Inflation/Deflation

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation Chart 17The Case For US Inflation Chart 18The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China Chart 27No Inflation In China Chart 28No Inflation In China Chart 29No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are ElevatedChart 36Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force Chart 38A Mania In Full Force Chart 39A Mania In Full Force Chart 40A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese StocksChart 45Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks Chart 62The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1  Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens Chart 10Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES   Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In   In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples   In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks   A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth.  We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade. But this perception is due to a singular focus on the economic slack component of the modern-day version of the curve to the exclusion of inflation expectations, and a failure to fully consider the lasting impact of sustained periods of a negative output gap on those expectations. In addition, many investors tend to downplay the long-term balance sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. The COVID-19 pandemic was certainly a major economic shock. But for now, it seems like this was a sharp income statement recession, not a balance-sheet recession. This fact, along with lower odds of negative supply-side shocks and several structural factors, suggest that inflation will be higher over the next ten years than it has over the past decade. Investors looking to protect against potentially higher inflation should look primarily to commodities, cyclical stocks, and US farmland. Gold is likely to remain well supported over the coming few years, but rich valuation suggests the long-term outlook for the yellow metal is poor. A hybrid TIPS/currency portfolio has historically been strongly correlated with the price of gold, and may provide investors with long-term protection against inflation – at a better price. Introduction Chart II-1A Surge In Long-Dated Inflation Expectations The pandemic, and the corresponding fiscal and monetary response is challenging the low-inflation outlook of many market participants. Chart II-1 highlights that long-dated market-based inflation expectations have surged past their pre-COVID levels after collapsing to the lowest-ever level in March. The shift in thinking about inflation has partly been a response to an extraordinary rise in government spending in many countries. But Chart II-1 shows that long-dated expectations in the US were mostly trendless from April to June as Federal support was distributed, and instead rose sharply in July and August in the lead-up to the Fed’s official shift to an average inflation targeting regime. This new dawn for US monetary policy has been prompted not just by the pandemic, but also by the extended period of below-target inflation over the past decade. In this report, we review how the past ten-year episode of low inflation can be successfully explained through the lens of the expectations-augmented (i.e. “modern-day”) Phillips Curve. Many investors fail to fully appreciate the impact that inflation expectations have on driving actual inflation, as well as the cumulative impact of two major capital and savings misallocations over the past 25 years on the responsiveness of demand to interest rates and on the level of inflation expectations. Using the modern-day Phillips Curve as a guide, we present several reasons in favor of the view that inflation will be higher over the next decade than over the past ten years. Finally, we conclude with an assessment of several ways for investors to protect their portfolios from rising inflation. Revisiting The “Modern-Day” Phillips Curve The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. Chart II-2Rising Unemployment And Inflation Challenged The Original Phillips Curve However, the experience of rising inflation alongside high unemployment from the late 1960s to the late 1970s underscored that prices are also importantly determined by inflation expectations and shocks to the supply-side of the economy (Chart II-2). In the 1980s and 1990s, the Federal Reserve’s success at reigning in inflation was achieved not only by raising interest rates to punishingly high levels, but also by sharply altering consumer, business, and investor expectations about future prices. The experience of the late 1960s and 1970s led to a revised form of the Phillips Curve, dubbed the “expectations-augmented” or “modern” version. As an equation, the modern Phillips Curve is described today by Fed officials, in terms of core inflation, as follows: πct = β1πet + β2πct-1 + β3πct-2 - β4SLACKt + β5IMPt + εt where: πct = Core inflation today πet = Expectations of inflation πct-n = Lagged core inflation SLACKt = Slack in the economy IMPt = Imported goods prices εt = Other shocks to prices Described verbally, this framework suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations.1” This framework can easily be extended to headline inflation by adding changes in food and energy prices. In most formal models of the economy in use today, the modern Phillips Curve is combined with the New Keynesian demand function to describe business cycles: Yt = Y*t – β(r-r*) + εt where: Yt = Real GDP Y*t = Real potential GDP r = The real interest rate r* = The neutral rate of interest εt = Other shocks to output This equation posits that differences in the real interest rate from its neutral level, along with idiosyncratic shocks to demand, cause real GDP to deviate from potential output. Abstracting from import prices and idiosyncratic shocks, these two equations tell a simple and intuitive story of how the economy generally works: The stance of monetary policy determines the output gap and, The output gap, along with inflation expectations, determine inflation. The Modern-Day Phillips Curve: The Pre-2000 Experience This above view of inflation and demand was strongly accepted by investors before the 2008 global financial crisis, but the decade-long period of generally below-target inflation has caused a crisis of faith in the idea of the Phillips Curve. Charts II-3 and II-4 show the historical record of the New Keynesian demand function and the modern-day Phillips Curve, using five-year averages of the data in question to smooth out the impact of short-term and idiosyncratic effects. We use nominal GDP growth as our long-run proxy for the neutral rate of interest,2 the US Congressional Budget Office’s (CBO) estimate of potential GDP to determine the output gap, and a proprietary measure of inflation expectations based on an adaptive expectations framework3 (Chart II-5). Chart II-3With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 Chart II-4Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Chart II-3 shows that until 1999, the stance of monetary policy was highly predictive of the output gap over a five-year period, with just two exceptions where major structural forces were at play: the late 1970s, and the second half of the 1990s. In the case of the former, the disruptive effect of persistently high inflation negatively impacted output growth despite easy monetary policy, and in the latter case, economic activity was modestly stronger than what interest rates would have implied due to the beneficial impact of the technologically-driven productivity boom of that decade. Similarly, Chart II-4 shows that until 1999 there was a good relationship between the output gap and the deviation in inflation from expectations, again with the late 1970s and late 1990s as exceptions. Along with the beneficial supply-side effects of the disinflationary tech boom, persistent import price weakness (via dollar strength) seems to have also played a role in suppressing inflation in the late 1990s (Chart II-6). Chart II-5The Expectations Component Of The Modern Phillips Curve, Visualized Chart II-6A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s   The Modern-Day Phillips Curve Post-2000 Following 2000, deviations between the monetary policy stance, the output gap, and inflation become more prominent, particularly after 2008. As we will illustrate below, these deviations are more apparent on the demand side. In the case of inflation, the question should be why inflation was not even lower in the years immediately following the global financial crisis. On both the demand and inflation side, these deviations are explainable, and in a way that helps us determine future inflation. Charts II-7 and II-8 show the same series as in Charts II-3 and II-4, but focused on the post-2000 period. From 2000-2007, Chart II-8 shows that the relationship between the output gap and the deviation in inflation from expectations was not particularly anomalous. The output gap was negative from the end of the 2001 recession until the beginning of 2006, and inflation was correspondingly below expectations on average for the cycle. Chart II-7Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Chart II-8Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong   Chart II-7 shows that the anomaly during that cycle was in the relationship between the output gap and the stance of monetary policy. Monetary policy was the easiest it had been in two decades, yet the output gap was negative for several years following the recession. Larry Summers pointedly cited this divergence in his revival of the secular stagnation theory in November 2013, arguing that it was strong evidence that excess savings were depressing aggregate demand via a lower neutral rate of interest and that this effect pre-dated the financial crisis. Why was demand so weak during that period? Chart II-9 compares the annualized per capita growth in the expenditure components of GDP during the 2001-2007 expansion to the 1991-2001 period. The chart shows that all components of GDP were lower than during the 1991-2001 period, with investment – the most interest rate sensitive component of GDP – showing up as particularly weak. On the surface, this supports the idea of structural factors weighing heavily on the neutral rate, rendering monetary policy less easy than investors would otherwise expect. But Chart II-9 treats the 2001-2007 years as one period, ignoring what happened over the course of the expansion. Chart II-10 repeats the exercise shown in Chart II-9 from Q1 2001 to Q3 2005, and highlights that the annualized growth in per capita residential investment was much stronger than it was during the 1991-2001 period – and nonresidential fixed investment was much weaker. Spending on goods was roughly the same, which is impressive considering that the late 1990s experienced a productivity boom and robust wage growth. All the negative contribution to growth from residential investment during the 2001-2007 expansion came after Q3 2005, as the housing market bubble burst in response to rising interest rates. In short, Chart II-10 highlights that there was a strong relationship between easy monetary policy and the demand for housing, but that this was not true for the corporate sector. Chart II-9Looking At The Whole 2001-2007 Period, Investment Was Extremely Weak Chart II-10Housing Absolutely Responded To Easy Monetary Policy   Explaining Weak CAPEX Growth In The Early 2000s This leads us to ask why CAPEX was so weak during the 2001-2007 period. In addition to changes in interest rates, business investment is strongly influenced by expectations of consumer demand and corporate profitability. Chart II-11 shows that real nonresidential fixed investment and as-reported earnings moved in lockstep during the period, and that this delayed corporate-sector recovery also impacted the pace of hiring. Weak expectations for consumer spending do not appear to be the culprit. Chart II-12 highlights that while real personal consumption expenditure growth fell during the recession, spending did not contract (as it had done during the previous recession) and capital expenditures fell much more than what real PCE would have implied. Chart II-11Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Chart II-12CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending   Instead, persistently weak CAPEX in the early 2000s appears to be best explained by the damaging impact of corporate excesses that built up during the dot-com bubble. The Sarbanes-Oxley Act of 2002 was passed in response to a series of corporate accounting frauds that came to light in the wake of the bubble, but in many cases had been occurring for several years. Chart II-13 highlights that widespread write-offs badly impacted earnings quality and the growth in the asset value of equipment and intellectual property products (IPP), both of which only began to improve again in early 2003. This occurred alongside an outright contraction in real investment in IPP as investors lost faith in company financial statements and heavily scrutinized corporate spending. Chart II-14highlights that a contraction in IP spending was a huge change from the double-digit pace of growth that occurred in the late 1990s. Chart II-13The Damaging Impact Of Corporate Excesses Chart II-14A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble   In addition, corporate sector indebtedness also appears to have played a role in driving weak investment in the early 2000s. While the interest burden of nonfinancial corporate debt was not as high in 2000 as it was in the early 1990s, Chart II-15 highlights that debt to operating income surged in the late 1990s – which likely caused investors already skeptical about company financial statements to impose a period of elevated capital discipline on corporate managers following the recession. Chart II-16 shows that while the peak in the 12-month trailing corporate bond default rate in January 2002 was similar to that of the early 90s, it was meaningfully higher on average in the lead-up to and following the recession. Chart II-15The Late-1990s Saw A Major Increase In Corporate Debt Chart II-16Above-Average Corporate Defaults Before And After The 2001 Recession   To summarize, Charts II-10-16 underscore that management excesses, governance failures, and elevated debt in the corporate sector in the 1990s were the root cause of the seeming divergence between monetary policy and the output gap from 2001 to 2007. This was, unfortunately, the first of two major savings/capital misallocations that have occurred in the US over the past 25 years. Explaining The Post-GFC Experience In the early 2000s, the Federal Reserve was faced with a decision between two monetary policy paths: one that was appropriate for the corporate sector, and one that was appropriate for the household sector. The Fed chose the former, and it inadvertently contributed to the second major savings/capital misallocation to occur over the past 25 years: the enormous debt-driven bubble in US housing that culminated into the global financial crisis (GFC) of 2007-2009. Chart II-17It Is No Mystery Why Demand And Inflation Were Weak Last Cycle As a result, 2007 to 2013/2014 was a mirror image of the early 2000s. Unlike previous post-war downturns, the GFC precipitated a balance-sheet recession that deeply affected homeowners and the financial system. This lasting damage led to a multi-year household deleveraging process, which substantially lowered the responsiveness of the economy to stimulative monetary policy. On a year-over-year basis, Chart II-17 shows that total nominal household mortgage credit growth was continuously negative for six and a half years, from Q4 2008 until Q2 2015, underscoring that the large divergence during this period between the stance of monetary policy and the output gap should not, in any way, be surprising to investors. And this is even before accounting for the negative impact of the euro area sovereign debt crisis and double-dip recession, or the persistent fiscal drag in nearly every advanced economy last cycle. What is surprising about the post-GFC experience is that inflation was not substantially weaker than it was, which is ironic considering that the secular stagnation narrative was revived to help explain below-target inflation. Chart II-8 showed that actual inflation steadily improved versus expected inflation alongside the closing of the output gap and the decline in the unemployment rate, but that it was much stronger than the output gap would have implied – particularly during the early phase of the economic recovery. It is still an open question as to why this occurred. A weak dollar and a strong recovery in oil prices likely helped support consumer prices, but we doubt that these two factors alone explain the discrepancy. A more credible answer is that expectations stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. For example, in a CBS interview following the Fed’s November 2010 decision to engage in a second round of quantitative easing (“QE2”), then-Chair Bernanke prominently tied the decision to the fact that “inflation is very, very low.” When asked whether additional rounds of easing might be required, Bernanke responded that it was “certainly possible” and again cited inflation as a core consideration. Chart II-18Rising US Oil Production Caused The Massive 2014 Oil Price Shock While inflation did not ultimately fall relative to expectations post-GFC as much as the output gap would have implied, the long-lasting weakness in demand left expectations vulnerable to exogenous shocks. In 2014, such a shock occurred: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-18), a level of output that many experts had previously believed would not be attainable (or would roughly mark the peak in production). We view this event as a truly exogenous shock to prices, given that research & development of shale technology had been ongoing since the late 1970s and only happened to finally gain traction around 2010. Chart II-19 shows that the 2014 oil price collapse caused a clear break lower in our measure of inflation expectations, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-20). This decline in inflation expectations meant that the output gap needed to be above zero in order for the Fed to hit its 2% target (absent any upwards shock to prices), and that the meaningful acceleration of inflation from 2016 to 2018 should actually be viewed as inflation “outperformance” because its long-term trend had been lowered by the earlier downward shift in expectations. Chart II-19The 2014 Oil Price Shock Collapsed Inflation Expectations... Chart II-20...No Matter What Inflation Expectations Measure Is Used   The Modern-Day Phillips Curve: Key Takeaways Based on the evidence presented above, we see the perceived “failure” of the Phillips Curve to predict weak inflation over the past decade as being due to: A singular focus on the output gap/slack component of the modern Phillips Curve, to the exclusion of expectations A failure to fully consider the lasting impact of sustained periods of a negative output gap on expectations Downplaying the long-term balance-sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. One crucial takeaway from the modern-day Phillips Curve equation presented above is that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. The extended period of below-potential output over the past two decades, accelerated recently by a major negative shock to energy prices, has now lowered inflation expectations to a point that merely reaching the Fed’s target constitutes inflation “outperformance.” This realization, made even more urgent by the COVID-19 pandemic, has strongly motivated the Fed’s official shift to an average inflation targeting regime. That shift does not suggest that the Fed is moving away from the modern-day Phillips Curve framework; rather, the Fed’s new policy is aimed at closing the output gap as quickly as possible in order to prevent a renewed decline in inflation expectations (and thus inflation itself) from another long period of activity running below its potential. The Outlook For Inflation While the Fed has shifted its policy to prefer higher inflation, that does not necessarily mean it will get it. Why is it likely to happen this time, if the last economic cycle featured such a large divergence between monetary policy and the output gap? Chart II-21Above-Target Inflation Is Not Imminent First, to clarify, we do not believe that above-target inflation is imminent. The COVID-19 pandemic was an extreme event, and even given the very substantial recovery in the labor market, the unemployment rate remains almost 2½ percentage points above the Congressional Budget long-run estimate of NAIRU (Chart II-21). But based on our analysis of the modern-day Phillips Curve presented above, there are at least four main reasons to expect that inflation may be higher on average over the next ten years than over the past decade. Reason #1: This Appears To Be A Sharp Income Statement Recession, Not A Balance-Sheet Recession We highlighted above the importance of savings/capital misallocations in driving a gap between monetary policy and the output gap over the past two decades, but this recession was obviously not sparked by such an event. The onset of the pandemic came following a long period of US household sector deleveraging which, while painful, helped restore consumer balance sheets. Chart II-22 highlights that household debt to disposable income had fallen back to 2001 levels at the onset of the pandemic, and the interest burden of debt servicing had fallen to a 40-year low. From a wealth perspective, Chart II-23 highlights that total household liabilities to net worth have fallen below where they were at the peak of the housing market boom in 2005 for almost all income groups, and that a decline in leverage has been particularly noteworthy for the lowest income group since mid-2016. Chart II-22Households Have Repaired Their Balance Sheets... Chart II-23...Across Almost All Income Brackets   Total credit to the nonfinancial corporate sector rose significantly relative to GDP over the course of the last cycle, but subpar growth in real nonresidential fixed investment and a rise in share buybacks highlight that this debt went largely to fund changes in capital structure rather than increased productive capacity. Chart II-24 highlights that corporate sector interest payments as a percentage of operating income are low relative to history, and they do not seem to be necessarily dependent on extremely low government bond yields.4 Finally, the corporate bond default rate may have already peaked (Chart II-25) and the percentage of jobs permanently lost looks more like 2001 than 2007 (Chart II-26), signaling that a prolonged balance-sheet recession is unlikely. Chart II-24Corporate Sector Debt Is Currently High, But Affordable Chart II-25Corporate Defaults Have Already Peaked Chart II-26So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 The bottom line is that while the pandemic has not yet been resolved and that major and permanent economic damage cannot be ruled out, the absence of “balance-sheet dynamics” is likely to eventually lead to a stronger responsiveness of demand for goods and services to what is set to be an extraordinarily easy monetary policy stance for at least another two years. Reason #2: The Fed May Be Able To Jawbone Inflation Higher The Fed’s public commitment to set interest rates in a way that will generate moderately above-target inflation is highly reminiscent of its defense of quantitative easing in the early phase of the last economic expansion, and (in the opposite fashion) of Paul Volker’s campaign in the 1980s against the “self-fulfilling prophecy” of inflation. From 2008-2014, the Fed explicitly linked the odds of future bond buying to the pace of actual inflation in its public statements. On its own, this was not enough to cause inflation to rise, but we highlighted above that it may have contributed to the fact that inflation expectations did not collapse. Chart II-1 on page 12 showed that long-dated market-based expectations for inflation have already been impacted by the Fed’s regime shift, suggesting decent odds that Fed policy will contribute to self-fulfilling price increases if the US economy does indeed avoid “balance-sheet dynamics” as a result of the pandemic. Reason #3: The Odds Of Negative Supply Shocks Are Lower Than In The Past We noted above the impact that energy price shocks and large typically exchange-rate driven changes in import prices can have on inflation, with the 2014 oil price collapse serving as the most vivid recent example. On both fronts, a value perspective suggests that the odds of negative shocks to inflation over the coming few years from oil and the dollar are lower than they have been in the past. Chart II-27 shows that the cost of global energy consumption as a share of GDP has fallen below its median since 1970, and Chart II-28 highlights that the US dollar is comparatively expensive relative to other currencies – which raises the bar for further gains. Stable-to-higher oil prices alongside a flat-to-weak dollar implies reflationary rather than disinflationary pressure. Chart II-27Massive, Downward Shocks To Oil Prices Are Now Less Likely Chart II-28Valuation Favors A Declining Dollar, Which Is Inflationary   Reason #4: Structural Factors In addition to the cyclical arguments noted above, my colleague Peter Berezin, BCA’s Chief Global Strategist, has also highlighted several structural arguments in favor of higher inflation. Chart II-29 highlights that the world support ratio, calculated as the number of workers relative to the number of consumers, peaked early last decade after rising for nearly 40 years. This suggests that output will fall relative to spending the coming several years, which should have the effect of boosting prices. Chart II-30 also highlights that globalization is on the back foot, with the ratio of trade-to-output having moved sideways for more than a decade. Since the early 1990s, rising global trade intensity has corresponded with very low goods prices in many countries, and the end of this trend reduces the impact of a factor that has been weighing on consumer prices globally over the past two decades. Chart II-29Less Production Relative To Consumption Is Inflationary Chart II-30Trade Is Not Suppressing Prices As Much As It Used To   Positioning For Eventually Higher Inflation Below we present an assessment of several potential candidates across the major asset classes that investors can use to protect their portfolios from rising inflation once it emerges. We conclude with a new trade idea that may provide investors with inflation protection at a better valuation profile than more traditional inflation hedges. Fixed-Income Within fixed-income, inflation-linked bonds and derivatives (such as CPI swaps) are the obvious choice for investors seeking inflation protection. Inflation-linked bonds are much better played relative to nominal equivalents, as inflation expectations make up the difference between nominal and inflation-linked yields. But Table II-1 shows that 5-10 year TIPS are also likely to provide positive absolute returns over the coming year even in a scenario where 10-year Treasury yields are rising, so long as real yields do not account for the vast majority of the increase. Barring a major and positive change in the long-term economic outlook over the coming year, our sense is that the Fed would act to cap any outsized increase in real yields and that TIPS remain an attractive long-only option until the Fed becomes sufficiently comfortable with the inflation outlook. Table II-1TIPS Will Earn Positive Absolute Returns Next Year Barring A Surge In Real Yields Commodities Commodities are arguably the most traditional inflation hedge, and are likely to provide investors with superior risk-adjusted returns in an environment where inflation expectations are rising. Our Commodity & Energy Strategy service is positive on gold, and recently argued that Brent crude prices are likely to average between $65-$70/barrel between 2021-2025.5 Chart II-31Gold Is Expensive And Long-Term Returns May Be Poor One caveat about gold is that, unlike oil prices, it appears to be quite expensive relative to its history. Since gold does not provide investors with a cash flow, over time real (or inflation-adjusted) prices should ultimately be mean-reverting unless real production costs steadily trend higher. Chart II-31 highlights that the real price of gold is already sky-high and well above its historical average. Over a ten-year time horizon, gold prices fell meaningfully following the last two occasions where real gold prices reached current levels, suggesting that the long-term outlook for gold returns is poor. However, over the coming few years, gold prices are likely to remain well supported given our economic outlook, the Fed’s new monetary policy regime, and the consistently negative correlation between real yields and the US dollar and gold prices. As such, we would recommend gold as a hedge against the fear of inflation, which is likely to increase over the cyclical horizon. Equities We provide two perspectives on how equity investors may be able to protect themselves against rising inflation. The first is simply to favor cyclical versus defensive sectors. The former is likely to continue to benefit next year in response to a strengthening economy as COVID-19 vaccines are progressively distributed, and historically cyclical sectors have tended to outperform during periods of rising inflation. In addition, my colleague Anastasios Avgeriou, BCA’s Equity Strategist, presented Table II-2 in a June Special Report,6 and it highlights that cyclical sectors (plus health care) have enjoyed positive relative returns on average during periods of rising inflation. Table II-2S&P 500 Sector Performance During Inflationary Periods The second strategy is to favor companies that are more likely to successfully pass on increasing prices to their customers (i.e., firms with “pricing power”). Pricing power is a difficult attribute to identify, but one possible approach is to select industries that have experienced above-average sales per share growth over the past decade. While it is true that the past ten years have seen low rather than high inflation, it has also seen firms in general struggle to achieve robust top-line growth. Industries that have succeeded in this environment may thus be able to pass on higher costs to their customers without disproportionately suffering from lower sales. Chart II-32Last Decade's Revenue Winners: Potential Pricing Power Candidates Chart II-32 presents the historical relative performance of these industries in the US plus the materials and energy sector, equally-weighted and compared to an equally-weighted industry group portfolio (level 2 GICS). The chart shows that the portfolio has outperformed steadily over the past decade, although admittedly at a slower pace since 2018. An interesting feature of this approach is that, in addition to including industries within the industrials, consumer discretionary, and health care sectors (along with the food & staples retailing component of the consumer staples sector), tech stocks show up prominently due to their outstanding revenue performance over the past decade. Table II-2 above highlighted that tech stocks have historically performed poorly during periods of rising inflation, although it is unclear whether this is due to increasing prices or expectations of rising interest rates. Tech stocks are typically long-duration assets, meaning that they are very sensitive to the discount rate, but the Fed’s new monetary policy regime all but guarantees that investors will see a gap between inflation and rates for a time. It is thus an open question how tech stocks would perform in the future in response to rising inflation, and we plan to revisit this topic in a future report. Chart II-33Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies As a final point within the stock market, we would caution against equity portfolios favoring companies that are owners or operators of infrastructure assets. While increased infrastructure spending may indeed occur in the US over the coming several years, indexes focused on companies with sizeable existing infrastructure assets tend to be highly concentrated in the utilities and telecommunications sectors. Chart II-33 shows that the relative performance of the MSCI ACWI Infrastructure Index is nearly identical to that of a 50/50 utilities/telecom services portfolio, two sectors that are defensive rather than pro-cyclical and that have historically performed poorly during periods of rising inflation. Direct Real Estate Alongside commodities, direct real estate investment is also typically viewed as a traditional inflation hedge. For now, however, the outlook for important segments of the commercial real estate market is sufficiently cloudy that it is difficult to form a high conviction view in favor of the asset class. CMBS delinquency rates on office properties have remained low during the pandemic, but those of retail and accommodation have soared and the long-term outlook for all three may have permanently shifted due to the impact of the pandemic. By contrast, industrial and medical properties are likely to do well, with the former likely to be increasingly negatively correlated with the performance of retail properties in the coming few years (i.e., “warehouses versus malls”). I noted my colleague Peter Berezin’s structural arguments for inflation above, and Peter has also highlighted farmland as a real asset that is likely to do well in an environment of rising inflation.7 Chart II-34 further supports the argument: the chart shows that despite a significant increase in real farm real estate values over the past 20 years, returns to operators as a % of farmland values are not unattractive. In addition, USDA forecasts for 2020 suggest that operator returns will be the highest in a decade relative to current 10-year Treasury yields, underscoring both the capital appreciation and relative yield potential of US farmland. A Hybrid TIPS/Currency Inflation-Hedged Portfolio Finally, as we highlighted in Section 1, in a world of extremely low government bond yields, global ex-US investors have the advantage of being able to hedge against deflationary risks in a long-only portfolio by employing the US dollar as a diversifying asset. The dollar is consistently negatively correlated with global stock prices, and this relationship tends to strengthen during crisis periods. The flip side is that US-based investors have the advantage of being able to hedge against inflationary risks in a long-only portfolio by buying global currencies. Chart II-35 presents a 50/50 portfolio of US TIPS and an equally-weighted basket of six major DM currencies against the US dollar. The chart highlights that the portfolio is strongly positively correlated with gold prices, but with a better valuation profile. We already showed in Chart II-28 on page 28 that global currencies are undervalued versus the US dollar. TIPS valuation is not as attractive given that real yields are at record low levels, but the 10-year TIPS breakeven inflation rate currently sits at its 40th percentile historically (and thus has room to move higher). Chart II-34Farmland: Protection Again Inflation, At A Decent Yield Chart II-35A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold   As such, while gold prices are likely to remain supported over the cyclical horizon, a hybrid TIPS/currency portfolio may also provide investors with long-term protection against inflation – at a better price. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 “Inflation Dynamics and Monetary Policy,” Janet Yellen, Speech at the Philip Gamble Memorial Lecture, University of Massachusetts - Amherst, Amherst, Massachusetts, September 24, 2015. 2 The use of nominal GDP growth as our proxy for the neutral rate of interest is based on the idea that borrowing costs are stimulative if they are below that of income growth. 3 An adaptive expectations framework suggests that expectations for future inflation are largely determined by what has occurred in the past. Our proxy for inflation expectations is thus calculated using simple exponential smoothing of the actual PCE deflator, which provides us with a long and consistent time series for expectations. 4 The second debt service ratio shown in Chart II-24 would only rise to its 68th historical percentile if the 10-year Treasury yield were to rise to 3%, or the 75th with a 10-year yield at 4%. This would be elevated relative to history, but not extreme. 5 Please see Commodity & Energy Strategy Report “BCA’s 2021-25 Brent Forecast: $65-$70/bbl,” dated November 12, 2020, available at ces.bcaresearch.com 6 Please see US Equity Strategy Special Report “Revisiting Equity Sector Winners And Losers When Inflation Climbs,” dated June 1, 2020, available at uses.bcaresearch.com 7 Please see Global Investment Strategy Weekly Report “Will There Be A Fiscal Hangover?” dated May 29, 2020, available at gis.bcaresearch.com

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Chart 5B… But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment Chart 7Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

This week, we present the BCA Central Bank Monitors Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions. The Chartbook has previously been published by BCA Research Global Fixed Income Strategy but, starting today, will be jointly published with BCA Research Foreign Exchange Strategy twice per year.  Given how expectations of monetary policy changes influence both bond yields and currencies, we see the Chartbook as a useful forum for cross-market analysis of fixed income and foreign exchange. We have Monitors for ten major developed market economies and, currently, all are below the zero line, indicating the need for continued easy global monetary policy (Charts 1A & 1B). The Monitors are all trending higher, however, as global growth and financial markets have steadily recovered from the brutal collapse spurred by the first wave of COVID-19 earlier this year. The recovery in the Monitors is consistent with two of BCA’s highest conviction views for 2021 – rising global bond yields, led by the US, but with additional weakness in the counter-cyclical US dollar. The compression in the US interest rate advantage this year is sufficient to allow for some upside, without derailing the dollar bear market. Chart 1ALess Easy Money Required... Chart 1B...Given The Rebound From Depressed Levels   An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data that have historically been correlated to changes in interest rates.  The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors.  Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). Chart 2AA Rebound In Our CB Monitors... Chart 2B...Suggesting Bond Yields Should Creep Higher The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar.  We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Previously, the country coverage for the Monitors has included the US, euro area, UK, Japan, Canada, Australia, New Zealand and Sweden. In this report, we introduce new Monitors for Norway and Switzerland – countries with relatively small government bond markets but with actively traded currencies.  We have also revamped the individual component lists of the existing Monitors to include a broader range of economic and inflation data, as well as adding more measures of financial conditions like equity prices or corporate credit spreads. The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates.  Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). None of the Monitors is indicating a need for policymakers to turn more hawkish. At the moment, the common signal from the Monitors is that there is diminished pressure to ease global monetary policies compared to mid-2020. At the same time, none of the Monitors is indicating a need for policymakers to turn more hawkish. There are growing divergences between the individual Monitors, though, which are creating more interesting opportunities for relative bond and currency trades and portfolio allocations – as we discuss throughout the pages of this Chartbook. Fed Monitor: Less Pressure For More Easing Our Fed Monitor has rebounded sharply during the latter half of 2020 on the back of improving US economic growth momentum and booming financial markets. However, it is not yet signaling a need for the Fed to begin moving to a less accommodative policy stance (Chart 3A).    The US economy has recovered impressively from the COVID-19 recession, with real GDP expanding at an annualized 33% pace in Q3 and the ISM Manufacturing index reaching a two-year high in October. Rapid growth also fueled a recovery in the labor market, with the US unemployment rate falling from a peak of 14.7% in April to 6.7% in November. It will take a few years for the US economy to return to full employment, given the severity of this year’s recession. The IMF estimates that the US output gap will not be effectively closed until 2023, thus a sustained return of US inflation to the Fed’s 2% target will take time to develop (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BAn Improving US Economic Backdrop Chart 3CThe US Dollar Is Countercyclical The recovery in the Fed Monitor has been led primarily by the financial and growth components (Chart 3C). The inflation components will be more relevant to time the start of the Fed’s next rate hiking cycle. The Fed’s recent shift to an Average Inflation Targeting framework means that US monetary policy will not be tightened based on a forecast of higher inflation, as the Fed has done in past cycles. This means that both US growth and inflation will be allowed to accelerate in 2021 without a pre-emptive hawkish response from the Fed. The result: additional downward pressure on the counter-cyclical US dollar, which tends to weaken when the Fed Monitor is rising (bottom panel). The current surge in US COVID-19 cases represents a near-term downside risk to US growth momentum, as evidenced by a string of softer data prints in November.  Another round of fiscal stimulus and, more importantly, the start of the vaccine distribution process will give a bigger lift to economic confidence and growth – and US bond yields - in the first half of 2021.  We recommend an underweight strategic allocation to US Treasuries within global government bond portfolios (Chart 3D). Chart 3DUpside For Treasury Yields BoE Monitor:  Subdued Inflation Requires A Dovish Stance Our Bank of England (BoE) Monitor has rebounded sharply from the Q2 collapse, but remains well below zero indicating the ongoing need for easy UK monetary policy (Chart 4A). To that end, the BoE increased the size of its Gilt quantitative easing (QE) program by £150bn last month. However, the central bank chose to not cut the Bank Rate from 0.1% into negative territory, despite many public flirtations with such a move by BoE officials in recent months. Both the output gap and unemployment gap show high levels of excess capacity in the UK economy that are projected to take years to unwind according to the IMF and OECD (Chart 4B). UK real GDP grew by 15.5% on a quarter-on-quarter basis in Q3, a big reversal from the -19.8% plunge in Q2, but more recent domestic data has softened with the UK under national lockdowns to fight a surge in COVID-19 cases. UK headline CPI inflation is threatening to dip into deflation, even with a soft pound. Chart 4AUK: BoE Monitor Chart 4BUK Excess Capacity Will Take Years To Unwind Chart 4CLingering Weakness In UK Inflation Components Looking at the details of our BoE Monitor, all three main sub-components remain below the zero line, but with some diverging trends (Chart 4C). The inflation components remain very weak, but the growth components have almost rebounded back to the pre-pandemic level. The financial components have also recovered sharply thanks in no small part to the BoE’s highly accommodative monetary policy. The BoE Monitor has historically been positively correlated to the momentum of the UK currency, and the trade-weighted pound appears to have outperformed the weakness in the Monitor (bottom panel). The near term direction of the pound, however, is completely linked to the final stage of the UK-EU Brexit negotiations. A no-deal Brexit would likely see the gap between the momentum of the pound and our BoE Monitor close via a sharp fall in the currency.  If a trade agreement is reached, however, we would expect the convergence to happen via a rising Monitor catching up to a firming currency, driven by a likely improvement in portfolio inflows. With COVID-19 vaccines already starting to be administered in the UK, a “peaceful” resolution to the Brexit saga could give the UK economy a solid lift in 2021 – especially with the UK government preparing a big fiscal impulse.  Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields. Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields (Chart 4D). Given the lack of UK inflation, and with the BoE taking down a large share of new Gilt issuance via QE, UK bond yields will lag the rise in global bond yields that we expect in the first half of 2021, even if there is good news on Brexit. We continue to recommend an overweight stance on UK Gilts. Chart 4DExpect UK Gilts To Lag Behind As Global Bond Yields Rise ECB Monitor: Price Deflation Leads To Asset Reflation Our European Central Bank (ECB) Monitor is in “easy money required” territory, but has rebounded significantly from the lows seen earlier in 2020 (Chart 5A). The ECB delivered on that easing message at the December policy meeting, increasing the size of its Pandemic Emergency Purchase Program by €500bn to €1.85tn and extending the end-date of the program from June 2021 to March 2022.  The central bank also extended the maturity date for its offer of heavily discounted funding (at rates as low as -1%) for bank lending to June 2022. The ECB needed to deliver another round of easing because the euro area has fallen back into deflation. Year-over-year headline CPI inflation reached -0.3% in November, while core inflation was not much further behind at +0.2% (Chart 5B). With much of Europe now under increased economic restrictions due to the latest surge in COVID-19 cases, the near-term downside risks to euro area growth could push inflation even deeper into negative territory in the coming months. Chart 5AEuro Area: ECB Monitor Chart 5BLots Of Slack In The Eurozone Chart 5CThe Euro Is Too Strong For The Economy Looking at the breakdown of our ECB Monitor, there is a very large divergence between the components. The inflation components are at the most depressed levels since the turn of the century, while the growth components have rebounded sharply (Chart 5C). The financial conditions components have now surged above the zero line, suggesting pressure on the ECB to tighten policy from robust European financial markets. Of course, booming markets are a direct result of the ECB’s dovish monetary stance, which includes the rapid expansion of its balance sheet and significant purchases of riskier sovereign bonds in Italy, Spain and even Greece.  The ECB realizes that it cannot cut policy interest rates any further into negative territory without harming the ability of the fragile European banking system to earn profits.  This effective floor on nominal policy rates, combined with deepening price deflation, has boosted real European interest rates.  The result is a steadily climbing euro, even as the ECB has continued to signal a continued dovish policy bias and an aggressive expansion of its balance sheet.  The weakening trend for the US dollar that we expect in 2021 will leave the ECB little choice but to continue doing what it has been doing – more asset purchases, more cheap funding for bank lending and extending the time duration of all its easing programs in an effort to keep European financial markets aloft while also limiting the damage from an appreciating euro.  The introduction of a COVID-19 vaccine should provide a lift to growth, but inflation is likely to remain very subdued without a weaker euro. Inflation is likely to remain very subdued without a weaker euro. The depressed level of the ECB Monitor suggests that there is additional scope for lower euro area bond yields (Chart 5D), although the impact will not be the same for all countries in the region.  Deeply negative German and French bond yields will likely not decline much in 2021, although they will not rise much either even as US Treasury yields move higher, making them good defensive overweights in a global bond portfolio. At the same time, Italian and Spanish bond yields will continue to grind lower as ECB buying and more European fiscal co-operation help further reduce the risk premium on Peripheral Europeans - stay overweight. Chart 5DEuropean Yields Should Lag The US BoJ Monitor:  Fighting Deflation, Once Again Our Bank of Japan (BoJ) Monitor has rebounded from the recent low but is still well below zero, indicating that easier monetary policy is required (Chart 6A). That will be hard for the BoJ to deliver, however - policy rates are already negative, the BoJ’s balance sheet has blown up to 128% of GDP, and a more dovish forward guidance is impossible as most market participants already believe the BoJ will keep rates untouched for years. Japan’s economic recovery is currently at near-term risk from a particularly sharp increase in COVID-19 cases, although Japan’s labor market did not suffer much from the pandemic-induced plunge in growth earlier this year (Chart 6B). Nonetheless, while the unemployment rate remains below the OECD’s estimate of full employment (4.1%), there remains significant excess capacity in Japan according the IMF output gap estimates, with headline CPI inflation now in mild deflation. Chart 6AJapan: BoJ Monitor Chart 6BSignificant Excess Capacity In Japan Chart 6CJapanese Equities Have Bolstered Financial Conditions The individual elements of the BoJ Monitor show a large divergence between the growth and inflation components, which are very depressed, and the more stable financial component (Chart 6C). The latter reflects the outstanding performance of Japanese equities in recent months, with some benchmark indices reaching levels last seen in the mid-1990s. The continued steady expansion of the BoJ’s balance sheet is clearly helping to underwrite easy financial conditions in Japan. While the BoJ is reaching some operational constraints with its asset purchases, owning nearly one-half of all JGBs and three-quarters of all Japanese equity ETF’s, the central bank has no choice but to continue buying assets to support financial conditions. Cutting policy interest rates deeper into negative territory is a non-starter given the negative impact sub-0% rates have had on the profitability of Japanese banks. The inability of the BoJ to further ease Japanese monetary policy is boosting real rates and supporting the yen. The historical correlation between the BoJ Monitor and the yen has not been as consistent as that seen in other countries, but since the 2008 financial crisis a deteriorating BoJ Monitor has tended to coincide with a rising yen – given the lower bound of policy rates.  The inability of the BoJ to further ease Japa-nese monetary policy is boosting real rates and supporting the yen.  The weakness of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should fall significantly (Chart 6D). However, the BoJ’s Yield Curve Control policy, with the central bank buying enough bonds to keep the 10yr JGB yield around 0%, is preventing JGB yields from plunging to the deeply negative yield levels seen in core Europe. This policy-induced stability of Japanese yields actually makes JGBs a defensive bond market when US Treasury yields are rising. Thus, we recommend an overweight stance on JGBs given our view that US bond yields have more upside. Chart 6DPolicy Will Keep JGB Yields Stable BoC Monitor:  No Choice But To Stay Ultra-Dovish Our Bank of Canada (BoC) Monitor has seen a much weaker rebound off the lows than some of our other Central Bank Monitors, indicating that the BoC cannot lay off the monetary gas pedal (Chart 7A). The BoC has already been aggressive in easing policy earlier this year, cutting the Bank Rate to 0.25%, initiating several liquidity facilities and quickly ramping up bond purchases. The central banks now owns around 40% of all Government of Canada bonds outstanding, from a starting point of essentially 0% before the pandemic, and has started to shift its purchases to longer maturity bonds in order to suppress risk-free yields and lower borrowing costs for households and business. While Canada did see a sharp recovery in GDP growth in Q3 – rising 8.9% on a non-annualized, quarter-on-quarter basis following the -11.3% drop in Q2 – the level of real GDP is still -5.2% lower than Q3 2019 levels.  The BoC has already significantly revised down its estimates of potential growth for 2020-22 by nearly one full percentage point due to the various negative shocks including COVID-19. Inflation remains weak because of significant economic slack – the BoC forecasts that CPI inflation will remain below its target until 2022 (Chart 7B).  Chart 7ACanada: BoC Monitor Chart 7BCanada: BoC Monitor Chart 7CWeaker Growth Is Holding Down Our BoC Monitor Within the details of our BoC Monitor, the weakness in the overall indicator is clearly driven by the depressed level of the growth components (Chart 7C). Heavy containment measures to fight the spread of COVID-19, combined with uneven recoveries in different sectors, have weighed on the Canadian economy. At the same time, the financial conditions components have been relatively stable, even with the rapid expansion of the BoC’s balance sheet. The Canadian dollar has clearly outperformed its typical positive correlation to the BoC Monitor (bottom panel), as the “loonie” has benefitted from rising global commodity prices and the overall depreciation of the US dollar. Both of those trends are likely to remain in place in 2021 as global growth gains upward momentum, which should keep the Canadian dollar well supported – and also force the BoC to stay dovish to prevent an even greater rise in the currency. We currently recommend a neutral stance on Canadian government bonds within global fixed income portfolios. In more normal times, a backdrop of accelerating economic growth and rising commodity prices would typically push Canadian yields higher and justify an underweight stance – particular given the relatively high historical “yield beta” of Canada to changes in US bond yields  (Chart 7D). However, with the BoC forced to stay aggressive with its QE program to dampen Canadian yields and suppress the rising Canadian dollar, Canadian government bonds are likely to outperform their normal high-beta status as US Treasury yields continue to drift higher in 2021. Chart 7DAn Aggressive BoC Will Hold Down Canadian Yields RBA Monitor: Not Out Of The Woods Yet Our Reserve Bank of Australia (RBA) monitor remains in “easier policy required” territory despite a strong rebound after bottoming in April (Chart 8A).  Since our last update, the RBA has slashed the official cash rate once more to 0.1%, largely in an effort to contain the surging Australian dollar. The unemployment gap in Australia has staged a tentative recovery but is set to remain elevated and recover only gradually going forward, according to the IMF’s forecast (Chart 8B). The RBA actually sees unemployment ticking up slightly in the near term as the eligibility conditions for the JobSeeker program tighten. Inflation, meanwhile, will have a tough time reaching the target 2-3% band in the absence of wage price pressures. Chart 8AAustralia: RBA Monitor Chart 8BA Lot Of Slack In The Australian Economy Chart 8CFinancial Conditions In Australia Call For Tightening Breaking down our RBA monitor into its constituent growth, inflation, and financial conditions components, we see a sharp rebound led by financial conditions which, taken in isolation, are calling for tighter monetary policy (Chart 8C). This comes as no surprise with the RBA growing its balance sheet at an unprecedented rate. The growth component, meanwhile, has been driven by rebounding consumer and business sentiment data with Australia benefitting from Chinese reflation. We are also beginning to see a divergence in the historically tight correlation between the RBA monitor and the trade-weighted Australian dollar, as investors pile into the growth-sensitive currency with the Fed reflating the global economy. For its part, the RBA has tried to combat this by reiterating its support for its QE program and leaving the door open to further bond-buying. We can see the RBA’s core problem summarized in Chart 8D. The rise in Australian bond yields has cornered the RBA towards a more dovish tilt. Although RBA Governor Lowe has ruled out negative rates, the RBA has some bullets remaining, including shifting its purchases to the long-end of the curve. With that in mind, we feel confident reiterating our neutral stance on Australian sovereign debt. Chart 8DAustralian Yields Have Outpaced Our RBA Monitor RBNZ Monitor: Between A Rock And A Hard Place Our Reserve Bank of New Zealand (RBNZ) monitor has rebounded slightly but is still calling for easing (Chart 9A). While the RBNZ has held its official cash rate steady at 0.25% since our last update, it has expanded its large-scale asset purchase (LSAP) program to a whopping NZD 100bn. Unemployment and output gaps indicate a good deal of slack in the New Zealand economy, with the output gap set to recover slightly faster than the unemployment gap, according to IMF forecasts (Chart 9B). Although inflation momentarily breached the 2% mark, it is expected to remain subdued as spare capacity and low tradables inflation weigh on the overall measure. Chart 9ANew Zealand: RBNZ Monitor Chart 9BNZ Inflation Is Set To Subside Chart 9CThe Appreciating NZD Is A Problem As with neighboring Australia, financial conditions have led the rebound in the RBNZ monitor while the growth component has ticked up slightly and the inflation component remains subdued (Chart 9C). However, one of the variables in our model, house prices, has recently leapt to the forefront of the monetary policy discussion in New Zealand, with the government asking the RBNZ to cool the rapidly heating market. The RBNZ has responded by reinstating loan-to-value ratio restrictions but we cannot expect the bank to turn hawkish anytime soon, given recent appreciation in the New Zealand dollar, which not only hurts export competitiveness but also threatens import price inflation. Going forward, political pressure on the RBNZ will prevent it from taking an overly accommodative stance and has made it unlikely that the bank will go into negative rate territory next year. The momentum in NZ yields has largely kept pace with our RBNZ monitor despite the dramatic spike last month (Chart 9D). The RBNZ will increasingly have to find ways to suppress both bond yields and the New Zealand dollar without stimulating the housing market. Given these opposing forces, yields will likely move sideways, supporting our neutral stance on NZ sovereign debt. Chart 9DYields Have Kept Pace With Our RBNZ Monitor Riksbank Monitor: Sluggish Recovery Ahead Our Riksbank monitor has rebounded but is still calling for easier policy (Chart 10A). Given the bank’s fraught relationship with negative rates and the associated financial stability concerns, it will likely deliver further stimulus in the form of asset purchases, which it has recently ramped up to SEK 700bn while also promising to step up the pace of purchases in the next quarter. Both output and unemployment gaps indicate slack in the Swedish economy, with OECD and IMF estimates pointing towards a gradual recovery (Chart 10B). While GDP in the third quarter did come out stronger than expected, it was likely just a temporary development. After failing to contain surging infections, the Swedish government has finally decided to impose restrictions, which will limit the recovery until we start to see mass immunization. The Riksbank does not expect inflation to be sustainably close to 2% until 2023. Chart 10ASweden: Riksbank Monitor Chart 10BSweden Is Set For A Slow Recovery Chart 10CThe Rallying Swedish Krona Is A Concern For The Riksbank Looking at the components of the Riksbank monitor, all of them are currently below zero, implying a need for easier policy (Chart 10C). The growth component rebounded strongly on the back of improving exports and sentiment data. On the currency side, we have seen strong appreciation in the trade-weighted Krona this year, far exceeding the levels implied by our Riksbank monitor. This could dampen export growth in the small, open economy, making it a prime concern for policymakers. While the Riksbank monitor fell drastically, Swedish government bond yields remained largely rangebound this year, with the 10-year yield hovering around zero (Chart 10D). The bottom line is that yields for the most part are reflecting expectations of a policy rate stuck at 0%, that the Riksbank is unwilling to cut and cannot afford to hike. Chart 10DSwedish Yields Have Remained Rangebound Norges Bank Monitor: On A Recovery Path Our Norges Bank Monitor is improving from very depressed levels, but still remains well below the zero line. This is signaling that continued monetary accommodation is still needed, but emergency settings are no longer appropriate (Chart 11A). Consistent with the message from the Monitor, Norges Bank governor Øystein Olsen has pledged to keep interest rates at zero for the next couple of years, before a gradual rise begins. The central bank also continues to extend emergency F-loans to commercial banks at 0%, to encourage much needed lending to Norwegian firms. The rebound in Q3 mainland GDP (which excludes oil & gas production) was the strongest on record. The unemployment rate has also declined from a high of 10.4% to 3.9% for the month of November. That said, there was a small tick up in November, a sign that the second wave of COVID-19 engulfing the euro area is beginning to bite into Norwegian growth. Underlying inflation remains above well above target, while headline inflation is slowly rebounding. But given that the output gap is expected to remain wide into 2021, these trends should flatten, rather than accelerate (Chart 11B). Chart 11ANorway: Norges Bank Monitor Chart 11BNorwegian Inflation Is At Target Chart 11CThe Norwegian Krone Tracks The Monitor The key improvement in our Norges Bank Monitor has come from the growth component, which is very close to the zero line (Chart 11C). Not surprisingly, the Monitor shows a very tight correlation with the trade-weighted currency, suggesting the latter is an important valve in adjusting monetary conditions. As an oil-producing economy, the drop in the krone cushioned the crash in oil prices. A recovery will benefit the krone.  The correlation between the Monitor and Norwegian bond yields has become more robust (Chart 11D). This suggest yields in Norway should participate as global yields modestly grind higher. Within a global bond portfolio, our default stance is neutral, as the market is thinly traded. Chart 11DNorwegian Yields Should Modestly Track Higher SNB Monitor: More Currency Weakness Needed Our Swiss National Bank (SNB) Monitor has shown very tepid improvement, as the SNB has maxed out its policy options (Chart 12A). Interest rates have been at -0.75% since 2015, making the currency channel the only valve to ease monetary conditions. To achieve this, the central has been heavily expanding its balance sheet via the accumulation of foreign assets and reserves. Switzerland has seen a less powerful rebound in Q3 GDP at 7.2%, compared to the euro zone where growth stood at 12.5%. Meanwhile, Q4 data is likely to disappoint as Switzerland was hit harder by the second COVID-19 wave. Labor market tightness has eased, with the unemployment rate at a 2020 high of 3.4%. This will continue to suppress inflationary pressures, which are now the weakest since the 2008 Global Financial Crisis (Chart 12B). Chart 12ASwitzerland: SNB Monitor Chart 12BThe Swiss Economy Is Deflating Chart 12CThe Swiss Franc Is Too Strong Looking at the components of our SNB Monitor, both growth and inflation are anchoring down the indicator. The message is that Switzerland needs a weaker currency, especially relative to its trading partners (Chart 12C). This concern is repeatedly echoed by SNB governor Thomas Jordan. As such, the Swiss franc should lag other European currencies, including the euro and Swedish krona.  The SNB Monitor does a good job at capturing shifts in Swiss bond yields. Constrained by the lower bound, they were not really able to fall when the pandemic was raging in March. By the same token, they should lag any modest increase in global bond yields, as suggested by the Monitor (Chart 12D). Like Norway, our default stance on Swiss bonds is neutral in a global portfolio, given low market liquidity. Chart 12DSwiss Yields Should Lag The Global Upswing   Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Shakti Sharma Research Associate shaktiS@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com