain to accelerate as the economy reopens and consumers begin to deploy the massive hoard of savings they’ve accumulated over the last year-plus. We see many of the tailwinds that the banks cited on their earnings calls. The growth backdrop into 2022 looks so good that maintaining risk-friendly asset allocations still looks like the best course of action for investors with one-year timeframes. The fundamental support is enhanced by extremely accommodative fiscal and monetary policy that has left households, businesses, banks and financial markets swimming in cash. All that money has to go somewhere and we expect that it will continue to support risk assets, even at their currently demanding valuations, for at least the next twelve months. As for the SIFI banks themselves, we think their significant outperformance versus the overall market has come to an end. They are no longer ridiculously inexpensive on a price-to-book basis and their earnings prospects will be limited by the overabundance of capital in the financial system. Traditional intermediation just doesn’t pay very well when every creditworthy borrower has more money than he or she needs. However, the SIFIs’ capital markets exposure does grant them an edge on the pure-play commercial banks, which derive much more of their earnings from taking deposits and making loans, and we do like them relative to the large-cap regional banks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Systemically important financial institutions.

Highlights There are tentative signs that US growth outperformance is ebbing. The recovery in the manufacturing sector abroad is already taking leadership from the US. This trend will soon rotate to the service sector. As such, long-term investors should begin to accumulate the euro on weakness. The Canadian economy is improving faster than our February assessment. This suggests the CAD could outperform sooner rather than later. Feature Chart I-1The Euro Drives The DXY The US economy has been the growth outperformer this year. As such, yields have been rising faster in the US and the dollar has caught a bid. Since the start of the year, the DXY index has retraced 2.5% of its yearly losses against developed market currencies. Meanwhile, the rally has been a broad-based one with the euro, yen and Swedish krona taking the brunt of the decline (Chart I-1). Our bias is that growth outperformance will rotate from the US to the rest of the world later this year. This should hurt the dollar and benefit procyclical currencies. This week, we look at the euro and loonie, two currencies that should benefit from this shift. EUR/USD And The Manufacturing Cycle The relationship between bond yields and the economy is circular. Long bond yields can be regarded as a key signaling mechanism about the growth prospects of an economy. At the same time, bond yields directly affect financial conditions, especially when they rise too far too fast. From the point of view of short-term currency forecasting, determining the tipping point at which rising yields become restrictive could be extremely beneficial in forecasting relative economic growth. Chart I-2 shows that whenever the relative bond yield between the US and the euro area rises by 1%, near-term relative growth subsequently tips in favor of the latter, with a lag of about 12 months. This is important since the correlation between EUR/USD and relative growth is quite strong in the short term (Chart I-3). As such, while the rise in yields between the US and the euro area can hurt EUR/USD in the short term, it will begin to benefit relative euro/US growth in the longer term. Chart I-2Relative Bond Yields And The Manufacturing Cycle Chart I-3Economic Data Is Surprising To The Upside In The Euro Area Bond Flows And Other Market Signals Despite the increase in US Treasury yields, we have not seen higher European purchases of US bonds this year (Chart I-4). During the dollar bull market from 2011 to 2020, there was a direct correlation between rising US yields and higher Treasury purchases. One difference this time around is that other safe-haven bond markets like Canada, Australia, New Zealand and even the UK, are sporting attractive yields today. US yields have not risen much against other G10 countries in aggregate. This will continue to dent the extent to which the euro can fall. On the flipside, the upside to the euro could be quite substantial. From a purchasing parity perspective, the euro can rise 15% just to reset its discount relative to the US. PPP adjustments tend to take several years, but if the US continues to pursue inflationary policies, then by definition, the fair value of the euro will also rise (Chart I-5). Chart I-4Europeans Have Not Been Increasing Treasury Holdings Chart I-5The Euro Remains Slightly ##br##Undervalued Other cyclical factors also suggest that the euro could experience a coiled-spring rebound. Copper prices have surged this year and the traditional relationship with the euro has been offside (Chart I-6). While copper is benefiting from a move away from carbon towards cleaner electricity, the euro can benefit as well. European economies have decades of experience in renewable technology and could begin to see meaningful inflows into these sectors once investment capital is deployed. This makes the Bloomberg forecast of EUR/USD at 1.23 at the end of 2022 too pessimistic (Chart I-7). Chart I-6The Euro Could Have A Coiled-Spring Rebound Soon Chart I-7Sentiment On The Euro Has Been Slightly Reset Finally, we are short EUR/JPY as a tactical hedge with tight stops at 131. We are also lifting our limit-buy on the EUR/USD from 1.15 to 1.16. The Canadian Recovery Is Accelerating Chart I-8The Canadian Business Survey Outlook Was Encouraging The Canadian recovery is taking shape faster than our February assessment, which the latest Business Outlook Survey corroborated. Both investment intentions and future sales growth were quite strong, with the former hitting a multi-decade high (Chart I-8). Notably: Two-thirds of firms see sales exceeding pre-pandemic levels; most firms stated that the second wave is having less or no impact to sales, compared to the first; and capacity constraints remain high in certain industries, but overall inflationary concerns remain relatively subdued. The robustness of the survey took us by surprise, given that a second wave of infections is raging, and most of the country is under lockdown. That said, the strength in investment spending is becoming a key theme in a global context, suggesting Canada could see significant FDI flows in the coming years. Markets have started pricing in a faster pace of rate hikes in Canada (Chart I-9). This has been a rare occurrence over the last decade and, together with our Global Fixed Income Strategy colleagues, we still believe there is less of a chance that Canada leads the hiking cycle. However, this could change if momentum in the economy allows it to surpass US growth. Chart I-9Markets Are Pricing In Faster Hikes In Canada The IMF estimates that Canadian real GDP growth will be 5% this year and 4.7% next year. Growth could be much stronger than these levels, according to the Bloomberg Nanos Confidence Index (Chart I-10). Chart I-10Canadian GDP On The Mend The employment report has improved tremendously since our February assessment (Chart I-11). Looking at the sub-components of the BoC Monitor, the weakness was centered on economic variables. This is changing, as the Canadian unemployment rate is falling faster than the US unemployment rate (Chart I-12). That is a bullish development for the CAD. Chart I-11The Canadian Jobs Recovery Is Robust Chart I-12Canadian Employment Catching Up To The US The Canadian housing market is heating up. Overall, house prices are up 10% with many cities well exceeding these levels (Chart I-13). The path for Canadian housing prices has been as follows: government support and macro prudential measures leading to a convergence in prices between low- and high-priced cities. Specifically, Vancouver (and to a certain extent, Toronto) are seeing softer pricing growth, while other cities recover. However, as prices start to deviate away from nominal incomes in lower-priced cities, the risk of wider macro prudential measures greatly increases. The second point is crucial, since the rise in Canadian home prices has been more pronounced than in other countries, such as Australia or the US. This means that both rising indebtedness and falling affordability are likely to present a key macro risk to the Canadian economy. Residential construction is a non-negligible part of the Canadian economy (Chart I-14). Chart I-13The Canadian Housing Market Has Heated Up Chart I-14Residential Construction Is Booming Bottom Line: Recent developments are increasing the odds that the Bank of Canada hikes rates sooner rather than later. This will allow further gains in the CAD. The CAD And Oil Crude oil prices are another hugely important driver for the CAD. In fact, for most of this year, interest rates have not been an important factor as the BoC faded any near-term improvement in the Canadian outlook. The Covid-19 crisis together with slow vaccination progress also hurt the recovery, putting the brakes on an appreciating loonie (Chart I-15). Our commodity strategists predict that Brent crude will hit $75 in 2023. This is higher than the forward markets are discounting. Rising forward prices will be synonymous with a higher CAD. However, Canada sells the Western Canadian Select (WCS) blend, which has historically traded at a significant discount to Brent or WTI (Chart I-16). Rising environmental standards hurt Canada, since WCS has a higher sulphur content. Pipeline capacity also remains a major bottleneck to getting Canadian crude to US refineries. Chart I-15The Loonie Has Lagged Chart I-16Canadian Oil Prices Could Lag The Recovery The redeeming feature this time around is that the correlation between the CAD/USD and crude oil prices is rising faster than for other currencies, as the US begins to embark on significant infrastructure projects (Chart I-17). Around 50% of US oil imports come from Canada. The Covid-19 crisis also slowed US oil production relative to Canada, which has helped increase the correlation between oil prices and the currency. Portfolio flows into Canada have been accelerating this year, benefitting oil stocks and the loonie. Chart I-17Sensitivity Of USD/CAD To Oil Has Increased Investment Conclusions Chart I-18The CAD Is Cheap The CAD remains cheap. It is trading at one standard deviation below its long-term mean, on a real effective exchange rate basis (Chart I-18). A return to the mean would generate about 10% upside. Our PPP model is less bullish, suggesting the loonie is cheap by about 5%. This still puts 84-85 cents within striking distance. Should the nascent Canadian recovery morph into a genuine acceleration, the CAD could rally even higher.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 US economic data has been robust this week:         CPI in March rose 2.6% year-on-year and 0.6% month-on-month, both exceeding expectations. PPI in March came in at 4.2% year-on-year and 1% month-on-month, beating expectations. The Empire Manufacturing survey staged a meaningful rebound from 17.4 to 26.3 in April. Retail sales were particularly strong, coming in at 9.8% month-on-month in March. The NAHB housing market index remained strong at 83 in April.  The DXY Index fell by 0.5% this week. The drop in bond yields was surprising, given robust data. This is likely a signal that bond short positions are becoming a crowded trade. The DXY index is rolling over in April; a trend that supports its seasonal pattern. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been mildly positive: Retail sales grew by 3% month-on-month in February versus the expected 1.7%. ZEW Economic Sentiment for both Germany and the EU in April came in lower than forecast. Industrial production fell by 1% in February over the prior month. German CPI came in at 0.5% month-on-month, in line with forecasts. The euro rose by 0.5% against the dollar this week, making this a second week of appreciation. The new Covid-19 wave may be a drag on EUR/USD in the near term, but this has also reset sentiment and positioning indicators. Our intermediate-term indicator has rolled over substantially, which is bullish from a contrarian perspective. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 JapaneseYen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Data out of Japan have been mixed: Machinery orders recorded another month of decline, falling by 8.5% month-on-month in February versus an expected 2.8% increase. However, more positively, machine tool orders grew by 65% year-on-year in March. PPI in February came in at 0.8% month-on-month, better than expectations. The Japanese yen rose by 0.4% against the US dollar this week and remains one of the strongest G10 currencies in April. Our intermediate-term indicator has collapsed and speculators are net short the currency. We remain short EUR/JPY as a portfolio hedge. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been mildly positive: February GDP rose 0.4% versus the prior month, slightly falling short of the expected 0.6% rise. Both the industrial and manufacturing production and the construction output exceeded expectations in February, growing at 1%, 1.3%, and 1.6% month-on-month. The trade deficit with the EU increased to 16.4B in February. The British pound rose by 0.3% against the US dollar this week, ranking in the middle among G10 currencies and flat against the Euro. We exited our short EUR/GBP trade last week to take profit on UK’s vaccination success and expected catch up phase for other economies. The elevated net speculative positioning on the pound also makes us neutral.  Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia were strong: NAB business conditions came in at 25 in March versus 17 in February. The Westpac Consumer Confidence Index for April rose 6.2% month-on-month to 118.8, highest since August 2010.  The labor recovery remains on track. 71K new jobs were added in March versus expectations of 35K. The unemployment rate also fell from 5.8% to 5.6%. The Australian dollar remained flat against the US dollar this week. However, the recent robust data, soaring terms of trade, and high bond yields make AUD/USD a suitable recovery trade. That said, given Mexico’s proximity to the US where recent economic data are strong, we are short the AUD/MXN pair. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: RBNZ held the official cash rate at 0.25% and its asset purchase program steady against a backdrop of a heated housing market, citing uncertainty over the outlook for growth. The NZIERB Business Confidence came in at -13% for Q1 versus -6% in Q4, a first decline in four quarters. The New Zealand dollar remained flat against the US dollar this week. On the day of the rate announcement, NZD rallied while the OIS curve flattened, which is a perplexing development. We believe the OIS curve had the appropriate response. Near term upside risk for Kiwi is the planned travel bubble with Australia. We are long the AUD/NZD. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been strong: The Bank of Canada Business Outlook Survey was robust. The sentiment indicator recorded 2.87 in Q1, up from 1.3 in Q4 and highest since 2018. The March employment report was blockbuster. There were 303K new jobs versus an expectation of 100K. The split between part-time and full-time was healthy, 175K versus 128K. This brought down the unemployment rate to 7.5% in March, beating both forecasts and the February reading of 8.2%. The Canadian dollar rose by 0.3% against the US dollar this week. We spend some time in the front section discussing the Canadian dollar, which could be a little vulnerable in the short term, but could touch 84 cents in the coming 12-months. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: The unemployment reading was 3.3% in March, lower than both the forecast and prior month. The Swiss franc was flat against the US dollar this week, remaining a top performer amongst the G10 currencies in April. As we indicated in last week’s report, the Franc may be due for a rebound after its underperformance in the first three months this year. While the CHF may continue its appreciation against the US dollar, we are long EUR/CHF on valuations concern, but are maintaining tight stops at 1.095. Our USD/CHF intermediate-term indicator is also due for a reversal. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The recent data out of Norway have been mixed: GDP in February fell by 0.5% month-on-month. House prices increased by 3.4% quarter-on-quarter in Q1. March CPI came in at 3.1% year-on-year, versus expectations of a 3.4% increase. CPI disappointment was driven mainly by a 0.6% month-on-month decline in consumer goods prices. The Norwegian krone remained flat against the US dollar this week. Despite the Norges Bank’s expected rate hike this year, the earliest amongst the G10 nations, the NOK may see near term downside risks given the weak inflation data this month and the potential weakening in oil prices due to renewed virus lockdowns globally. Strategically we remain long NOK along with SEK for an eventual decline in the dollar.    Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The recent inflation data out of Sweden have been strong: The CPIF measure, favored by the Riksbank, rose 1.9% year-on-year versus the 1.5% increase in February. The rise was only was 1.4% ex-energy, but most inflation measures have rebounded powerfully from the 2020 lows. The Swedish krona, up by 1.4% against US dollar this week, was a top performing G10 currency both this week and in April. The 5-year and 10-year inflation swaps remain well anchored above the 2% level, suggesting markets are not regarding the increase in Swedish inflation as transitory. This could bring forward rate hike expectations. The higher 2-year real yield in Sweden versus US, due to higher US inflation, will also support the SEK. However, new Covid-19 cases remain a concern. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights If fully implemented, President Biden’s Made in America Tax Plan would reduce S&P 500 earnings by about 8%. We expect some of the proposed tax measures to be watered down, resulting in a 5% decline in earnings. Investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy. Looking further out, however, we see four reasons why US tax rates are likely to keep rising, eventually reaching levels that hurt stock prices: First, the effective US corporate tax rate is still very low; second, the failure of President Trump’s tax cuts to boost investment spending will make it easier eventually to fully reverse them; third, rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing; and fourth, and most importantly, the political winds are shifting in favor of higher taxes on corporations and the wealthy. The Democrats have been moving leftward on economic matters for some time. For their part, conservative Republicans are starting to ask themselves why they should support tax cuts for a growing list of “woke” companies that seemingly hate them. The US corporate sector is at risk of being left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. The Biden Tax Plan On March 31st, President Biden unveiled the American Jobs Plan. The plan proposes $2.25 trillion in new federal spending, spread out over eight years, on public infrastructure and other areas. As outlined in the Made In America Tax Plan, the Biden Administration will seek to raise $2 trillion in tax revenue over the next 15 years in order to fund the new spending package. The three most important provisions in the tax plan are: Raising the domestic corporate income tax rate from 21% to 28%. This would bring the tax rate halfway back to where it was prior to the Trump tax cuts (35%). Taking into account the global distribution of corporate profits and other factors, such a tax hike would reduce S&P 500 earnings by about 4%. Increasing the minimum tax on the foreign profits of US companies. The Biden administration proposes doubling the minimum tax rate on Global Intangible Low-Taxed Income (GILTI) from 10.5% to 21%. It also plans to eliminate the Foreign-Derived Intangible Income deduction (FDII). These two measures would reduce S&P 500 earnings by about another 3.5%. A 15% minimum tax on “book income” (i.e., the earnings that companies report to shareholders). The tax applies to corporations with annual profits in excess of $2 billion. The Treasury department estimates that 45 companies will be liable for this tax. It would cut S&P 500 earnings by a further 0.5%. Taken together, these provisions would reduce S&P 500 earnings by about 8%. In practice, we think the impact will be closer to 5%. The Biden plan includes a variety of tax credits, focusing on areas such as clean energy and R&D, which should offset some of the tax increases. The ultimate corporate tax rate is also likely to fall short of 28%. West Virginia Senator Joe Manchin, the critical swing voter, has already said he would prefer to cap it at 25%. What Has Been Priced In? Chart 1Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Our reading of the data suggests that very little of the impact from higher taxes has been baked into either analyst earnings estimates or market expectations. Chart 1 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. Yet, they have outperformed their low-taxed peers since the Georgia runoff election, which handed the Senate to the Democrats. Likewise, earnings estimates have not reacted to the prospect of higher taxes. This is not surprising. Chart 2 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Similar to what happened back then, analysts appear to be waiting for the details of the ultimate tax package before changing their estimates. Chart 2Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes For Now, Business Cycle Dynamics Are More Important Than Taxes While the failure of the investment community to price in higher taxes represents a headwind to stocks, we would characterize it as a modest headwind. IBES estimates still point to earnings growth of 15% for S&P 500 companies in 2022. It would take an unrealistically large tax hit to keep corporate profits from rising next year. The IMF’s latest economic projections, released a few weeks ago, foresee US real GDP growing by 3.5% in 2022, one full percentage point faster than the Fund expected in January (Table 1). Given the strong correlation between equity returns and economic growth, the equity bull market will likely survive a tax increase (Chart 3). Table 1Growth Remains Robust Chart 3Stocks Usually Outperform Bonds When Economic Growth Is Strong   Of course, some stocks could still feel the pinch from higher taxes. The tech sector is especially vulnerable, given that it currently enjoys one of the lowest effective tax rates in the S&P 500 (Chart 4). Tech companies have also been very adept at shifting income from intangible assets such as patents to offshore tax havens, which is likely to put them in the crosshairs of the soon-to-be bulked up IRS.1 We currently favor value over growth stocks. The likelihood that higher taxes will have a disproportionately negative effect on growth sectors such as tech only reinforces this view. Chart 4Tech Is Vulnerable To Higher Taxes   Higher Taxes: Start Of A Long-Term Trend? While we are not too worried about the near-term impact of higher taxes on equity prices, we are more concerned about the longer-term consequences. As we discuss below, not only is Biden likely to raise personal income and capital gains taxes to fund future spending initiatives such as the forthcoming American Families Plan, but the pressure to keep raising business taxes will persist well beyond his administration. There are four reasons for this: Reason #1: The effective US corporate tax rate is still very low Chart 5Corporate Tax Revenues Are Low In April 2018, four months after the Tax Cuts and Jobs Act came into effect, the Congressional Budget Office projected that US corporations would pay $276 billion in corporate taxes in 2019. In the end, they paid only $230 billion.2 US corporate income tax receipts stood at only 1% of GDP in 2018-19, half of what they were in 2013-17 (Chart 5). During Ronald Reagan’s second term in office, US corporations faced an effective tax rate of around 30%. Today, it is less than 15% (Chart 6). As a share of GDP, the US government collects less corporate tax revenue than almost all other OECD economies (Chart 7).   Chart 6The Economy-Wide Effective Corporate Tax Rate Has Been Shrinking For More Than Three Decades Chart 7US Corporate Taxation Is Not High Chart 8Trump Was Unlucky To Be Singled Out By The IRS Moreover, the US government often does not even bother to even collect the money that is owed to it. Audits of corporations with more than $20 billion in assets are down 50% since 2011. Audits of individuals with annual income above $1 million are down 80% (Chart 8). In his testimony to the US Senate this week Chuck Rettig, IRS Commissioner, estimated that tax evasion costs the government $1 trillion per year. Reason #2: The failure of Trump’s tax cuts to boost investment spending will make it easier to eventually fully reverse them If the Trump tax cuts had raised investment spending, it would be easier to overlook the negative effect that they had on the budget deficit. The evidence, however, suggests that lower corporate taxes did very little to spur capex. Chart 9 shows that capital spending barely increased as a share of GDP in the two years following the passage of the Tax Cuts and Jobs Act. According to the International Monetary Fund, only one-fifth of the tax cuts were used to finance capital investment and R&D spending.3 Along the same lines, Hanlon, Hoopes, and Slemrod found that fewer than a quarter of S&P 500 companies discussed plans to increase capex in response to lower taxes during their conference calls.4 Chart 9Trump's Tax Cuts Did Little To Spur Investment Chart 10Business Equipment And IP Do Not Last Long   Why did corporate investment fail to rise much? One answer is that a tax on profits is not the same thing as a tax on capital investment. As Appendix 1 explains, lower corporate taxes are unlikely to have much of an effect on debt-financed capital spending when interest costs are tax deductible. Unlike long-lived assets such as homes, most of the corporate capital stock is fairly short-lived (Chart 10). The demand for business equipment and software depends more on the outlook for aggregate demand than on the cost of capital. Finally, as we explained in a report entitled Inequality Led To QE, Not The Other Way Around, the majority of corporate profits these days can be attributed to monopolistic power of one form or another. Standard economic theory suggests that taxing monopoly rents will not reduce output or investment. Reason #3: Rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing With interest rates still at exceptionally low levels, there is no immediate need to raise taxes to finance increased government spending. This is especially true for infrastructure spending, which can reasonably be expected to boost economic growth (and hence tax receipts) over the long haul. Chart 11US Interest Payments Will Skyrocket Under The Status Quo If interest rates were to rise, however, governments would likely find it advantageous to increase taxes rather than face spiralling debt-servicing costs. Public debt levels are very high in the US and in most other economies, so any increase in interest rates would siphon funds from social programs towards bondholders. This would not be popular with voters. The Congressional Budget Office estimates that federal government interest payments will swell rapidly over the coming decades if measures are not taken to rein in budget deficits (Chart 11). As we discuss next, these measures are likely to take the form of higher taxes rather than spending cuts.   Reason #4: The political winds are shifting in favor of higher taxes on corporations and the wealthy Democrats have been moving leftward for some time. In 2001, 50% of Democrats said that “government should do more to solve our country’s problems.” Today, that number is 83% (Chart 12). Chart 12Democrats Want More Government Chart 13Big Ticket Social And Health Care Spending To Keep Rising While Republicans continue to show a preference for small government, this may not last. Medicare and Social Security consume over 40% of all federal non-interest spending. Outlays on both programs (Medicare in particular) are set to grow rapidly over the coming years (Chart 13). To the extent that the political preferences of older Americans lean Republican, this could make the GOP more inclined to support higher taxes in order to sustain benefits to the elderly. The fact that corporations and the rich increasingly favor socially liberal policies is leading conservative Republicans to ask why they should continue to support tax cuts for people and companies that seemingly hate them. Whereas Joe Biden won the richest US counties by 20 percentage points last November, Trump saw his support rise in the poorest counties (Chart 14). Reflecting this trend, the share of Republicans who expressed “hardly any confidence in Corporate America” rose from 19% in February 2018 to 30% in March 2021 (Chart 15).   Chart 14Democrats Have Made Serious Inroads Among The Better-Off Chart 15Republicans Growing More Skeptical Of Corporate CEOs More than twice as many Republicans now favor raising corporate taxes as lowering them (Chart 16). Nationally, 73% of Americans are dissatisfied with the influence that corporations have over the nation, a 25-point jump from 2001 (Chart 17). Chart 16More Americans Want To Soak The Rich Chart 17Souring Attitudes Toward Big Corporations Given the shift in public opinion, it is not too surprising that the Republican response to Biden‘s tax plan was decidedly “low energy”. After a perfunctory condemnation of the plan, Republican leaders quickly pivoted to attacking “woke” corporations. Addressing the corporate reaction to Georgia’s new election law, Senate Republican Leader Mitch McConnell declared “We are witnessing a coordinated campaign by powerful and wealthy people to mislead and bully the American people.” He went on to say, “From election law to environmentalism to radical social agendas to the Second Amendment, parts of the private sector keep dabbling in behaving like a woke parallel government. Corporations will invite serious consequences if they become a vehicle for far-left mobs to hijack our country from outside the constitutional order.” If current trends continue, as we suspect they will, the US corporate sector will be left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Appendix 1: When Do Higher Taxes On Corporate Profits Reduce Investment? Suppose a company is considering whether to purchase a piece of machinery for $1000. Let us assume that the company faces an external rate of return, r, of 8%. That is to say, it can borrow and lend at 8%. The accompanying table illustrates how the firm’s profits will vary depending on its internal rate of return (the return on investment that the machine will generate). Let us start with the case where the company finances the purchase of the machine by issuing new debt. For now, assume that the internal rate of return is 10% and that the machine can be used indefinitely (i.e., it never depreciates). In this case, the machine will generate $100 in operating income per year. After subtracting the $80 in interest expense, the company will be left with $20 in pre-tax income (Example A). Suppose the company faces an income tax of 20% and interest is fully tax deductible. Then, the company will pay a tax of $20*0.2=$4, leaving it with $16 in after-tax profits (Example B). Notice that while the tax reduced the company’s after-tax profit, it did not extinguish the incentive to purchase the machine in the first place. After all, while $20 is better than $16, $16 is still better than zero. Thus, in this simple example, we see that when the purchase of capital equipment is financed through debt and interest payments are fully tax deductible, the imposition of a profit tax will not affect the ultimate decision of whether to invest or not. Things change when interest is not tax deductible. In this case, the internal rate of return must rise to r/(1-t) to make the company indifferent between buying the machine or not. In the example above, this means the internal rate of return must increase to 8%/(1-0.2)=10%. Then, the company will make an operating profit of $100, pay $20 in tax on that profit, and after paying $80 in interest, end up breaking even (Example C). The calculus in deciding whether to invest in new capital equipment is similar for equity financing as it is for debt financing when interest payments are not tax deductible. The best way to think about equity financing is to ask how much the market price of the machine will be after the company purchases it. If there is no tax and the internal rate of return is 10%, the market price will be $100/0.08=$1250 (Example D). Since the company can buy the machine for $1000, it makes sense to buy it. If the owner of the machine has to pay a profit tax of 20% on the stream of income that it generates, its market value will only be $80/0.08=$1000 (Example E). At this point, the company is indifferent about whether to purchase the machine or not. How do things change when we abandon the assumption that the machine lasts forever? The main difference is that the decision of whether to buy the machine becomes less sensitive to changes in the cost of capital. For example, suppose the machine only lasts one year. To make it worthwhile for the company to purchase that machine, the revenue that it generates in that one year must rise dramatically (Example F). This makes the decision to purchase the machine much less dependent on the interest rate and more dependent on business cycle considerations, especially the outlook for aggregate demand.   Appendix Table 1 Footnotes 1 Jed Graham, “Biden's Tax Plan: What It Means For Amazon, Google, Facebook, Apple, Microsoft,” Investor’s Business Daily (April 8, 2021). 2 “The Accuracy of CBO’s Baseline Estimates for Fiscal Year 2019,” Congressional Budget Office (December 2019). 3 Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “U.S. Investment Since the Tax Cuts and Jobs Act of 2017,” IMF Working Paper (May 31, 2019). 4 Michelle Hanlon, Jeffrey L. Hoopes, and Joel Slemrod, “Tax Reform Made Me Do It!” NBER Working Paper 25283 (November 2018). 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