Monetary

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust Neutral Fiscal Thrust Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak Final Demand Remains Weak Final Demand Remains Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Data Can't Disappoint The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration.   The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Move Down In Quality Move Down In Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 5High-Yield Valuation High-Yield Valuation High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense.                           Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April Inflation Will Peak In April Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Price Pressures Are Building Price Pressures Are Building Chart 8Shelter Inflation About To Bottom Shelter Inflation About To Bottom Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS Stay Long TIPS Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3  With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Yield Betas & Country Allocation: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. UK Follow-Up: The conclusions from our UK Special Report published last week do not change after adjusting for the difference in the inflation indices used to calculate UK inflation-linked bond yields compared to those of other countries. UK real interest rates are the lowest in the developed economies, while inflation breakevens are the highest. NOTE: There will be no Global Fixed Income Strategy report published next week. Instead, BCA Chief Global Fixed Income Strategist Rob Robis will do a webcast discussing his latest thoughts on global bond markets. Yields Rising Around The World Chart of the WeekPolicy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish The path of least resistance for global bond yields remains biased upward. Optimism on future economic growth remains ebullient with consumer and business confidence indices surging in much of the developed world. The epicenter of the global bond bear market remains the US, where pandemic related economic restrictions are being unwound with 21.4% of the US population now having received at least one dose of a vaccine. Fiscal policy in the US is also supporting the positive vibes on future growth after the $1.9 trillion stimulus package was signed into law by President Biden last week. The 10-year US Treasury yield climbed back to the 2021 high of 1.63% on the back of that announcement. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget (Chart of the Week). This, combined with ongoing quantitative easing from global central banks eager to keep bond yields as low as possible until inflation expectations sustainably return to policymaker targets, is providing a bond-bearish lift to both inflation expectations and real yields – most notably in the US. Central bankers can try to fight back against the speed of the increase in bond yields by maintaining their commitment to current policy settings, as the European Central Bank (ECB) and Bank of Canada (BoC) did last week. The Fed, Bank of England (BoE) and Bank of Japan (BoJ) will all get the chance to do the same this at this week’s policy meetings. The likely message from all will be one of staying the course and not reflexively responding to higher bond yields, which have not triggered a broad-based selloff in global risk assets that would pre-emptively tighten financial conditions. The S&P 500 index hit an all-time high last week, while equity markets in Europe and Japan have returned to pre-pandemic levels (Chart 2). Global corporate credit spreads have remained calm, consistent with a positive growth backdrop that diminishes the potential for credit downgrades and defaults. The US dollar has gotten a lift from improving US growth expectations and relatively higher US Treasury yields, which has had some negative spillover effect into emerging market equities and currencies. The dollar rebound has been relatively modest to date, however, with the DXY index up only 3% from the early 2021 lows. A major reason why global equity and credit markets have absorbed higher bond yields so well is because the sheer scope of the new US fiscal stimulus will have a major impact on growth momentum both in the US and outside the US. This comes on top of the boost to optimism from the speed of the US and UK vaccine rollouts. In an update to its December 2020 economic outlook published last week, the OECD estimated that the $1.9 trillion US stimulus will boost US real GDP growth by 3.8 percentage points versus its original forecast over the next year (Chart 3). Other countries will also benefit from the implied surge in US demand spilling over from that stimulus package, with the OECD projecting a 1.1 percentage point increase to world real GDP growth. Chart 2Risk Assets Ignoring Rising Global Bond Yields Risk Assets Ignoring Rising Global Bond Yields Risk Assets Ignoring Rising Global Bond Yields Chart 3Big Growth Spillovers From US Fiscal Stimulus Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Countries that have the greater exposure to US demand, like Canada and Mexico, are expected to benefit a bit more than the rest of the world, but the expected boost to growth is consistent (around one half of a percentage point) from China to Europe to Japan to major emerging market countries like Brazil. That US-fueled pickup in global economic activity will help absorb some of the spare capacity that opened up during the COVID-19 pandemic. In Chart 4 and Chart 5, we show the estimates taken from the December 2020 OECD Economic Outlook for the output gaps in the US, euro area, UK, Japan, Canada and Australia for 2021 and 2022. We adjust those projections by the OECD’s estimate of the impact of the US fiscal stimulus in 2021, as well as by the additional upward revisions to the OECD growth projections in 2021 and 2022 that were published last week. Chart 4The $1.9 Trillion Stimulus Will Close The US Output Gap … Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 5… And Help Narrow Output Gaps Elsewhere Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 6Maintain Below-Benchmark Duration Maintain Below-Benchmark Duration Maintain Below-Benchmark Duration The conclusion is that the US output gap will be eliminated in 2022, while output gaps will still be negative, but diminished, in the other countries after factoring in the impact of the latest US fiscal package. This suggests that the maximum upward pressure on global bond yields should still be centered in the US, where inflation pressures will be more evident and the Fed will likely begin signaling a shift to a less dovish stance sooner than other central banks (although not likely until much later in 2021). Our Global Duration Indicator continues to flag pressure for higher bond yields ahead for the major developed economies (Chart 6). The improving growth momentum means that rising real yields should increasingly become the more important driver of higher nominal bond yields. Persistent central bank dovishness in the face of that growth surge, however, means that it is still too soon to position for narrowing global inflation expectations or any bearish flattening of government bond yield curves - even in the US. Bottom Line: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Using Yield Betas For Bond Country Allocation, One More Time Over the past two months, we have published Special Reports that delved into the outlook for bond yields and currencies in Australia, Canada and the UK. We selected those three countries as they represented the most likely downgrade candidates within our recommended government bond country allocation given their status as “higher beta” bond markets that are more correlated to US Treasury yields. We estimate US Treasury yield betas from a rolling regression (over a three-year window) of changes in 10-year non-US government bond yields to changes in 10-year US Treasury yields (Chart 7). This allows us to assess which markets are more or less sensitive to the ups and downs of US bond yields. We have used this framework to help guide our country allocation strategy during the pandemic and, for the most part, it has been successful. Chart 7Government Bond Yield Sensitivities To USTs Are Shifting Fast Government Bond Yield Sensitivities To USTs Are Shifting Fast Government Bond Yield Sensitivities To USTs Are Shifting Fast So far in 2021, the markets with higher US Treasury yield betas (Canada, Australia and New Zealand) have underperformed the lower beta markets (Germany, France and Japan). We show that in the top panel of Chart 8, which plots the yield betas at the start of the year versus the year-to-date relative return of each country’s government bond market to that of the overall Bloomberg Barclays Global Treasury index. The returns are adjusted to reflect any differences in the durations of each country versus that of the overall index, and are shown in USD-hedged terms to allow for a common currency comparison. The bottom panel of Chart 8 shows the same relationship for the all of 2020. This is a mirror image of what has occurred so far in 2021, with the countries with higher yield betas outperforming the lower beta markets. The obvious difference between the two years is the direction of Treasury yields, which fell in 2020 and have been rising this year. So far in 2020, the differences between the returns of the higher beta markets have been quite similar. New Zealand has had the biggest negative performance (-2.8% versus the global benchmark), but this has only been moderately worse than Australia (-2.6%) and Canada (-2.4%). These are all just slightly worse than the return of US Treasuries relative to the Global Treasury index (-2.3%). Our estimated yield betas have changed rapidly over the past few months. For example, the rolling three-year yield beta of Australia has shot up from 0.61 at the beginning of the year to 0.78, while Canada has seen a similar move (0.81 to 0.88). This reflects the rapid repricing of interest rate expectations in both countries as current growth momentum and growth expectations improve. While not a perfect relationship, yield betas do show some correlation to our Central Bank Monitors – designed to measure the pressure on central banks to tighten of ease monetary policy (Chart 9). The latest increases in the yield betas of Australia, New Zealand and Canada have occurred alongside a rising trend in our Central Bank Monitors for each nation. The implication is that the relative underperformance of government bonds in those countries is related to the cyclical pressure for the RBA, RBNZ and BoC to tighten monetary policy. Chart 8An Intuitive Link Between Yield Betas & Bond Market Performance Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger Chart 9Cyclical Pressures & Yield Betas Are Linked Cyclical Pressures & Yield Betas Are Linked Cyclical Pressures & Yield Betas Are Linked At the same time, the yield betas of government bonds in Germany and the UK have remained low despite the cyclical upturn in our ECB and BoE Monitors. The lingering impact of COVID-19 lockdowns on economic growth and inflation in the euro area and UK is likely weighing on bond yields in both regions. This limits any challenge to the dovish forward guidance of the ECB and BoE, in contrast to the repricing of interest rate expectations seen in other countries. The market-implied path of policy interest rates extracted from OIS forward curves does show a much more aggressive expected path of policy rates in the higher beta markets versus the lower beta markets (Chart 10). Chart 10More Rate Hikes Expected In The Higher Yield Beta Countries Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger ​​​​​​​ The “liftoff” date for each central bank shown, representing when the first full interest rate hike is priced into the OIS forwards, is shown in Table 1. We rank the countries in the table by the amount of time until the discounted liftoff date, from shortest to longest. The first rate hike is expected in New Zealand in June 2022, with the BoC expected to lift rates in Canada two months later. The market is not pricing a full rate hike by the Fed until January 2023, while liftoff in the UK and Australia are expected during the summer of 2023. Table 1The "Pecking Order" Of Global Liftoff Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger We treat the countries with perpetually low interest rates, the euro area and Japan, differently in Table 1, as both the ECB and BoJ would most likely move slowly if and when they ever decided to raise rates again. Thus, we define liftoff as only a 10bp increase in policy interest rates for those two regions, while for all the other central banks we assume the size of the first rate hike will be 25bps. On that reduced basis, the market is priced for “liftoff” by the ECB and BoJ in September 2023 and February 2025, respectively. In terms of that “order of liftoff” shown in Table 1, we generally agree with current market pricing except for New Zealand and Canada. We fully expect the Fed to be the first central bank to begin signaling the path towards monetary policy normalization, largely due to the impact of the fiscal stimulus, starting with a move to begin tapering the Fed’s asset purchases at the start of 2022. The Fed will also be the first to begin rate hikes after tapering. We do not anticipate the BoC or Reserve Bank of New Zealand (RBNZ) to make any hawkish moves (reduced asset purchases or rate hikes) before the Fed does the same, as this would put unwanted appreciation pressures on the New Zealand and Canadian dollars. We expect the BoC and RBNZ to move soon after the Fed begins to shift, followed by the BoE and RBA a bit later after that in line with the current liftoff ordering. The pace of rate hikes after liftoff also appears to be a bit too aggressively priced in the countries with higher yield betas. The cumulative amount of interest rate increases to the end of 2024 currently priced in OIS curves is larger in Canada (175bps) and Australia (156bps) than the US (139bps) and New Zealand (140bps). The relative differences are not huge, however, but we think the odds favor the Fed delivering the greater amount of rate hikes over the next three years. More generally, when looking at what is more important for each central bank in determining the timing of liftoff, we can boil it down to a couple of the most important measures for the higher beta countries (Chart 11): US: The Fed will continue to focus on both inflation expectations and broad measures of labor market utilization before signaling any policy shift. On that basis, there is still some way to go before TIPS breakevens return to the 2.3-2.5% level we believe to be consistent with the Fed sustainably hitting its 2% inflation goal on the PCE deflator. Also, there is still a lot of ground to cover before the US labor market fully returns to pre-pandemic health, as the employment/population ratio is four percentage points below the pre-COVID peak. New Zealand: The RBNZ is now under a lot more pressure to tighten policy after the New Zealand government changed the central bank’s remit to include stabilizing house prices, which have soured to unaffordable levels that have exacerbated income inequality. With house prices now rising at a 19% annual rate, the highest since 2004, the RBNZ will be under pressure to hike sooner, although any associated rise in the New Zealand dollar will likely be of equal concern. Canada: The BoC has been very candid that its current policy mix of aggressive asset purchases and 0% policy rates will be altered if the Canadian economy improves. We believe that the current trends of booming house price inflation, recovering business investment prospects and a rapidly recovering labor market will all make the BoC more willing to signal tighter monetary policy fairly soon after the Fed does the same. Australia: The RBA is likely to continue surprising bond markets with its dovishness in the face of a rapidly recovering economy, given underwhelming inflation. In a recent speech, RBA Governor Philip Lowe noted that Australian inflation will not return to the RBA’s 2-3% target band without wage growth rising from the current 1.4% pace up to 3%. The RBA does not expect the labor market to tighten enough to generate that kind of wage growth until at least 2024, suggesting no eagerness to begin normalizing monetary policy. Among the lower-beta markets, the most important things that will dictate future policy moves are the following (Chart 12): Chart 11What To Watch In The Higher Yield Beta Countries What To Watch In The Higher Yield Beta Countries What To Watch In The Higher Yield Beta Countries Chart 12What To Watch In The Lower Yield Beta Countries What To Watch In The Lower Yield Beta Countries What To Watch In The Lower Yield Beta Countries UK: The BoE’s current focus is on how fast the UK economy recovers from the pandemic shock, with inflation expectations remaining elevated (see the next section of this report). The degree of strength in business investment and consumer spending will thus dictate the timing of any BoE shift to a less accommodative policy stance. Euro Area: The latest set of ECB projections call for inflation to only reach 1.4% by 2023. As long as inflation (both realized and expected) stays well below the 2% ECB target, the central bank will focus more on supporting easy financial conditions (lower corporate bond yields, tighter Italy-Germany yield spreads and resisting euro currency strength). Japan: Inflation continues to underwhelm in Japan, and the BoJ is a long way from contemplating any tightening measures. Summing it all up, we still see value in using yield betas to dictate our recommended fixed income country allocations. Although these should be complemented with assessments of the relative likelihood of central banks moving before others to further refine country allocations. Bottom Line: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. A Brief Follow-Up To Our UK Special Report In our Special Report on the UK published last week, we noted that the UK had the lowest real bond yields and highest inflation expectations among the developed market countries with inflation-linked bonds.1 Some astute clients pointed out that we neglected to discuss how the UK inflation-linked bonds are priced off the UK Retail Price Index (RPI) which typically runs with a faster inflation rate than the UK Consumer Price Index (CPI). This creates a downward bias to UK real yields in comparison to other countries that use domestic CPI indices in inflation-linked bond pricing. We did not ignore the RPI-CPI differential in our report, we just did not think it to be relevant to the conclusions of our report. The UK still has the lowest real rates and highest inflation expectations even after adjusting both by the RPI-CPI gap (Chart 13). Furthermore, survey-based measures of UK inflation expectations are broadly in line with the RPI-based inflation breakevens, confirming the message from the RPI-based real yields and inflation expectations. Chart 13UK Real Yields Are Too Low, Using RPI Or CPI UK Real Yields Are Too Low, Using RPI Or CPI UK Real Yields Are Too Low, Using RPI Or CPI Looking ahead, the RPI-CPI gap is likely to stay in a much narrower range compared to its longer run history. Chart 14A Less Active BoE Has Narrowed The RPI-CPI Gap A Less Active BoE Has Narrowed The RPI-CPI Gap A Less Active BoE Has Narrowed The RPI-CPI Gap For example, between 2000 and 2007, the RPI-CPI gap averaged a full percentage point but with very large fluctuations (Chart 14). This is because mortgage interest costs are included in the RPI but are not part of the CPI. Thus, RPI inflation tends to be more volatile when the BoE is more active in adjusting interest rates. After the 2008 financial crisis, the BoE has kept policy rates at very low levels with very few changes. The RPI-CPI gap has narrowed as a result, averaging only one-half of a percentage point between 2009 to today. Thus, our conclusion on UK bond yields remains the same – Gilt yields are too low and are likely to rise further over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?",dated March 10, 2021, available at gfis.bcaresearch.com and fes.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Harder, Better, Faster, Stronger Harder, Better, Faster, Stronger ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights With the vaccination campaign in full gear and plenty of fiscal support in the pipeline, investors have swung from worrying that the US economy will grow too slowly to worrying that it will grow too fast. Thanks to the latest stimulus bill, US households will have $2 trillion in excess savings at their disposal by April. This money will seep into the economy as lockdown measures end. There is still scope for US interest rate expectations to rise beyond 2023. However, the Fed is unlikely to raise rates in the next two years even if the economy does begin to overheat. This should keep rate expectations at the short end of the curve well anchored near zero, allowing the curve to further steepen. Investors should continue to overweight equities on a 12-month horizon. Historically, stocks have been able to shrug off rising bond yields, provided borrowing costs did not rise so high as to tip the economy into recession. A faster start to the vaccination campaign in the US and accommodative fiscal policy should support the dollar over the next few months. Nevertheless, the greenback will still decline modestly over a 12-month horizon. Too Hot For Comfort? With the vaccination campaign in full gear and plenty of fiscal support in the pipeline, investors have swung from worrying that the US economy will grow too slowly to worrying that it will grow too fast. Chart 1 illustrates these concerns in a nutshell. Point A on the aggregate demand schedule corresponds to a situation where the economy is operating below capacity and interest rates are stuck at zero. An outward shift in the demand curve from AD1 to AD2 would eliminate the output gap without necessitating higher interest rates (Point B). Such an outcome would be good news for equity investors because it would lead to more output and increased corporate profits without any tightening in monetary policy. Chart 1Where Will Fiscal And Monetary Policy Take Us? When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart If the demand curve were to shift further out to AD3, however, the Fed might be forced to take away the punch bowl. The result would be higher interest rates rather than higher output (Point C). This would be bad news for equity investors. Two Questions Analyzing the current debate about where bond yields are going through the lens of this simple chart, two questions arise: How likely is the US economy to run out of excess capacity over the next few quarters? How would the Fed respond to evidence that the US economy is overheating? On the first question, the honest answer is that no one knows. According to the Congressional Budget Office, the output gap stood at 3% of GDP in the fourth quarter of 2020. The true number is probably closer to 5% of GDP since the CBO implausibly assumes that GDP was 1% above potential prior to the pandemic. As of February, payroll employment was down 5.3% from its pre-pandemic level, suggesting that there is still a fair amount of slack in the economy. Employment had fallen even more among low-income workers, women, and certain ethnic minority groups – an important consideration given the Fed’s heightened focus on “inclusive growth” (Chart 2). Chart 2Some Have Suffered More Job Losses Than Others When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Slack Will Shrink Chart 3Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings US households were sitting on around $1.7 trillion in excess savings as of the end of January. Households generated about two-thirds of those excess savings by cutting back on spending during the pandemic, with the remaining one-third stemming from increased transfer payments (Chart 3). We estimate that the stimulus bill that President Biden signed into law earlier today will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. As lockdown measures ease, it is reasonable to assume that households will spend a portion of this cash cushion. Unlike President Trump’s Tax Cuts and Jobs Act, Biden’s American Rescue Plan Act will raise the incomes of the poor much more than the rich (Chart 4). Since the poor tend to spend a greater share of each dollar of disposable income than the rich, aggregate demand could rise meaningfully. Chart 4Biden’s Package Will Boost The Income Of The Poor When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Meanwhile, the supply side of the economy could face a temporary setback. Under the legislation, about 40% of jobless workers will receive more income from extended unemployment benefits than they did from working. While these additional benefits will expire in early September, they could temporarily curtail labor supply at a time when firms are trying to step up the pace of hiring. Putting it all together, there is a high probability that the US economy will heat up this summer, stoking fears of higher inflation. Door C, D, Or E? For investors, how the Fed reacts to any potential overheating will be critical. If the market prices in an earlier liftoff date for the fed funds rate, the economy will move towards Point C. However, there is another possibility: Rather than fretting about an overheated economy, the Fed could welcome it, stressing its commitment to maintain very easy monetary policy. In that case, the economy would find itself closer to Point D. In fact, Point D could turn out to be a waystation to Point E. An overheated economy could lift inflation. In the absence of any rate hikes, real interest rates would fall. Lower real rates would further stoke spending, causing the aggregate demand curve to shift to AD4. What point will the US end up reaching? As we discuss below, our guess is “eventually Point C,” but with a temporary detour towards Points D/E. The Long-Term Case For C Chart 5Real Yields Have Recovered But Are Still Low Real Yields Have Recovered But Are Still Low Real Yields Have Recovered But Are Still Low The 5-year/5-year forward US TIPS yield currently stands at 0.18%. This is well above the trough of -0.84% reached last August, but still below the average of 0.7% that prevailed in 2017-19 (Chart 5). One can make a case that real bond yields will eventually rise above where they were before the pandemic. Even though the US budget deficit will decline next year due to the expiration of most stimulus measures, fiscal policy will remain looser than it was for most of the post-GFC period. Notably, BCA’s geopolitical strategists expect Congress to pass a $4 trillion 10-year infrastructure bill by this fall, only half of which will be financed through tax hikes. They also anticipate increased spending on health care and other social programs. Chronically easier fiscal policy will lift the neutral rate of interest. Recall that the neutral rate – also known as the “equilibrium rate” –  is simply the interest rate that equalizes aggregate demand with aggregate supply. To the extent that looser fiscal policy raises aggregate demand, a higher interest rate will be necessary to bring aggregate demand back down so that it matches aggregate supply. Temporary Detour Towards D/E That journey to higher real bond yields is likely to be prolonged, however. As noted above, the Fed has no desire to validate market expectations of tighter monetary policy anytime soon. Chart 6 shows that yields rarely rise significantly when the Fed is on hold. Chart 6Treasurys Tend To Underperform When The Fed Delivers Hawkish Surprises When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Currently, investors expect the Fed to start hiking rates in November 2022, with a second rate hike delivered in May 2023, and a third in November 2023 (Chart 7). This is considerably more hawkish than the Fed’s own forecast from December, which called for no rate hikes until at least 2024. Chart 7The Market Expects Liftoff In Late 2022 The Market Expects Liftoff in Late 2022 The Market Expects Liftoff in Late 2022 While the Fed is likely to bring forward its dots during this month’s FOMC meeting, our US bond strategists still expect the revised dots to signal a later liftoff than what the market is pricing in. On balance, we expect the 10-year Treasury yield to finish the year at about 1.7% – broadly in line with market expectations – but to rise more than expected over a longer-term horizon of 2-to-5 years. Is Inflation A Short-Term Or Long-Term Risk? A sizeable gap has opened up between US 5-year and 10-year inflation breakevens (Chart 8). Investors believe that inflation will accelerate over the next few years but then settle down to a lower level by the middle of the decade.  We think the opposite is more likely to transpire. Economies can often operate above potential for a while before inflation expectations become unmoored. For example, in the 1960s, the unemployment rate spent over two years below NAIRU before inflation finally burst onto the scene. However, as the sixties also revealed, when inflation does rise, it can rise quickly. Core CPI inflation doubled within the span of nine months in 1966. Inflation continued rising all the way to 6% in 1969 (Chart 9). Chart 8Breakeven Curve Inversion Breakeven Curve Inversion Breakeven Curve Inversion Chart 9Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart   As we discussed in February, there are numerous similarities between the present environment and the mid-1960s. This suggests that inflation could surprise significantly to the upside in the middle of the decade, even if it is slow to get off the ground over the next few years. Remain Overweight Stocks Over A 12-Month Horizon Stocks usually rise when growth is strong and monetary policy is accommodative (Chart 10). While bond yields in the US and most other economies will trend higher, they will remain below their equilibrium level for at least the next two years. Chart 10Stocks Do Well When The Economy Does Well Stocks Do Well When The Economy Does Well Stocks Do Well When The Economy Does Well In fact, fiscal largesse may have boosted the US neutral rate of interest by more than bond yields have risen, implying that monetary policy has become more, not less, stimulative over the past few months. Historically, stocks have been able to shrug off rising bond yields, provided borrowing costs did not rise so high as to tip the economy into recession (Chart 11 and Table 1). Chart 11What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Mixed Picture For The US Dollar The OECD estimates that GDP in the rest of the world will receive a modest lift from US fiscal stimulus (Chart 12). Nevertheless, the US economy will be the primary beneficiary. This has important implications for the direction of the dollar. Chart 12The Benefits Of US Fiscal Stimulus Will Spill Over To Other Countries When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart The dollar is normally a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle. One key reason for this is that the US economy, with its relatively small manufacturing base and large service sector, is less cyclical than most other economies. Thus, when global growth rises, the US often lags behind. The pattern has been different this year, however. Chart 13 shows that growth expectations have risen more in the US than abroad. This is partly because US fiscal policy has been more stimulative than elsewhere. In addition, the US has been faster out of the gate in vaccinating its population (Chart 14). Chart 13US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US growth outperformance should support the greenback over the next few months. Nevertheless, we are not ready to abandon our bearish 12-month dollar view. For one thing, growth revisions should shift back in favor of other developed economies later this year as they catch up to the US in their vaccination campaigns. The prospect of negative fiscal thrust in 2022 due to the expiration of various stimulus measures will also weigh on the US growth outlook. Lastly, the Fed’s reticence to signal a tighter monetary stance will prevent US 2-year real yields – which are already quite low compared to other developed markets – from rising very much (Chart 15). We have found that shorter-dated yields help explain currency movements better than longer-dated yields. Chart 14US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders   Chart 15Real Rate Differentials Are A Headwind For The Dollar Real Rate Differentials Are A Headwind For The Dollar Real Rate Differentials Are A Headwind For The Dollar A modestly softer dollar should, in turn, support cyclical equity sectors and value stocks over the next 12 months.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Special Trade Recommendations When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart Current MacroQuant Model Scores When Good News Becomes Bad News In One Chart When Good News Becomes Bad News In One Chart

Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Rising US Real Yields Have Caused A Shakeout In EM Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral Investor Sentiment And Positioning In US Treasurys Are Neutral Investor Sentiment And Positioning In US Treasurys Are Neutral   Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Surging Purchases Of US Treasurys By The Fed And Commercial Banks Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar Investors Are Still Bearish On The US Dollar Investors Are Still Bearish On The US Dollar   From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5).  Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar US Real Yields (TIPS) Will Continue Driving The US Dollar US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows Aggregate Financial Market Volatility: Higher Lows Aggregate Financial Market Volatility: Higher Lows   Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January Investor Sentiment On EM Stocks Was At A Record High In January Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 US Markets Were Not Hit By The Taper Tantrum In 2013 US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Rising Corporate Bond Yields Are Bad For Share Prices Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Investors Are Record Long Commodities Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances Asian Currencies Hit Technical Resistances Asian Currencies Hit Technical Resistances   In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights UK Interest Rates: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Implications for Gilts & GBP: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Maintain below-benchmark duration on Gilts, while downgrading UK allocations within dedicated global fixed income portfolios to neutral. The pound has upside in this environment, especially if depressed UK productivity starts to recover. Feature Chart 1UK Real Yields: Deeply Negative Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? The UK has become one of the more peculiar corners of the global fixed income universe. The outright level of longer-term Gilt yields is in the middle of the pack among the major advanced economies. The story is much different, however, when breaking those nominal UK yields into the real and inflation expectations components. The deeply negative real yields on UK inflation-linked Gilts are the lowest among the majors, even in a world where sub-0% real yields are prevalent in most countries (Chart 1). The flipside of that deeply negative real yield is a high level of inflation expectations. The breakeven inflation rate derived from the difference between the nominal and real 10-year Gilt yields is 3.3%, the highest in the developed “linkers” universe. Inflation expectations in UK consumer surveys are at similar levels, well above the 2% inflation target of the Bank of England (BoE), suggesting little confidence in the central bank’s ability or willingness to hit its own inflation goals. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy and Foreign Exchange Strategy, we investigate why UK real interest rates have remained so persistently negative and assess the possibility of a shift in the low interest rate regime in a post-Brexit, post-pandemic UK – a move that could be quite bearish for UK fixed income markets and bullish for the British pound. Can The BoE Ignore Cyclical Upward Pressure On UK Bond Yields? The UK has suffered from a series of shocks, starting with the 2008 crisis, that have limited the ability of the BoE to attempt to tighten monetary policy. The 2011/12 European debt crisis hurt the UK’s most important trading partners, while the 2016 Brexit vote began a multi-year process of uncertainty over the future of those trading relationships. The COVID-19 pandemic is the latest shock, triggering a recession of historic proportions. The UK economy contracted by -10% in 2020, the largest decline since “The Great Frost” downturn of 1709. UK bond yields collapsed in response as the BoE cut rates to near-0% and reinforced that easy stance with aggressive quantitative easing and promises to keep rates unchanged over at the next few years. Today, UK financial markets are waking up to a world beyond the current COVID-19 lockdowns. The UK is running one of the world’s most successful vaccination rollouts, with 23 million jabs, or 35 per 100 people, already having been administered. UK Prime Minister Boris Johnson recently unveiled a bold plan to fully reopen the UK economy from the current severe lockdowns by mid-year. The UK government’s latest budget called for additional spending measures over the next year, including maintaining the work furlough scheme that has supported household incomes during the pandemic. As a result, UK growth expectations have exploded higher. According to the Bloomberg consensus economics survey, UK nominal GDP growth is expected to surge to 8.4% over calendar year 2021, an annual pace not seen since 1990 (Chart 2). Nominal Gilt yields have begun to reprice higher to reflect those surging growth expectations, with the 5-year/5-year forward Gilt yield climbing 67bps so far in 2021. Real Gilt yields are also moving higher with the 10-year inflation-linked Gilt climbing 38bps year to date, providing additional interest rate support that has fueled a surge in the pound versus the dollar (bottom panel). Our own BoE Monitor - containing growth, inflation and financial variables that typically lead to pressure on the central bank to adjust monetary policy – is signaling a reduced need for additional policy easing (Chart 3). The momentum of changes in longer-maturity UK Gilts and the trade-weighted UK currency index are usually correlated to the ebbs and flows of the BoE Monitor. The latest surge higher in yields and the currency suggests that the markets are anticipating the type of recovery that will put pressure on the BoE to tighten. Chart 2A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP Chart 3Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? It may take a while to see the BoE turn more hawkish, however. The BoE has become one of least active central banks in the world over the past decade. After the BoE cut its official policy interest rate, the Bank Rate, by 500bps during the 2008 financial crisis and 2009 recession, rates were kept in a range between 0.25% and 0.75% for ten consecutive years. The BoE cut rates aggressively in response to the COVID-19 pandemic, lowering the Bank Rate in March 2020 from 0.75% to 0.1%, where it still stands. The BoE has used quantitative easing (QE) and forward guidance to try and limit movements in bond yields whenever cyclical surges in inflation could have justified tighter monetary policy. That has led to an extended period of a negative BoE Bank Rate, something not seen since the inflationary 1970s (Chart 4). Back then, the BoE was lagging the surge in UK inflation, but still hiking nominal interest rates. Today, the central bank is keeping nominal rates near 0% with much lower levels of inflation. Chart 4Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Short-term interest rate markets are still pricing in a very slow response from the BoE to the current growth optimism. Only 36bps of rate hikes over the next two years are discounted in the UK overnight index swap (OIS) curve. This go-slow response is in line with the BoE’s guidance on future rate hikes which, similar to the language used by other central banks like the Fed, calls for no pre-emptive rate hikes before inflation has sustainably returned to the BoE target. That combination would be consistent with current forward market pricing on both short-term interest rates and inflation. Chart 5BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* In Chart 5, we show the real BoE Bank Rate, constructed by subtracting UK core CPI inflation from the Bank Rate. We also show a forward real rate calculated using the forward UK OIS and CPI swap curves. The market-implied path of the real Bank Rate shows very little change over the next decade, with the real Bank Rate expected to average around -2.5%. This is far below the estimates of a neutral UK real rate (or “r-star”) of just under 2%, as calculated by the New York Fed or recent academic studies. The neutral UK real rate has likely dipped because of the pandemic. The UK Office For Budget Responsibility (OBR) estimates that there has been a long-term “scarring” of the UK economy from COVID-19 through supply-side factors like weaker investment spending, lower productivity growth and diminished labor force participation – equal to three percentage points of the level of potential GDP.1 The BoE estimates a smaller “scarring” of 1.75 percentage points of potential output, but coming with a 6.5% reduction in the size of the UK capital stock. While these are significant reductions in the supply-side of the UK economy, they are not enough to account for the 4.5 percentage point difference between pre-pandemic estimates of the UK r-star and the market-implied path of the real BoE Bank Rate over the next decade. The implication is that the markets are not expecting the BoE to deviate from its strategy of doing very little with interest rates, even as growth recovers from the pandemic shock. That can be seen in the recent upturn in UK inflation expectations that is evident in both market-implied and survey-based measures. Chart 6UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation The 5-year/5-year forward UK CPI swap rate now sits at 3.6%, not far off the 3.3% level of 5-10 year consumer inflation expectations from the latest YouGov/Citigroup survey (Chart 6). The fact that inflation expectations can remain so elevated at a time when headline CPI inflation is struggling to avoid deflation is striking. This indicates a belief that the BoE will do very little in the future to stop a booming UK economy that is expected to put sustained downward pressure on the UK unemployment rate over the next few years (bottom panel). This is from a relatively low starting point of the unemployment rate given the massive government support programs that have limited the amount of pandemic-related layoffs over the past year. The BoE should have reasons to be more concerned about a resurgence of UK inflation. In its latest Monetary Policy Report, the BoE published estimates showing that the entire collapse in UK inflation in 2020 was attributable to weaker demand for goods and services – especially the latter (Chart 7). This suggests that UK inflation could rebound by a similar amount as the UK economy reopens from pandemic lockdowns. According to the UK OBR, 21% of UK household spending is on items described as “social consumption”, like restaurants and hotels (Chart 8). This is a much larger proportion than seen in other major developed economies (excluding Spain) and explains why consumer spending plunged so much more dramatically in the UK during 2020 than in other countries. Chart 7Only A Temporary Drag On UK Inflation From COVID-19 Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? Chart 8UK Households More Focused On “Social Consumption” Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? If the UK pandemic-related restrictions are eased as planned over the next few months, the potential for a sharp snapback in UK consumer spending is significant. The BoE estimates that UK households now have £125bn of “excess” savings thanks to government income support and reduced spending on discretionary items like dining out and vacations. This is the fuel to support a rapid recovery in consumption over the next 6-12 months, especially as personal income growth will get a boost as furloughed workers begin returning to work (Chart 9). Chart 9UK Economy On The Mend UK Economy On The Mend UK Economy On The Mend Chart 10Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending A similar argument can be made for investment spending – the BoE estimates that UK businesses have amassed £100bn pounds of excess cash, and the latest reading on the BoE’s Agents' Survey of UK firms shows a slight increase after months of decline (bottom panel). With a Brexit deal with the EU finally reached at the start of 2021, UK businesses can also look to increase investment spending that had been delayed because of the years of Brexit uncertainty. The UK economy is already getting a boost from a recovery in the housing market fueled by low interest rates, high household savings and improving consumer confidence. Mortgage approvals have soared to the highest level since 2007, while house prices are now expanding at a 6.4% annual rate (Chart 10). Add it all up, and the economic momentum in the UK is positive and likely to accelerate further in the coming months as a greater share of the population becomes vaccinated. The BoE’s dovish policy stance is likely to appear increasingly inappropriate relative to accelerating UK growth and inflation trends over the next several months. Thus, on a cyclical basis, UK bond yields, both nominal and real, have more upside potential even after the recent increase. Bottom Line: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Structural Forces Keeping UK Interest Rates Low Are Fading Looking beyond the cyclical drivers, the structural factors that have held down UK interest rates in recent years are also starting to fade. The supply side of the UK economy has suffered because of Brexit uncertainty. The OECD’s estimate of potential UK GDP growth fell from 1.75% in 2015 to 1.0% in 2020 (Chart 11). This was mostly due to declining productivity growth – a consequence of years of very weak business investment. The 5-year annualized growth rate of real UK investment spending fell to -3% in 2020, a contraction only matched during the past 30 years after the 1992 ERM crisis and 2008 financial crisis. That plunge in investment coincided with almost no growth in UK labor productivity over that same 5-year window. Chart 11The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment Slowing population growth also weighed on UK potential growth, slowing to the lowest level in 15 years in 2019 as immigration from EU countries to the UK fell sharply. COVID-19 also hurt immigration flows into the UK last year. The UK Office for National Statistics estimated that the non-UK born population in the UK fell by 2.7% between June 2019 and June 2020. Diminished potential GDP growth is a factor that would structurally reduce the equilibrium real UK interest rate. We are likely past the worst for that downward pressure on potential growth and real rates. Population growth should also stabilize as the UK borders open up again and pandemic travel restrictions are loosened. Measured productivity is already starting to see a cyclical recovery, while investment spending is likely to improve as cash-rich UK companies began to ramp up capital spending plans deferred by Brexit and COVID-19. While the process leading from faster investment spending into speedier productivity growth is typically slow, the key point is that the worst of downtrend is likely over. This is an important development that has implications for UK fixed income markets. When looking at an international comparison of real central bank policy rates within the developed economies, the UK has fallen into the grouping of countries with persistently negative policy rates, namely Japan, the euro area, Switzerland, Sweden and Norway (Chart 12). We have dubbed that group the “Secular Stagnation 5”, after the term made famous by former US Treasury Secretary Lawrence Summers describing a state where the “natural” real rate of interest (r-star) that equates savings with investment is structurally negative. Chart 12Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does the UK belong in the “Secular Stagnation 5”? As a way to assess this, we made some comparisons of selected UK data with the same data for those five countries. When looking at potential GDP growth and population growth, the UK sits right in the middle of the range of those growth rates for the five countries (Chart 13). UK productivity growth has underperformed the others recently but, prior to the 2016 Brexit shock, UK productivity was also in the middle of the Secular Stagnation 5 range. Chart 13Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Chart 14UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports On other measures, the UK is nothing like those other countries. The UK’s economy is far less geared towards exports and investment (Chart 14) and is more tilted towards consumer spending. That can be seen most clearly when looking at the data on savings/investment balances. The UK continuously runs a current account deficit, as opposed to the persistent surpluses seen in the Secular Stagnation 5 (Chart 15). Put another way, the UK is not a “surplus” country that saves more than it invests on a structural basis, a condition that typically depresses real interest rates. Chart 15The UK Is Not A Surplus Country The UK Is Not A Surplus Country The UK Is Not A Surplus Country Chart 16Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Based on these cross-country comparisons, it is unusual for the UK to have such persistently low real interest rates. This has implications for UK bond yields. Over the past few years, Gilts have been transitioning from a status as a “high yield beta” market – whose yield movements are more correlated to swings in the overall level of global bond yields. The lower beta markets are in countries like Germany, France and Japan – all members of the Secular Stagnation club (Chart 16). The UK does not appear to warrant a permanent membership in that low-yielding group, based on structural factors. That is evident when looking at how Gilt yields are rising even with the BoE absorbing an increasing share of the stock of outstanding Gilts (bottom panel). We conclude that the transition of the UK to a low-beta market is related to the Brexit uncertainty post 2016 and the pandemic shock that has hit the consumer-focused UK economy exceptionally hard – both factors that are set to fade over the next year. Bottom Line: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Investment Conclusions Chart 17Downgrade Gilts To Underweight Downgrade Gilts To Underweight Downgrade Gilts To Underweight Our assessment of the cyclical and structural drivers of UK interest rates leads us to the following conclusions on UK fixed income and currency strategy: Duration: Maintain a below-benchmark exposure to UK interest rate movements. Gilt yields will rise by more than is discounted in the forwards over the next 6-12 months (Chart 17), coming more through rising real yields as the UK economy continues its post-Brexit, post-pandemic recovery. Country Allocation: Downgrade strategic allocations to UK Gilts to neutral from overweight in dedicated fixed income portfolios. Our long-standing view that Brexit uncertainty would lead to the outperformance of Gilts versus other developed bond markets is no longer valid. It is still too soon to move to a full underweight stance on Gilts – a better opportunity will develop by mid-year once it is more evident that the current success on UK vaccinations leads to a faster reopening of the UK economy. Yield Curve: Maintain positioning for a bearish steepening of the UK Gilt yield curve. While there is limited scope for more steepening through an even larger increase in inflation breakevens from current elevated levels, the long end of the Gilt curve can move higher by more than the front end as the market re-rates Gilts to a higher-beta status with a higher future trajectory for UK interest rates. Corporate Credit: Downgrade UK investment grade corporate bond exposure to neutral from overweight in dedicated fixed income portfolios. UK corporate spreads have returned to the 2017 lows and, while an improving growth dynamic is not overly bearish for credit, there is no longer a compelling valuation-based case for staying overweight UK investment grade corporates. This move brings our recommended UK allocation in line with our neutral stance on US and euro area investment grade corporates. Chart 18GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis Chart 19Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Currency: A growth-driven path towards interest rate normalization should be positive for the British pound, which remains undervalued versus the US dollar on a purchasing power parity basis (Chart 18).2 A move to 1.45 on GBP/USD is possible within the next six months. A broader move towards pound strength will require an improvement in business investment, as the trade-weighted pound looks fairly valued on our productivity-based model (Chart 19). We do maintain our view that EUR/GBP can approach 0.80 by year-end based on a relatively stronger cyclical improvement in UK growth versus the euro area.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For further details on the OBR estimates of UK growth, inflation and fiscal policy, please see the March 2021 OBR Economic & Financial Outlook, which can be found here: https://obr.uk/ 2 Please see BCA Research Foreign Exchange Strategy Report, "Thoughts On The British Pound", dated December 18, 2020, available at fes.bcaresearch.com.

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact Bearish Trend Intact Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration No Panic From Powell No Panic From Powell This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators Cyclical & Valuation Indicators Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Financial Conditions Are Easy Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity Treasury Market Liquidity Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive Reserve Supply Is Massive Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios No Panic From Powell No Panic From Powell If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries.   In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Fed Created ON RRP In 2013... Fed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward.   Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date No Panic From Powell No Panic From Powell This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry No Panic From Powell No Panic From Powell Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The recent backup in bond yields could cause stocks to fall further in the near term. However, history suggests that as long as yields remain low in absolute terms, as they are now, equities will recover. Market angst that the Fed is about to turn more hawkish is unwarranted. Central banks around the world have both the tools and the inclination to keep bond yields from rising excessively. Despite the jump in bond yields, the forward earnings yield is 540 basis points above the real bond yield in the US. Outside the US, the forward earnings yield is 615 basis points above the real bond yield. In 2000, the earnings yield was below the real bond yield. Just as value stocks began to outperform growth stocks in mid-2000, the end of the pandemic will herald a similar period of value-oriented outperformance. Commodity producers and banks will lead the way. Some Parallels Between Today And 2000… Stock prices have buckled in recent weeks, raising concerns that global bourses are at risk of a major crash, just like they were in early 2000. There are certainly some notable similarities between 2000 and the present: In both cases, the preceding rise in stock prices was fueled by the Federal Reserve’s desire to prevent an exogenous shock from causing a major recession (Chart 1). Last year, the shock was the pandemic. In 1998, it was the collapse of Long-Term Capital Management (LTCM). The Connecticut-based hedge fund imploded shortly after Russia defaulted on its debt, leading to a gut-wrenching 22% decline in the S&P 500. The brewing crisis prompted the Fed to cut rates by a total of 75 basis points. Spurred on by fears of Y2K, the Fed also injected vast amounts of liquidity into the financial system. Tech stocks led the market higher both in the late 1990s and last year. The NASDAQ Composite rose 68% between its intra-day low in October 1998 and March 2000. In 2020, the NASDAQ outperformed the S&P 500 by 24% and returned 44% overall. Chart 1The NASDAQ's 1999 Surge Followed The 1998 “Insurance Cuts” And Coincided With The Fed’s Balance-Sheet Expansion The NASDAQ's 1999 Surge Followed The 1998 "Insurance Cuts" And Coincided With The Fed's Balance-Sheet Expansion The NASDAQ's 1999 Surge Followed The 1998 "Insurance Cuts" And Coincided With The Fed's Balance-Sheet Expansion Chart 2Low-Priced Stocks Have Been The Winners In The First Quarter Shades Of 2000 Shades Of 2000 The speculative mania in the 1990s spread from large-cap tech stocks to small-cap companies. We saw the same pattern earlier this year, with prices and trading volumes exploding among smaller, low-priced stocks (Chart 2). As was the case in the late 1990s, retail investors – this time armed with “stimmy” checks and access to zero-commission trading accounts – plowed into the market. Chart 3Some Pockets Of Bullish Equity Sentiment Shades Of 2000 Shades Of 2000 Chart 4Some Pockets Of Bullish Equity Sentiment Shades Of 2000 Shades Of 2000 Bullish equity investor sentiment was rampant at the peak of the stock market in 2000. Although not quite to the same extent as back then, most measures of investor sentiment turned bullish prior to the recent selloff (Chart 3). Like most investors, analysts were wildly optimistic on stocks in the late 1990s (Chart 4). Long-term earnings growth projections are very optimistic today, a potentially ominous signal given that (unlike in the late 1990s), productivity growth is now more anemic. Rising stock prices in the late 1990s allowed corporate insiders to cash in their options, while enabling new companies to go public. Recently, we have seen a flurry of companies list their shares, in some cases through dubious SPAC vehicles (Chart 5). Valuations reached nosebleed levels in 2000. While the forward P/E ratio on the S&P 500 is somewhat below its 2000 peak, other valuation measures such as price-to-sales, Tobin’s Q, and enterprise value-to-EBITDA are above where they were in 2000 (Chart 6). Chart 5Renewed Interest In Listing Stocks Shades Of 2000 Shades Of 2000 Chart 6Stretched Valuations, Then And Now Shades Of 2000 Shades Of 2000 … But One Important Difference Despite the parallels between today and 2000, there is an important difference: The Federal Reserve. Having cut rates in 1998, the Fed reversed course in mid-1999, eventually taking the fed funds rate up to 6.5% in May 2000. The yield curve inverted in February of that year, shortly after the 10-year yield reached a high of 6.79%. Chart 7What Happens To Equities When Treasury Yields Rise? Shades Of 2000 Shades Of 2000 Bond yields have risen briskly over the past six months. However, they remain very low in absolute terms. While rising yields can produce a temporary stock market correction, they need to move into restrictive territory in order to trigger a recession and an accompanying bear market in equities. Chart 7 highlights some research that Garry Evans and BCA’s Global Asset Allocation team recently produced. It shows eight episodes since 1990 of a sharp rise in the 10-year Treasury yield. On every occasion (except in 1993-94, when the Fed unexpectedly raised rates in February 1994), equities performed strongly while rates were rising (Table 1). Today, the forward earnings yield on the S&P 500 is 540 basis points above the real yield. In 2000, the real bond yield was higher than the earnings yield (Chart 8). The gap between earnings yields and real bond yields is even greater outside the US, where valuations are generally more attractive. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 21% in real terms for equities to underperform bonds. Many other stock markets would have to decline by more than that (Chart 9). Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover Shades Of 2000 Shades Of 2000 Chart 8Relative To Bonds, Stocks Are More Favorably Valued Now Than in 2000 Relative Valuations Favor Equities Relative Valuations Favor Equities Chart 9Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Central Banks Will Lean Against Rising Bond Yields Stocks sold off earlier today on the perception that Jay Powell had failed to push back forcefully against the recent increase in bond yields. We think this angst is unwarranted. As Powell noted, most of the rise in bond yields reflected economic optimism. If yields were to continue rising in the absence of further economic improvements, the Fed would dial up the rhetoric, stressing its ability to buy bonds in unlimited quantities in order to support the economy. Despite all the fiscal stimulus, the unemployment rate remains elevated – perhaps as high as 10% according to some Fed measures. The prime-age employment-to-population ratio is four percentage points below where it was before the pandemic (Chart 10). Moreover, many stimulus measures will expire towards the end of the year. With the prospect of a “fiscal cliff” in 2022, we expect the Fed to want to tread carefully in withdrawing monetary support. What would really rattle investors is if long-term inflation expectations were to rise above the Fed’s comfort zone. However, considering the 5-year/5-year forward inflation breakevens are still below where they were in 2012-13, this is not an imminent risk (Chart 11). Chart 10The Fed Will Remain Accommodative To Aid The Labor Market Recovery The Fed Will Remain Accommodative To Aid The Labor Market Recovery The Fed Will Remain Accommodative To Aid The Labor Market Recovery Chart 11Inflation Expectations Have Recovered But Are Still Low Shades Of 2000 Shades Of 2000 Like the Fed, the ECB wants to keep financial conditions highly accommodative. On Tuesday, ECB Executive Board member Fabio Panetta, echoing comments made by other senior ECB officials, said that higher yields were “unwelcome and must be resisted.” He noted that “We are already seeing undesirable contagion from rising US yields into the euro area yield curve,” adding that the ECB “should not hesitate” to increase the pace of bond purchases. The ECB’s threat is credible. Already, its purchases have deviated significantly from its capital key, revealing Frankfurt’s willingness to act where and when it is needed. In the same spirit, the Reserve Bank of Australia boosted its government bond purchases earlier this week after the 10-year yield backed up from 0.7% last October to over 1.9% late last week. The RBA also reaffirmed its intent to maintain the current 3-year Yield Curve Control target at 0.1%, stating that “The Board will not increase the cash rate until actual inflation is sustainably within the 2-to-3 percent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.” The RBA’s determination to keep bond yields down is noteworthy given that the neutral rate of interest is higher in Australia than in most other developed economies.1  If the RBA does not intend to raise rates for the next three years, it may take even longer for other central banks to take away the punch bowl. Will Value Stocks Begin To Outperform As They Did Starting In Mid-2000? There is another potential parallel with 2000 that is worth mentioning. This was the year that the outperformance of growth stocks came to a halt and value stocks began to shine. In fact, outside of the tech sector, the S&P 500 did not peak until May 2001 (Chart 12). Value continued to outperform right through to 2007. Since February 12th of this year, the price of the highly liquid Vanguard Growth ETF (VUG, market cap of $143 billion) has fallen by 8.9% while the price of the Vanguard Value ETF (VTV, market cap of $97 billion) has risen 0.5%. Despite the nascent outperformance of value names, they still remain relatively cheap. According to a simple valuation measure that combines price-to-earnings, price-to-book, and dividend yields, value stocks are more than three standard deviations cheap relative to growth stocks – a bigger valuation gap than seen at the height of the dotcom bubble (Chart 13). Chart 12The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst Chart 13The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Outlook For Commodity Stocks And Bank Shares Commodity producers are overrepresented in value indices. Strong global growth against a backdrop of tight supply should heat up the commodity complex over the next 12-to-18 months. Chart 14 shows that capital investment in the oil and gas sector has fallen by more than 50% since 2014. BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects crude oil demand to outstrip supply over the remainder of this year (Chart 15). Chart 14Oil + Gas Capex Collapses In COVID-19’s Wake Shades Of 2000 Shades Of 2000 Chart 15Crude Oil Demand To Outstrip Supply Over The Remainder Of This Year Shades Of 2000 Shades Of 2000 A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Charts 16A & 16B). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, a big slug of demand in a market that consumes about 26mm tonnes per year. Chart 16ACopper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Chart 16B...As Will Aluminum ...As Will Aluminum ...As Will Aluminum Ongoing strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 17). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Chart 17China Keeps Buying More And More Commodities Chinese Consumption Of Most Metals Continues To Rise China Keeps Buying More And More Commodities Chinese Consumption Of Most Metals Continues To Rise China Keeps Buying More And More Commodities Chart 18Credit Growth Has Been Recovering Credit Growth Has Been Recovering Credit Growth Has Been Recovering Along with commodity producers, financials helped propel value indices during the 2000s. While credit growth is unlikely to revert to its pre-GFC days, it has been trending higher in both the US and Europe (Chart 18).   Analysts are starting to take note of improving bank earnings prospects. EPS estimates for banks are rising more quickly than for tech companies on both sides of the Atlantic (Chart 19). Not only is the “E” in the P/E ratio for banks likely to rise, the ratio itself will increase. Currently, US and European banks are trading at 14 and 10-times forward earnings, respectively, a huge discount to the broad market in general, and tech stocks in particular (Chart 20).  Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) Chart 20Banks Are Cheap Banks Are Cheap Banks Are Cheap   Bottom Line: Despite near-term uncertainty, investors should overweight stocks on a 12-month horizon, while pivoting away from last year’s winners (growth stocks) towards last year’s losers (value stocks).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  According to RBA’s estimates, the neutral rate of interest in Australia is at the high end of developed market estimates. Specifically, Australia’s R-star is higher than the average of the US and euro area R-stars and is slightly lower than the average of the Canadian and UK neutral rates. Global Investment Strategy View Matrix Shades Of 2000 Shades Of 2000 Special Trade Recommendations Shades Of 2000 Shades Of 2000 Current MacroQuant Model Scores Shades Of 2000 Shades Of 2000

Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered.  Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020.  The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed.  Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen A Healthy Reset In The Yen A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold USD/JPY Support Should Hold USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar.  Therefore, a market reset is also positive for the yen.     Housekeeping Chart I-5Remain Short AUD/MXN Remain Short AUD/MXN Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January.   The DXY index rose by 165 bps this week.  The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3%  quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on  procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion  in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights China’s primary vulnerabilities over the past decade have been, and remain, credit/money excesses and a misallocation of capital. China’s advantage has not been its banking system or monetary policy’s "magic touch," but its ability to continuously raise productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. As long as solid productivity gains persist, the economy will absorb excesses over time and remain structurally sound. Feature China’s credit and fiscal stimulus has peaked and will roll over significantly in 2021. Hence, the question now is: what will be the extent of the economic slowdown? The magnitude of the growth slowdown depends not only on the pace and extent of credit and fiscal tightening but also on the structural health of the economy. In a structurally sound economy, the end of a credit and fiscal stimulus does not produce a sharp and extended slowdown. Conversely, in an economy saddled with structural malaises, modest policy tightening could produce a dramatic or prolonged business cycle downtrend. Two examples from China’s not-so-distant past are the credit tightening in 2004 and policy tightening in 2013-14. After the acute credit tightening in 2004 and the ensuing loan slowdown, China’s growth moderated briefly but remained robust and, in fact, reaccelerated in 2005 (Chart 1, top panel). However, following the 2013-14 policy tightening episode, China’s industrial sector experienced an extended downtrend (Chart 2, top panel). Chart 1China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening Chart 2China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening   Consistently, China-related plays in financial markets experienced only a brief and short-lived shakeout in 2004 and resumed their bull market within a short time span (Chart 1, bottom panel). But in 2013-15, China-plays experienced a deep and extended bear market (Chart 2, bottom panel). In this report, we assess the structural health of the mainland economy. “Soft-Budget” Constraints And Capital Misallocation China’s primary vulnerabilities over the past decade have been, and remain, credit excesses and a misallocation of capital. Loose credit and fiscal policies – “soft-budget” constraints – starting in 2009 fueled money creation on a grand scale, causing corporate and household debt to mushroom. This has massively inflated property prices and led to capital misallocation. Many of these excesses have by and large lingered. In particular: Broad money supply in China has surged 4.7-fold since January 2009 (Chart 3, top panel). This is significantly above the 2.3-fold increase in the US, and the 1.6-fold rise in the euro area and in Japan. Chart 3Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Not only has broad money supply skyrocketed in China by much more than in other economies, but it has also risen by much more relative to its own nominal GDP (Chart 3, middle panel). Since January 2009, as unorthodox monetary policies gained traction around the world, the broad money-to-GDP ratio has risen by 80 percentage points in China, 35-percentage points in the US, 25-percentage points in the euro area and 70-percentage points in Japan.     Chart 4China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far Notably, China’s broad money-to-GDP ratio is the highest in the world, as illustrated in the middle panel of Chart 3. Finally, the absolute amount of broad money – all types of local currency deposits and cash in circulation converted into dollars to make numbers comparable – now stands at $40 trillion in China, $18 trillion in the US and the euro area each and $11 trillion in Japan (Chart 3, bottom panel). In brief, China’s money (RMB) supply is greater than the sum of money supply in the US and euro area. China’s domestic credit growth has been outpacing nominal GDP growth since 2008 (Chart 4, top panel). Consequently, its domestic credit-to-GDP ratio is making new highs (Chart 4, bottom panel). A continuously rising domestic debt-to-GDP ratio indicates that the nation has not really deleveraged in the past ten years. Concerning debt structure, local and central government debt stands at 61% of GDP, enterprise (including SOE) debt represents 162% of GDP and household debt is 61% of GDP. Notably, enterprise debt is the highest in the world, as illustrated in Chart 5.  This chart shows a decline in China’s corporate credit-to-GDP ratio from 2016 to 2018. The drop, however, is due to the Local Government Financing Vehicles (LGFV) debt swap. Authorities simply moved debt from LGFV balance sheets to local governments, which represents an accounting reshuffle and not genuine deleveraging. Meanwhile, households in China are as leveraged as those in the US (Chart 6) when debt-to-disposable income ratios are compared. The latter is how consumer debt is measured in all countries around the world. Chart 5Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chart 6Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chart 7Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Finally, the true indicator of debt stress is the debt-service ratio. The Bank for International Settlements (BIS) estimates that the debt-service ratio for Chinese enterprises and households is above 20% of income. The same ratio for the US rolled over at 18% in 2007 during the credit crisis (Chart 7). There are several symptoms consistent with pervasive capital misallocation. First, return on assets (RoA) for non-financial onshore listed companies has dropped to an 20-year low (Chart 8, top panel). Companies have raised substantial capital to invest but the return on investment has been disappointing, resulting in a falling RoA. Second, a falling output-to-capital ratio – an inverse analog of a rising incremental capital-to-output ratio (ICOR) – also indicates capital misallocation and falling efficiency (Chart 9). Chart 8Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Chart 9Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling   Falling return on capital is the natural outcome of too much investment. It is simply impossible to invest more than 40% of GDP every year over a 20-year period without capital misallocation. It has become difficult to find profitable projects, especially as China’s economy is no longer as underinvested as it was 20 years ago. Falling efficiency ultimately entails lower productivity and, eventually, declining potential real GDP growth. Has China Deleveraged? Following such an epic credit boom, one would typically expect creditors in general and banks in particular to undertake profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold - RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, banks have not yet sufficiently cleansed their balance sheets. Not surprisingly, their share prices have been among the worst performers in the Chinese equity universe and in the EM space more generally. Overall, the Chinese economy was very healthy and was on an extremely solid foundation until the credit boom (“soft-budget” constraints) began in 2009. Since then, the economic model has bred inefficiencies which could weigh on growth going forward. One widely circulated counterargument against the thesis of excessive credit/money growth in China has been that Chinese households save a lot. As the argument goes, this is what has prompted banks to lend out those deposits. This analysis is incorrect, and we have written extensively about this topic in a series of reports that are available upon request. The interaction between money creation, credit and savings is outside the scope of this report. We therefore limit the discussion to the key inferences from the series of reports we published: National savings, including household savings, do not create money supply or deposits. Also, banks do not lend out deposits. Money/deposits are created by commercial banks when they make loans to, or buy assets from, non-banks. This is true for any economy in the world. Chart 10Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s We agree that Chinese households do have a high savings rate. However, their savings do not impact whether banks originate loans and create deposits, i.e., expand money supply. To expand their balance sheets, banks require liquidity/excess reserves, not deposits. In short, the enormous money supply in China has been an outcome of reckless behavior on the part of banks and borrowers rather than originating out of household or national savings. As such, at the current levels, Chinese money and credit represent major excesses and, thereby, pose risks to financial stability and long-term development. A pertinent question is as follows: Is there an economy that did not experience a credit crisis following a credit bubble? Japan is one example. Yet, Japan suffered from deleveraging. The top panel of Chart 10 demonstrates that bank loan growth peaked at 12% in 1990 and gradually slowed thereafter, ultimately contracting. The bottom panel of Chart 10 shows that Japan’s companies and households underwent gradual deleveraging beginning in the mid-1990s. Such a long lasting but gradual adjustment contrasts with the acute and sharp crisis that occurred in the US in 2007-08. To sum up, credit excesses do not need to culminate in a credit crisis; Japan being the primary example. However, it is unusual for the non-public debt-to-GDP ratio to continuously rise from already elevated levels. In brief, China has seen its money and credit excesses rise continually and the problem has yet to be addressed. Other Structural Headwinds Chart 11China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed The Chinese economy is facing other structural headwinds: First, the oft-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85% – i.e., 85% of jobs in China are already in non-agricultural sectors (Chart 11). This entails a slower rate of industrialization and urbanization going forward. Second, the labor force is shrinking. This is a major drag on the nation’s potential real GDP growth rate – which is equal to the sum of productivity growth and labor force growth. In turn, productivity growth is estimated to have slowed down to about 6% with total factor productivity growth slipping to 2% (Chart 8, bottom panel, above). Chart 12Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending As we discussed in our recent Special Report A Primer On Productivity, productivity is the most important variable for any country’s long-term development and 6% is still a very high number. The challenge for China in the coming years is to prevent its productivity growth rate from dropping below 4.5-5%. Third, there is a misconception about what rebalancing really means for this economy. Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10.3% in real terms from 1998 until 2020 (pandemic) (Chart 12, top panel). Hence, the imbalance in China has not been sluggish consumer spending, which has actually been booming for the past 20 years. Rather, capital expenditure has been too strong for too long (Chart 12, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending decelerates? Our hunch is that this is unlikely. The basis is that investment outlays account for more than 40% of GDP and create many jobs and income, which in turn feeds into consumer spending. A meaningful downshift in capital expenditures will produce lower household income growth, resulting in a moderation in consumer spending growth. Bottom Line: Maturing industrialization, a shrinking labor force and an imperative to slow capital spending all constitute formidable headwinds to China’s secular growth outlook. China’s Advantage: What Makes It Distinct  Chart 13China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem Although all of the above structural drawbacks have persisted for the past ten years, the Chinese economy (1) has not experienced a credit crisis; and (2) has not seen an inflation outbreak despite burgeoning money supply. The question is: why? Concerning the credit excesses and the property bubble, China has avoided a credit crisis because its banking system has shown extreme forbearance towards debtors, i.e., banks have not forced corporate restructuring when companies were unable to service their debt. Besides, authorities – being fully aware of the risk of financial instability – have been lenient towards banks and debtors, tolerating continued credit overflow and rising credit excesses. The domestic credit growth rate has never dropped below nominal GDP growth (Chart 4 above). Rather, it has remained above 10% – despite several episodes of policy tightening and deleveraging campaigns. Authorities in any country with effective control over banks could do this. However, many economies with such a rampant money/credit boom would exhibit very high inflation. Yet, inflation in China has been absent (Chart 13). Critically, China’s advantage over other nations has not been its banking system or its monetary policy’s "magic touch" but its ability to continuously grow productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. The lack of inflation in China amid the credit and money boom is critical to understanding the unique structure and character of its economy. We have the following considerations: First, rampant money growth is typically associated with higher inflation because of the presumption that new money creation stimulates the demand for, but not the supply of goods and services. This is presently the case in the US where monetarization of public debt and fiscal transfers to households are boosting demand but not the potential productive capacity. However, in China’s case, credit flow to enterprises has always dwarfed credit to consumers. This means that the lion’s share of credit origination/money creation has been going directly into capital spending. Investment expenditures have led to rapid expansion of production capacity in the majority of industries. As a result, output has exceeded demand, resulting in an oversupply of goods and services and ultimately, in falling prices. Chart 14A and 14B illustrate that production capacity in many sectors in China has exploded over the past 20 years. In many industries, production capacity and output have expanded more than 10-fold since 2000. The outcome has been chronic deflation in many goods (Chart 15). Chart 14AProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Chart 14BProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries   In short, too much credit/money channeled into expanding production capacity could lead to deflation. Second, when banks make new loans/create new money, inflation occurs in goods/commodities that money is used to purchase. Those goods/commodities experienced periods of high price inflation during money/credit growth acceleration. For example, China’s credit/money growth impulse explains swings in commodities prices (Chart 16). Hence, the link between credit/money and certain goods/commodities prices has held up. Chart 15Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Chart 16Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals   Finally, the application of digital technologies in service sectors has kept a lid on service price inflation. Hence, China has benefited from productivity-enabled disinflation despite the ongoing money/credit boom. That said, there are also areas where there has been rampant inflation. These include land, housing and high-end services. On the whole, deflation in goods prices due to oversupply has overwhelmed the pockets of high inflation in services. Crucially, unit labor costs in both the industrial economy (secondary industry) and service sectors have been contained as strong wage growth has been offset by robust productivity gains (Chart 17). The following factors have enabled high productivity growth in China: Chinese people are genuinely entrepreneurial, hardworking and disciplined. Educational attainment has been rising and innovation has proliferated. China has closed the gap in all patents with the US (Chart 18, top panel). It has actually surpassed the US in the number of semiconductor patents (Chart 18, bottom panel). Chart 17Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Chart 18China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub Chart 19China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale Our report from June 24, 2020 has elucidated the nation’s innovation drive. Rising spending on research and development will ensure China’s continued ascent as a major global innovation hub. Consistent with rising productivity, China’s share in global trade continues to rise. China is aggressively implementing automation in many of its industries, replacing labor with robotics. Specifically, the number employees in the industrial sector has been falling while production of industrial robots - and presumably, demand for them - has surged (Chart 19). The outcome will be continued rapid productivity gains which will allow companies to keep a lid on costs and secure reasonable profit margins without resorting to price hikes. What could cause productivity growth to slow? The main risk is complacency associated with easy credit and recurring fiscal stimulus, i.e., “soft-budget constraints”. If zombie companies continue to enjoy easy access to financing and are not forced to restructure and become more efficient, the pace of productivity gains will decelerate with negative consequences for potential GDP growth and inflation. In such a case, the credit system’s forbearance towards enterprises that misallocate capital will continue channeling money to projects with low efficiency. The latter will increase the supply of goods and services that are not demanded. This will produce pockets of short-term deflation but will lay the foundation for higher inflation down the road.1  Bottom Line: China’s unique advantage has been its ability to avoid inflation despite the money/credit boom. Using a large share of credit to expand production capacity – rather than consumption – has been the key to maintaining low inflation. The latter has allowed policymakers to avoid material tightening policy and has kept the currency competitive.  In brief, the nation has been able to maintain reasonably high productivity gains, albeit slower relative to pre-2010. As long as productivity grows at a solid rate, the economy will over time absorb excesses with moderate pain/setbacks and will do well structurally. Investment Considerations Appreciating the long-term negative ramifications of “soft-budget” constraints, Chinese policymakers have embarked on another tightening campaign since last summer. This policy stance will continue, and the economy is now facing triple tightening: Monetary and fiscal tightening: The total social financing and our broad money (M3) impulses have already rolled over (Chart 16 above). Fiscal policy will also tighten relative to the unprecedented stimulus of last year. Regulatory tightening on banks and non-bank financial institutions: Authorities are planning to reinforce asset management regulation by the end of this year. This will limit how much these financial institutions can expand their balance sheets reinforcing a credit slowdown. Property market tightening: Restrictions on both property purchases and property developers’ leverage will lead to a notable slump in real estate construction. Chart 20Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks As China’s credit-sensitive sectors – construction and infrastructure spending – slow down this year, the risk-reward for industrial commodities and other China-plays worldwide is poor. Regarding Chinese stocks, Chinese A-shares will begin outperforming Chinese Investable stocks (Chart 20). We recommend the following strategy: long A shares / short China investable stocks. The primary reason is that the A-share index is heavy in value stocks while the MSCI China investable index has a large weight in expensive new economy stocks. The global investment backdrop has shifted in favor of global value versus global growth stocks due to strong US growth and rising US bond yields. Also, there has been more rampant speculation in global stocks that affect Chinese investable stocks more than onshore equities. Notably, the Composite A-share large and A-share small cap indexes have not performed well since July while investable stocks had been surging until recently. As to the exchange rate, the RMB is overbought and will likely experience a setback as the US dollar rebounds. However, the yuan’s long-term outlook versus the US dollar depends on the relative productivity growth. As long as the productivity growth differential between China and the US does not narrow, the RMB will appreciate versus the dollar on a structural basis. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Deflation can turn into inflation when the economy produces goods/services that are not demanded (type A goods) and not producing the ones that are in demand (type B goods). As a result, prices of type A goods will deflate often overwhelming inflation type B goods keeping overall inflation very low. Consequently, production of type-A goods will halt because plunging prices will discourage output. As a result, deflation will abate in the economy. If the economy still cannot produce type-B goods – the ones in demand, inflation will become prevalent.