Europe

Highlights Sweden’s economic recovery is robust and will deepen. Policy is accommodative. Very few advanced economies will benefit as much from the global economic rebound. The labor market will tighten, capacity utilization will increase, and inflation will rise faster than the Riksbank forecasts. On a one- to two-year investment horizon, the SEK is a buy against both the USD and the EUR. Despite their pronounced outperformance, Swedish stocks possess significantly more upside against both Eurozone and US equities over the remainder of the cycle. Swedish industrials will beat their competitors in both these markets. Nonetheless, China’s policy tightening creates a meaningful tactical risk, which selling Norwegian stocks can hedge. Italy’s fiscal plan constitutes a new salvo in Europe’s efforts to avoid last decade’s mistakes. Feature Last week, the Swedish Riksbank did not follow in the footsteps of the Norges Bank. The Swedish central bank acknowledged that the economy is performing better than anticipated and that the housing market is gaining in strength; yet, it refrained from hinting at any forthcoming adjustment to its policy rate or the pace of its asset purchase program. The positive outlook for the Swedish economy will force the Riksbank to tighten policy significantly before the ECB. As a result, we expect the Swedish Krona to outperform the euro and the US dollar. Moreover, investors should continue to overweight Swedish equities due to their large exposure to industrials and financials, even if they have already significantly outperformed the Euro Area. Sweden’s Economic Outlook The Swedish economy will accelerate, which will put pressure on resource utilization and fan inflationary risk in the years ahead. The degree of stimulus supporting Sweden is consequential. Chart 1A Dual Labor Market On the fiscal front, the government support measures that have been announced since the beginning of the COVID-19 crisis currently amount to SEK420bn, or SEK197bn for 2020 (4% of GDP), and SEK223bn for 2021 (4.5% of GDP). Moreover, generous labor market protection and part-time employment schemes meant that the number of employees in permanent employment contracts remained stable during the pandemic (Chart 1). Thus, the bulk of the rise in Swedish unemployment came from workers on fixed-term contracts. Monetary policy remains very accommodative as well. The Riksbank left its repo rate unchanged at 0% through the crisis, but cut its lending rate from 0.75% to 0.1%. More importantly, the Swedish central bank is aggressively injecting liquidity into the economy. It set up a SEK500bn funding-for-lending facility in order to incentivize bank lending to the nonfinancial private sector, and started a SEK700bn QE program, which as of Q1 2021 had purchased SEK380bn securities and which will purchase another SEK120bn in Q2, with covered bonds issued by banks accounting for 70% of it. As a result, the amount of securities held on the Riksbank balance sheet will nearly triple by year end (Chart 2). Chart 2The Riksbank Is Open For Business Beyond the monetary and fiscal stimulus, many factors point to greater economic strength for Sweden. Despite a slow start to the process, as of last week, nearly 30% of the Swedish population had received at least one vaccine dose, which is broadly in line with vaccination rates prevalent in France or Germany. Crucially, the pace of vaccination is accelerating at a rate of 13% per week. Even if this second derivative slows, more than 70% of the population will have received at least one dose by this summer. Thus, greater mobility is in the cards during the second quarter, which will boost household spending. Chart 3The Wealth Effect The housing market also favors a pick-up in consumption. The HOX housing price index is growing at a 15% annual rate, its fastest expansion in over 5 years. As a result of the wealth effect, this rapid appreciation is consistent with a swift improvement in the growth rate of household expenditures (Chart 3). Moreover, spending on durable goods now stands 1.3% above its pre-pandemic levels, while spending on non-durables is back to pre-pandemic levels. This context suggests that increased mobility translates into greater spending. The industrial sector remains a particularly bright spot in the Swedish economy. Sweden is extremely sensitive to the global industrial and trade cycle, because exports represent 45% of GDP. Moreover, the highly cyclical intermediate and capital goods comprise 56% of the country’s foreign shipments, which accentuates the beta of the Swedish economy. BCA Research remains optimistic about the global industrial cycle. Sweden will reap a significant dividend. Already the Swedish PMI points to stronger industrial production, and the index’s exports component is roaring ahead (Chart 4). The potential for a greater uptake in consumption, capex, and durable goods spending in the rest of the EU (Sweden’s largest trading partner) bodes well for the Swedish manufacturing sector. Additionally, if the collapse in the US inventory-to-sales ratio is any indication for the rest of the world, a global restocking cycle is forthcoming, which will further boost Swedish industrial activity (Chart 4, bottom panels). Finally, global public infrastructure plans are on the rise, which will also help Sweden. Chart 4Sweden Is well Placed Chart 5Brightening Labor Market Prospects In this context, the Swedish labor market should tighten significantly in the approaching quarters. Already, job vacancies are rebounding, and redundancy notices have normalized, which matches both the GDP growth surprise in Q1 and the continued rise in the NIER Sweden Economic Tendency Indicator. Furthermore, the employment component of the PMIs stands at 58.9 and is consistent with a sharp improvement in job growth over the coming year (Chart 5). The expected labor market growth will contribute to an increase in capacity utilization, which will place upward pressure on wages and inflation. When the 12-month moving average of US and Eurozone imports rises, so does the Riksbank Resource Utilization Indicator, because global trade has such a pronounced effect on the Swedish economy (Chart 6). Meanwhile, greater resource utilization leads to accelerated inflation, greater labor shortages, and rising unit labor costs (Chart 7).  Chart 6CAPU Will Rise Chart 7The Coming Pressure Buildup Bottom Line: As a result of generous stimulus and the global economic recovery, the Swedish economy is set to continue its rebound. Consequently, employment and capacity utilization will improve meaningfully, which will lead to a resurgence of inflation and wages in the coming 24 months. Investment Implications On a 12 to 24 months horizon, we remain positive on the Swedish krona and Swedish equities. Fixed Income And FX Chart 8Three Hikes By 2025 The backend of the Swedish OIS curve only discounts 75bps of hikes by 2025. This pricing is too modest (Chart 8). The Swedish economy will rebound further as the vaccination campaign advances, and rising house prices and household indebtedness will fan growing long-term risk to financial stability, both of which suggest that the Riksbank will have to change its tack in 2022. The great likelihood that the Fed will start tapering off its asset purchase toward the end this year, that the ECB will follow sometime in 2022, and that the Norges Bank will be increasing interest rates next year will give more leeway to the Swedish central bank. A wider Sweden/Germany 10-year government bond spread is not an appealing vehicle to play a more hawkish Riksbank down the road. This spread hit a 23-year high in March and now rests at 62bps or its 98th percentile since 2000. Moreover, the terminal rate proxy embedded in the German money market curve is currently so low that the spread between Sweden’s and the Eurozone’s terminal rate proxy stands near a record high. Hence, German yields already embed much more pessimism than Swedish ones. Nonetheless, BCA recommends a below benchmark duration exposure within the Swedish fixed-income space, as we do for other government bond markets around the world.1 A bullish bias toward the SEK is a bet on the Riksbank that offers a very appealing risk/reward ratio, according to BCA Research’s Foreign Exchange Strategy strategists.2 The krona is very cheap against both the euro and the US dollar, trading at 9% and 29% discounts to purchasing power parity, respectively. Moreover, the Swedish current account stands at 5.2% of GDP, compared to 2.3% and -3.1% for the Euro Area and the US, creating a natural underpinning under the SEK. Chart 9The SEK Loves Growth Over the coming 12 to 24 months, cyclical forces favor selling EUR/SEK and USD/SEK on any strength. The SEK is one of the most cyclical G-10 currencies and has one of the strongest sensitivities to the US dollar. Hence, our positive global economic outlook and our FX strategists negative view on the greenback are synonymous with a weak USD/SEK. These same factors also mean that the krona will appreciate more than the euro, as the negative correlation between EUR/SEK and our Boom/Bust Indicator and global earnings growth illustrate (Chart 9). Equities We also like Swedish equities, but the state of the Swedish economy and the evolution of the Riksbank policy surprise have a limited impact on Swedish equities. The Swedish bourse is mostly about the evolution of the global business cycle. The Swedish benchmark heightened sensitivity to the global business cycle reflects its massive overweight in deep cyclicals, with industrials, financials, consumer discretionary, and materials accounting for 38.4%, 26.1%, 9.7% and 3.7% of the MSCI index respectively, or 78% altogether (Table 1). As a result, BCA’s preference for global cyclicals at the expense of defensives and this publication’s fondness for the recovery laggards like the industrial and financial sectors automatically translate into a favorable bias toward Sweden’s stocks.3 Table 1Mamma Mia! That’s A Lot Of Cyclicals Valuations offer a more complex picture, but they do not diminish our predilection for Sweden. Swedish equities trade at a discount to US stocks but at a premium to Euro Area ones (Chart 10). However, Swedish stocks offer higher RoEs and profit margins than both the US and the Euro Area, while also sporting lower leverage (Chart 11). Thus, their valuation premium to Euro Area stocks is warranted and their discount to US ones is excessive, especially when rising yields hurt the relative performance of the growth stocks that dominate US indexes. Chart 10Swedish Discounts And Premia Chart 11Profitable Sweden The outlook for Swedish earnings is appealing, both in absolute and relative terms. The Swedish market’s extreme sensitivity to global economic activity means that Sweden’s EPS increase and beat US profits when the Riksbank Resource Utilization Indicator expands (Chart 12). These relationships are artefacts of the Swedish economy’s pro-cyclicality, which causes capacity utilization to interweave tightly with the global business cycle (Chart 6). Chart 12The Winner Takes It All Chart 13Better Capex Play Than You Global capex and infrastructure spending favor Swedish equities compared to Euro Area ones. Over the past thirty years, Sweden’s stocks have outperformed those of the Eurozone when capital goods orders in the advanced economies have expanded (Chart 13). This reflects the Swedish benchmark’s large overweight in industrials, a sector that is the prime beneficiary of global capex. Capital goods orders are recovering well, and their growth rate can climb higher, especially as western multinationals announce capex plans and as governments from the US to Italy intend to ramp up infrastructure spending. Moreover, the large pent-up demand for durable goods in the Eurozone further enhances the potential of industrial firms, and thus, of Swedish equities.4  Chart 14Another Sign Of Pro-Cyclicality BCA Research’s positive cyclical stance on commodities offers another reason to overweight Sweden’s market relative to that of the US and the Euro Area. Our Commodity and Energy Strategy sister service anticipates significant further upside for natural resources, especially base metals, over the remainder of the business cycle.5 Commodity prices still have room to rally, because demand will grow as the global economy continues to recover and because the supply of natural resources has been constrained by a decade of low investment. As a result, rising metal prices will symptomatize strong economic activity around the world and will incentivize capex in commodity extraction, both of which will boost the revenue of industrial firms. Furthermore, commodity price inflation often corresponds with rising yields, which boosts financials as well. These relationships explain the Swedish stocks’ outperformance of US and Eurozone stocks, when natural resource prices rally, despite the former’s low exposure to materials (Chart 14). At the sector level, the appeal of Swedish industrials relative to those of the Eurozone and the US completes the rationale to favor Swedish equities in a global portfolio. Swedish industrials are just as profitable as US ones and are more so than Euro Area ones, while having significantly lower leverage than either of them (Chart 15). Additionally, for the past two years, the EPS growth of Swedish industrials has bested that of US and Eurozone ones. Yet, their forward P/E ratio trades in line with the US and the Euro Area, while the sell-side’s long-term relative earnings growth estimate is too depressed (Chart 16). The same observations are valid when comparing Swedish industrials to French or German ones. Hence, in the context of a global business cycle upswing, buying Swedish industrials while selling their US and Euro Area competitors is an appealing pair trade, especially since it also involves short USD/SEK and short EUR/SEK bets. Chart 15Attractive Swedish Industrials... Chart 16...And Not Expensive Despite our optimism toward Swedish stocks on a 12 to 24 months basis, investors must hedge a near-term risk. Chinese authorities are aiming to contain financial excesses and trying to restrain credit growth. As we showed four weeks ago, China’s excess reserve ratio is contracting, which points toward a slowdown in the Chinese credit impulse.6 Historically, such a development can hurt global cyclicals, and thus, also Swedish equities. However, BCA Research’s China strategists believe that Beijing will not kill off the Chinese business cycle; thus, the recent disappointment in the Chinese PMI is transitory.7   Chart 17Industrials vs Materials: Europe vs China Materials more than industrials will suffer the brunt of a China slowdown, as the re-opening trade and capex cycle among advanced economies will create a buffer for the latter. Indeed, the performance of global industrials relative to materials stocks correlates with the evolution of the spread between the Euro Area and Chinese PMI (Chart 17). Thus, we recommend selling Norwegian equities to hedge the tactical risk inherent in an overweight on Sweden. As Table 1 above shows, Norway overweighs materials and energy (two sectors greatly exposed to China), hence, a temporary pullback in commodity prices should hurt Norwegian stocks more than Swedish ones. Bottom Line: The SEK is an inexpensive and attractive vehicle to bet on both the global business cycle strength and the Swedish economic recovery. Thus, investors should use any rebound in EUR/SEK and USD/SEK to sell these pairs. Moreover, Swedish stocks greatly overweight cyclical sectors, particularly industrials and materials. This sectoral profile renders Swedish equities as attractive bets on the global economy. Additionally, Swedish shares display alluring operating metrics. As a result, we recommend investors go long Swedish industrials relative to those of the US and Euro Area. They should also overweight Swedish equities against the US and the Eurozone. Consequent to some China-related tactical risks, an underweight stance on Norwegian stocks constitutes an attractive hedge to this Swedish exposure. A Few Words On Italy’s National Recovery And Resilience Plan Mario Draghi’s plan to revive the Italian economy, announced last week, is an important marker of Europe’s changing relationship with fiscal policy. Last decade, excessive austerity contributed to subpar growth, ultimately firing up concerns about debt sustainability in many peripheral economies, and fueled risk premia in Italy and Spain. Under the cover of the current crisis, and in the face of the changing political winds in Brussel and Berlin where fiscal rectitude is not the mantra it once was, national European governments are beginning to propose ambitious fiscal stimulus plans. The National Recovery and Resilience program illustrates these dynamics. The EUR248bn plan is a testament to the importance of the NGEU recovery program as well as the REACT EU recovery fund. Through these facilities, the EU will contribute EUR191.5bn to the fiscal plan via grants and loans. Italy will contribute the remainder of the funds. While the total amount disbursed over the next six years corresponds to 14% of Italy’s 2019 GDP, the Draghi government estimates that the program will add 3.2 percentage points to GDP between 2024 and 2026. Importantly, markets are not rebelling. Despite expectations that Italy would continue to run an accommodative fiscal policy, the BTP/Bund spreads remain stable. We can expect this trend of greater stimulus to be mimicked around the EU. Spain is another large recipient of the NGEU program, and it too is likely to increase stimulus beyond what the EU will fund. France will hold an election in May 2022, and President Macron has all the incentives to stimulate the economy between now and then. If, as we wrote last week, Germany shifts to the left in September, then this outcome will be guaranteed. Bottom Line: The Draghi plan is the first salvo of greater fiscal stimulus in the EU. This trend will help Eurozone growth improve relative to the US over the coming few years. Despite a loose fiscal policy, BTPs and other peripheral bonds will continue to outperform on the back of declining risk premia.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Footnotes 1Please see Global Fixed Income Strategy “GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening,” dated April 6, 2021, available at gfis.bcaresearch.com 2Please see Foreign Exchange Strategy “2021 Key Views: Tradeable Themes,” dated December 4, 2020, available at fes.bcaresearch.com 3Please see European Investment Strategy “Summer Of ‘21,” dated March 22, 2021, available at eis.bcaresearch.com 4Please see European Investment Strategy “Winds Of Change: Germany Goes Green,” dated April 23, 2021, available at eis.bcaresearch.com 5Please see Commodity & Energy Strategy “Industrial Commodities Super-Cycle Or Bull Market?” dated March 4, 2021, available at ces.bcaresearch.com 6Please see European Investment Strategy “The Euro Dance: One Step Back, Two Steps Forward,” dated March 29, 2021, available at eis.bcaresearch.com 7Please see China Investment Strategy “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021, available at cis.bcaresearch.com Cyclical Recommendations Structural Recommendations Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Bank Credit Analyst

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights The backdrop for global high-yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. With improving global growth taking over the reins from central bank liquidity as the primary driver of high-yield returns, we have decided to reassess the sources of value using some of our key indicators for junk bonds in the US and Europe. The US and euro area appear fairly evenly matched on our valuation metrics but euro area high-yield still offers good value on an absolute basis. We are therefore increasing our recommended allocation to overweight, matching our similar stance for US high-yield. Within the euro area, stay up in quality, favoring Ba-rated credit. Retail and consumer products are attractive bounce-back sectors as Europe emerges from lockdowns later this year. Feature Chart of the WeekCentral Bank Liquidity Has Driven High Yield Outperformance The past year has been excellent for global high-yield corporate bonds. Unprecedented monetary and fiscal stimulus in response to the COVID-19 economic shock and market rout helped rapidly lower credit spreads in the final three quarters of 2020. As the vaccine rollout picked up pace and the reopening trade began to dominate earlier this year, high-yield corporates continued to perform well despite defaults hitting a post-2008 high (Chart of the Week). An improving outlook for the global economy is highly supportive for lower-rated corporate debt from a fundamental perspective, even if that same pickup in growth will put pressure on policymakers to dial back monetary accommodation. Already, growth in major central bank balance sheets – a reliable leading indicator of high yield outperformance – is slowing, with corporate spreads approaching historically tight levels. Thus, we feel it is timely to assess valuation metrics in the largest high-yield markets of the US and Europe – and the implications for regional high-yield allocations - as economic growth takes over the reins from central bank liquidity as the primary driver of spread product performance. A Cyclical Reduction In Corporate Credit Risk In its recently published Global Financial Stability Report,1 the IMF noted that the COVID-19 shock has pushed up global nonfinancial corporate leverage, measured as debt relative to GDP, to historical highs (Chart 2). Some of that rise is due to companies ramping up debt issuance over the past year in response to supportive monetary policy and favorable financial market conditions. Yet according to the IMF, about half of the rise in global corporate debt-to-GDP ratios from Q4/2019 to Q3/2020 was attributable to sharply lower output. Now, with economic growth set to stage a strong rebound this year – the IMF is forecasting global real GDP growth of 6.0% in 2021 and 4.4% in 2022 - a rising denominator should result in corporate debt-to-GDP ratios stabilizing or even falling over the next couple of years. This will help maintain a positive backdrop for corporate spread product, even if central banks like the Fed turn less dovish later this year, as we expect Corporate interest coverage, using the Refinitiv Datastream bottom-up aggregates of individual company data, paints a similar cyclical picture (Chart 3). The absolute level of coverage ratios fell sharply in 2020, accelerating pre-pandemic downtrends that had already been in place in both the US and Europe. Since Q4/2019, however, interest expense actually fell very slightly in the US, meaning that of the 1.5 point fall in the interest coverage ratio, 1.3 points can be attributed to declining corporate earnings over that period. The picture was also lopsided in the euro area, with 2.5 points of the 2.8 point decline in interest coverage over that same period attributable to falling profits. Chart 2Rising Leverage Is Not Just A Debt Story Chart 3Falling Earnings Are Responsible For The Decline In Interest Coverage Rapid improvements in economic growth momentum, fueled by reopening economies and increased fiscal stimulus (especially in the US), should lead to a cyclical rebound interest coverage ratios in both the US and Europe in 2021 and 2022. Bottom Line: The backdrop for global high yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. A Trans-Atlantic Comparison Of High-Yield Bond Valuations Chart 4Our Relative Overweight On US HY Has Been A Success Since March of last year, we have maintained a recommended overweight stance on US high-yield versus European equivalents (Chart 4). That was originally a relative central bank play with the Fed including US high-yield in its corporate bond buying program, in contrast to the ECB that was only buying investment grade debt. Our relative regional allocation on high-yield corporates has worked out well, with the US outperforming the euro area by 3.9 percentage points (in excess return terms versus duration-matched government debt) since the pandemic peak in credit spreads last March. Today, with high-yield spreads back near historical tight levels and the momentum of excess returns starting to peak, a forward-looking reevaluation of our US versus Europe high-yield recommendation along value grounds is in order. To conduct our reassessment of value, we look at five key areas: default-adjusted spreads; 12-month breakeven spreads; volatility-adjusted spreads; credit quality curves; and, lastly, the relative carry offered by high-yield corporates in currency-hedged and unhedged terms. Default-Adjusted Spreads As discussed earlier in the report, fiscal and monetary support have helped stave off the worst for high-yield corporates on both sides of the Atlantic, with default rates spiking far less than the amount implied by the collapse in year-over-year GDP growth (Chart 5). Forecasts for 2021 are sanguine—Moody’s expects the trailing 12-month high yield default rate to reach 4.2% in the US and 2.6% in the euro area in 2021, in line with the IMF’s sharp upward revision to growth forecasts for both regions. The outlook for default-adjusted spreads, which look at the index option-adjusted spread (OAS) net of realized default losses, is much more positive in the euro area however, given that they have a much more attractive “starting point”. The realized default-adjusted spread in the euro area was already inching into positive territory last year, as opposed to the deeply negative spread in the US (Chart 6). This alone makes it much more likely that euro area high-yield will deliver a positive return net of default losses. Chart 5The Default Picture Is Expected To Improve Chart 6Euro Area Spreads Are More Attractive On A Default-Adjusted Basis In addition, the potential range for default-adjusted spreads (combining default rates and recovery rates, see the shaded boxes in the chart) is much narrower in the euro area given the lower post-crisis volatility in default rates in that region, making outcomes in the euro area far less uncertain than in the US. Volatility-Adjusted Spreads Chart 7Falling US Spreads Have Overshot The Level Implied By Equity Volatility Another way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX and the European VSTOXX indices. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. The global rally in riskier credit has helped push down volatility-adjusted spreads for both regions, making them expensive relative to the historic mean (Chart 7). However, the divergence between volatility and high-yield spreads is much more pronounced in the US, where the volatility-adjusted spread, currently at all-time lows and 1.8 standard deviations below the mean, appears much less attractive. In contrast, while the euro area measure is still within one standard deviation of the mean and has room to fall further, as it did in 2007. 12-Month Breakeven Spreads To look at valuations in high yield corporates relative to history, we turn to our 12-month breakeven spread metrics. These measure how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus a duration-matched position in government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. On this basis, there seems to be a bit more value in US high-yield spreads, with the 12-month breakeven at the 32nd percentile compared to the 18th percentile ranking for European high-yield. Both markets are not cheap on this metric, though, with the lion’s share of cyclical spread compression having already been realized (Chart 8). This additional value in the US is concentrated in the lower-quality tiers, with B-rated US HY looking most attractive (Chart 9). Chart 8US And Euro Area High-Yield Breakeven Spreads Chart 9All Credit Tier Breakeven Valuations Are In the Bottom Half Relative To History Credit Quality Curves To further inform our decision on value across credit tiers in the US and Europe, we look at credit quality curves, which measure the incremental spread pick-up earned from moving down to lower credit tiers. For example, we look at the spread differential between B-rated and Ba-rated high-yield bonds within the US or Europe. When making the comparisons, we adjust the spreads to account for duration differences between credit tier sub-indices and the overall regional high-yield index. This adjusts for slightly lower index durations as we move down in quality.2 Our colleagues at BCA Research US Bond Strategy have pointed out that the spread pickup earned from moving out of US Baa-rated bonds into Ba-rated bonds is elevated compared to typical historical levels.3 Credit quality curves in the euro area tell a similar story (Chart 10). The spread pickup from moving into Ba-rated credit is slightly higher in the euro area on a cross-country basis while there is a more attractive pickup in the US from moving further down in quality. Chart 10US & European HY Credit Quality Curves Chart 11Euro Area Caa-Rated Spreads Have Room To Fall To Pre-COVID Lows As quality curves have compressed across the board, we can also use the pre-COVID lows in these series as an anchor for how much more narrowing we could see (Chart 11). On that basis, there seems to be a bit more value left in the top two tiers of US high yield while there is more juice left in the euro area Caa-rated minus B-rated spread. The Caa-B spread differential is now quite expensive for the US, sitting -140bps below its pre-COVID low, a reflection of yield-chasing behavior by risk-seeking investors in an easy monetary policy environment. As the Fed begins to take its foot off the monetary accelerator within the next 6-12 months, as we expect, this credit tier is also most vulnerable to a repricing of default risk. Index Yield-To-Maturity Chart 12Junk Index Yields At All Time Lows The hunt for yield by fixed income investors has driven down the index yield on lower-quality credit to all-time lows in both the US and euro area (Chart 12). This dynamic has played out at a time when falling interest rate differentials between the two regions have cut down the cost of hedging US dollar (USD) exposures into euros (or, alternatively, reduced the gain from hedging euro exposures into USD). Importantly, this reduction in the gains/losses from currency hedging allows for a more honest assessment of the relative attractiveness of yields on lower-rated corporates in the US and Europe, reflecting compensation for taking credit risk rather than currency risk. With the backdrop for spread product looking positive, it is worth considering the simple carry over a twelve-month period for holding high-yield debt, in both USD-hedged and unhedged terms (Chart 13). For the overall index and the Ba-rated tier, the US dominates completely, with investors in the euro area better off holding US credit even after paying the currency hedging cost. This dynamic is flipped at the B- and Caa-rated tiers, with euro area credit appearing dominant. Chart 13US Ba-Rated Debt Is Dominant On A Carry Basis An Additional Point On High-Yield Sectors Sector composition will also be an important driver of high-yield returns going forward. In the April 2021 Global Financial Stability report, the IMF noted that global high-yield defaults in 2020 were concentrated in sectors most affected by the pandemic. On a relative basis, the US high-yield index appears more heavily weighted towards those sectors – a picture that becomes even more focused if Energy, which is the largest industry group in US high-yield, is considered as a pandemic-stricken industry (Chart 14). However, the euro area does have a slightly larger tilt towards the hard-hit Retail sector. Chart 14Oil And Gas Was Hardest-Hit In 2020 An important implication is that the sectors that suffered the most in 2020 are also the ones most poised for a snapback this year as economies reopen and growth recovers. One way to approach this from a relative valuation perspective is to look at the relative industry-level cross-country spreads between the US and Europe, compared to the change in global defaults by sector from 2019 to 2020 (Chart 15). Chart 15Sectors That Saw Rising Defaults In 2020 Are Poised For A Rebound Sectors that saw a moderate-to-high number of defaults last year, such as Retail and Consumer products, offer higher spreads in the euro area. These will also be the sectors to benefit the most from a consumption rebound as Europe exits lockdowns. On the other hand, US spreads are more attractive than European spreads for the Media and Transportation sectors that saw a big increase in defaults in 2020. Importantly, while the US Energy sector also looks more relatively attractive on that basis, much of a post-COVID recovery has already been priced in, with US high-yield energy spreads below pre-pandemic lows. Investment Conclusions Having looked at our suite of valuation metrics, euro area and US high-yield appear quite evenly matched. On a default and volatility-adjusted basis, spreads in the euro area appear to offer more value while US high-yield largely wins out on a breakeven spread and carry basis. Thus, the case for favoring US high-yield over European equivalents is no longer as compelling as it has been for much of the past twelve months. We are therefore taking profits on our long-held recommended overweight stance on US high-yield versus European high-yield. We are implementing this change by upgrading our strategic euro area high yield allocation to overweight (4 out of 5), which matches our similar overweight recommended tilt for US high-yield (see table on page 15). Within our model bond portfolio, we are “funding” that upgrade by reducing the size of our recommended overweight exposure to core European sovereign debt in Germany and France (see the model bond portfolio tables on pages 13-14). On the margin, this decision also positions us favorably with regards to the consumption driven H2/2021 recovery in euro area economies highlighted by our colleagues at BCA Research European Investment Strategy.4 Within European credit, we recommend staying up in quality, favoring the Ba-rated tier as lower quality tranches do not offer adequate compensation for the increased credit risk. Bottom Line: Rebounding global growth will help maintain a favorable backdrop for global high yield credit. The US and euro area look evenly matched on our valuation metrics, but there is still good value on offer in the euro area on an absolute basis. Increase allocations to euro area high-yield, favoring the Ba-rated credit tier and Retail and Consumer Products industries, in particular. Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1https://www.imf.org/en/Publications/GFSR/Issues/2021/04/06/global-financial-stability-report-april-2021 2 Please see BCA Research US Bond Strategy Report, "Ba- Rated Bonds Look Best", dated February 9, 2021, available at usbs.bcaresearch.com. 3 Note that this adjustment is made to facilitate more accurate comparisons within the credit tiers of the high-yield universe. No such adjustment is made to the Baa-rated credit spread, which is higher-quality investment grade and therefore not part of the high-yield universe. 4 Please see BCA Research European Investment Strategy Special Report, "A Temporary Decoupling", dated April 5, 2021, available at eis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns