Canada

Highlights Confidence vs. Inflation: Global bond yields are lacking direction at the moment. The variant is setting a near-term ceiling on bond yields while the medium-term floor is established by inflation. The inflation pressures – fueled by tightening global labor markets and persistent supply chain disruptions - will linger for much longer than the Delta surge. Investors should position for higher global bond yields, led by the US, on a medium-term basis. Canada: The Canadian economy is performing strongly as the nation is finally reopening after a poor initial vaccine rollout earlier this year. Next month’s federal election will likely result in a re-election of Justin Trudeau’s Liberals and a continuation of expansive fiscal policy. The Bank of Canada is on track to begin interest rate hikes in 2022 with inflation likely to remain higher for longer than the central bank projects. Remain underweight Canadian government bonds within global (USD-hedged) fixed income portfolios. A Tug Of War For Bond Yields Chart of the WeekThe Delta Surge Is Not That Bond Bearish Global bond yields are currently trapped in narrow ranges, pulled in opposing directions by two powerful forces. The spread of the Delta variant is raising worries about future economic growth. Yet central banks cannot signal dovish bond-bullish guidance in response because of persistently high inflation and rich financial asset valuations. The result is that real bond yields cannot decline deeper into negative territory because central banks are unable to signal easier future monetary policy. At the same time, inflation expectations cannot fall either because of high realized inflation and overly accommodative monetary settings. With global supply chains still disrupted by the pandemic and labor markets in many major developed countries tightening rapidly, the inflation side of this tug of war on bond yields will remain strong. This leaves the Delta variant as being most important in determining which side wins the war. The variant is proving to be much less deadly (so far) than past COVID waves on an aggregate global basis (Chart of the Week) thanks to vaccinations. However, there are notable differences in economic growth momentum that have opened up between countries where the variant has spread aggressively, especially if economic restrictions have been imposed. The preliminary services PMIs for August showed big monthly declines in the US and UK, where case numbers have surged, and Australia, where half of the population is under some form of lockdown to fight the spread of the variant. Delta-stricken Japan also saw a sharp drop in services activity in August. The services PMIs in Europe, however, dipped very modestly, in line with the subdued spread of the variant in euro area countries. Chart 2No Major Changes On Bond Markets From The Delta Variant While the variant appears to be having a noticeable impact on relative economic growth in the near-term, the relative performance of government bond markets in the developed world is a different story. When looking at the 2021 year-to-date relative returns of the major bond markets versus the Bloomberg Barclays Global Treasury index - in USD-hedged and duration-matched terms - the outperformers have been Germany (and euro area bonds, in general), Japan and Australia while the laggards have been the US, UK and Canada (Chart 2). Over the past month, however, when the global spread of the Delta variant has become front page news, there has been very little change in the relative bond returns outside of a modest pickup in the outperformance of Australia - one of our current overweight recommendations. A big reason why relative returns have remained stagnant is that monetary policy expectations have not changed much in response to the variant. Our 24-month discounters, which measure the amount of interest rate hikes over the next two years currently priced in overnight index swap (OIS) curves, are essentially at the same levels that prevailed in early July in the US, Europe, the UK, Canada, Australia and Japan. With little change in future interest rate expectations between countries, amid stable inflation expectations, there is no impetus driving changes in relative government bond market performance. Other financial markets are also taking the spread of the variant in stride, especially in the US. Forward looking US economic sentiment measures like the University of Michigan consumer expectations index and the Philadelphia Fed Business Outlook survey all showed sharp declines in the preliminary August readings. Yet US equity markets continue to hover near all-time highs, US high-yield spreads remain near pandemic lows and the VIX index is below 20 (Chart 3). Perhaps one reason why risk assets are holding in well despite the worries over the variant is that the news outside the US has been more upbeat. Consumer confidence in Canada and the UK remains solid (Chart 4), with the latter also seeing a huge upside surprise in retail sales volumes in August according to the Confederation of British Industry’s survey of retailers. Even in Australia, with widespread lockdowns, consumer confidence remains well above the 2020 pandemic lows. Chart 3Delta Variant Hitting US Economic (Not Market) Confidence Chart 4Lockdowns Are Bad For Confidence (And Vice Versa) Delta developments in China are also turning more positive, with new reported cases now at zero after a surge that began in July. There are even reasons for optimism in the US, where COVID-19 reproduction rates in most of the Southern states – the epicenter of the US Delta surge – have fallen below 1, suggesting a declining pace of transmission of the virus.1 The overall hit to global growth from the Delta variant will likely be modest, leaving the inflation side of the tug of war on global bond yields as the winner, particularly in countries that are seeing a broad-based increase in inflation that will be difficult for central bankers to ignore. In the US, UK, Canada and New Zealand – our least-preferred bond markets within the developed world - both realized consumer price inflation and the growth of house prices are soaring at the same time (Chart 5). Unsurprisingly, the central banks in those four countries have either tapered bond purchases – all the way to zero in the case of the Reserve Bank of New Zealand (RBNZ) – or are preparing the markets for tapering as the US Federal Reserve has been doing in recent weeks. Policymakers in those four countries will be watching to see if the latest uptrend in inflation starts to drive up longer term inflation expectations by enough to warrant a monetary policy response. In the US, the University of Michigan consumer survey shows that one-year-ahead expected inflation has climbed to 4.6%, compared to a more subdued 3.% expected inflation rate over the next five years (Chart 6). In Canada, the Q2/2021 Survey of Consumer Expectations produced by the Bank of Canada (BoC) shows that both one-year and five-year inflation expectations are 3.1% - just above the upper limit of the BoC inflation target range – although the longer-term measure is off the highs seen in 2020 (we discuss Canada in greater detail later in this report) Chart 5Difficult For Central Banks To ##br##Ignore This Chart 6Will Short-Term Inflation Expectations Bleed Into The Long-Term? Inflation expectations in the UK, according to the YouGov/Citigroup survey, are 3.1% in the short-term (and rising) and a higher 3.4% in the longer term. In New Zealand, the RBNZ’s inflation survey shows both short-term (1-year) and longer-term (5-year) inflation expectations have increased to 3% and 4%, respectively. Chart 7Inflation Expectations Still Moderate In Europe, Japan & Australia Importantly, market-based expectations extracted from breakevens on 10-year inflation-linked bonds in those four countries are somewhat more subdued than the survey-based expectations measures. This means that central bankers can be patient on moving towards tapering and eventual interest rate hikes until the concerns over the Delta variant have passed. However, lingering global supply chain disruptions, alongside tightening labor markets, represent inflationary risks that will force the Fed, the Bank of England (BoE), the BoC and RBNZ to begin dialing back monetary accommodation over the next year. We still anticipate that the RBNZ will hike rates this fall in response to booming New Zealand house prices, while the Fed will begin tapering its bond buying next January and will start hiking rates in Q4/2022. Both the BoC and BoE will fully taper QE and lift interest rates in 2022, with the BoC likely to move first in the first half of the year. In the euro area, Japan and Australia – where we are currently recommending overweight government bond allocations on a USD-hedged basis – the latest uptrends in both house prices and realized inflation have not translated into overshooting inflation expectations (Chart 7). The ECB, Bank of Japan and Reserve Bank of Australia are not expected to tighten policy in any form (taper or rate hikes) through at least the end of 2022. Net-net, we do not see the spread of the Delta variant as a reason to make changes to our strategic recommended country allocations on global government bonds. Bottom Line: Global inflation pressures – fueled by tightening labor markets and persistent supply chain disruptions - will linger for much longer than the Delta surge. Investors should position for higher global bond yields, led by the US, on a medium-term basis. Also, favor countries where inflation pressures are less entrenched (Europe, Japan and Australia) versus nations with more broad-based inflation visible in both consumer prices and house prices (the US, UK, Canada and New Zealand). Canada: The BoC Is Still On The Path To Tighten Perhaps no country has suffered greater extremes with regards to COVID-19 in 2021 than Canada. A slow vaccine rollout at the start of 2021 placed Canada behind the US and other developed market countries in terms of dialing back pandemic restrictions imposed last year. The low rate of vaccinations allowed a harsh third wave of COVID to take place this past spring, further delaying Canada’s exit from lockdowns. Since then, Canada has flipped the script with a spectacularly rapid vaccination campaign. Two-thirds of the population is now fully inoculated and the country has rapidly emerged from lockdowns, spurring a stronger economy much more resilient to the rapid spread of the Delta strain seen in Canada’s southern neighbor. Our view on Canadian fixed income markets has also evolved alongside pandemic developments over the course of this year. In a Special Report published back in February, we concluded that the BoC would likely need to begin withdrawing the extraordinary monetary easing measures put in place in response to the pandemic sooner than most other developed market central banks.2 This would justify cutting our recommended stance on Canadian government debt from neutral to underweight. The slow initial vaccine rollout delayed that decision until late April, when we pulled the trigger on that downgrade.3 Chart 8The Economic Future Looks Bright In Canada At the time, our shift to a bearish stance on Canada rested on several pillars: Better news on the vaccination front, which would give a lift to consumer and business confidence Booming house prices, fueled by negative real interest rates, raising financial stability risks in a country with an already overheated housing market Additional fiscal stimulus announced by the ruling Liberal government, dramatically reducing the fiscal drag that was expected in 2021. Since our downgrade, the BoC has already cut the pace of its quantitative easing (QE) asset purchases in half, after allowing other pandemic emergency liquidity programs to expire earlier in the year. Interest rate markets are now pricing in a full 25bp rate hike in Canada by August 2022, with 115bps of cumulative hikes discounted by the end of 2024. Only Norway and New Zealand are expected to lift rates sooner, and by more, than the BoC within the developed markets universe. Yet that is still a very slow and shallow expected path for Canadian interest rates, given the substantial tailwinds to economic growth in Canada (Chart 8). Canadian consumers have a strong base to support spending. Nominal household disposable income growth remains solid at 9% on a year-over-year basis and the household saving rate is still elevated at 13% after peaking at 27% during the COVID recession in 2020. The BoC’s Q2 Survey of Consumer Expectations noted that 40% of respondents reported that their savings were higher than usual because of pandemic, and that those that did accumulate excess savings planned to spend 35% of those funds over the next two years. This implies that Canadian consumers still hold plenty of cash to spend, and that pent-up demand coming out of lockdowns will support a solid pace of consumption. Moreover, continuously recovering labor market conditions will also contribute to a solid pace of domestic demand. Even though the recovery of employment to date has been uneven across different sectors and worker backgrounds, Canadian firms are reporting robust hiring plans and increased intensity of labor shortages - leading firms to plan for wage increases - according to the BoC’s Q2/2021 Business Outlook Survey. This indicates that the Canadian labor market will likely tighten further over the next 6-12 months, further supporting consumer incomes, confidence and spending. The Business Outlook Survey also reported that overall business sentiment was at the highest level in the history of the series, with a net 36% of firms– just off the record high of 40% in Q1/2021 – reporting stronger capital spending intentions. Thus, business investment catching up after the COVID pause will also help boost overall Canadian economic growth. Importantly, the Delta variant does not pose the same near term risk to growth as is the case in the US and other countries. The number of new COVID cases and related hospitalizations is a fraction of what was seen as recently as the third pandemic wave earlier this year (Chart 9). The rapid pace of vaccinations is clearly providing a buffer to the spread of the variant in Canada, with 74% of Canadians having had at least one vaccine dose and 66% of the population fully vaccinated. While there is solid upward momentum in Canadian growth, the same can be said for Canadian inflation. Headline CPI inflation climbed to 3.7% in July, while core inflation jumped to 2.8% (Chart 10), both the highest pace seen since 2003. Not all of that increase is due to base effect comparisons versus a year ago, as the monthly increases in both headline (+0.6%) and core (+0.4%) were strong. Chart 9Vaccinations Have Made A Huge Difference In Canada Chart 10Canadian Inflation Momentum Is ##br##Not Slowing As discussed earlier in this report, survey-based measures of Canadian consumer inflation expectations show that this surge in inflation is perceived to be temporary, with shorter-term expectations rising but longer-term expectations slowing. There is a lack of worry in the Canadian inflation-linked bond markets, as well, with breakeven inflation rates hovering near the midpoint of the BoC’s 1-3% inflation target range. This presents a potential problem for the BoC, and the Canadian bond market, if the current surge in inflation does not prove to be temporary. The BoC’s August Monetary Policy Report (MPR) included a detailed breakdown of the contribution to Canadian inflation by spending category (Chart 11). While energy costs were a major driver of the year-over-year increase in inflation, components that were exposed to supply constraints – like motor vehicles and other durable goods – accounted for nearly one-half of the level of year-over-over inflation over the past three months. The CPI elements that were linked to increased demand as the economy reopened from lockdowns – like spending in restaurants – represented a much smaller share of current inflation. Chart 11Lingering Supply Constraints Are A Major Upside Inflation Risk Thus, while energy price inflation is likely to cool off somewhat on a year-over-year basis over the next 6-12 months, Canadian inflation could remain surprisingly sticky at levels above the BoC target band if supply disruptions persist for longer. Canadian businesses are already facing higher input costs, and it is inevitable that firms will offer higher wages in order to attract workers while demand keeps rising in a tightening labor market. In the end, all these increased costs will continue to be passed on by firms to consumers, putting upward pressure on Canadian Dollar – especially with both the BoC and IMF projecting Canada’s output gap to steadily narrow and be fully closed in the second half of 2022. Risks from the upcoming federal election Prime Minister Justin Trudeau has called a snap federal election for September 20. The timing of the election seems odd on the surface, given Trudeau’s poor approval ratings and the lingering uncertainties of COVID-19. The Canada Geopolitical Risk Indicator constructed by our colleagues at BCA Research Geopolitical Strategy shows that there is a high level of domestic political risk in Canada, largely due to the underperformance of the Canadian dollar versus improving Canadian economic variables (Chart 12). However, in the current context of the pandemic, with all the associated uncertainty, this high risk is translating in favor of the incumbent Liberal Party, rather than calling for regime change. Chart 12An Interesting Time To Call An Election In Canada The likely reason is that the COVID crisis was exogenous and polling shows that voters are at least content with ruling party’s handling of the situation. Current polls have the Liberals with a modest lead over the opposition Conservatives (Chart 13). The far-left New Democratic Party (NDP) is in third place, even though its leader has the highest approval rating of the three major party leaders. Chart 13Trudeau Is Taking A Calculated Risk Trudeau is taking a gamble with this election to try and retake the parliamentary majority he lost in the 2019 election that resulted in a minority Liberal government. Trudeau has framed the election as a chance to “finish the fight” against COVID-19, and as a referendum on his government’s handling of the pandemic. Yet the broad Liberal party platform is also positioned well, based on Canadian voter preferences. Current opinion polls show that the most important issues among Canadian voters are climate change, health care and housing (Chart 14). COVID-19 itself is actually well down the list, as are government deficits and taxes – issues that the Conservatives are relentlessly focused on. Trudeau has skillfully read the tea leaves and positioned his party well on issues most Canadians care most about, unlike his main opposition party (Table 1). Furthermore, Trudeau has co-opted many of the policy planks of the NDP, allowing the Liberals to gain potential votes from more left-leaning voters. At a time when voters want to reassert the role of government in tackling collective challenges, this is a favorable place to be. Chart 14Canada: Most Important Issues Facing The Country Table 1The Liberal Agenda Lines Up With Top Voter Priorities The likely election result will be another Liberal victory, with the party expanding its minority and having a legitimate shot at winning a majority. This also means that the Canadian fiscal policy is likely to remain supportive for growth over the next few years. Stay Underweight Canadian Government Debt Given all the positive momentum and upside risks to economic growth, house prices, inflation and government spending, the BoC is likely to continue on its current path towards fully tapering asset purchases and eventually starting to lift interest rates as soon as mid-2022 (Chart 15). This would be faster than the liftoff date currently discounted in the Canadian OIS curve. The pace of rate hikes discounted is also very shallow, and the risks are tilted towards the BoC doing more tightening than the market is expecting over the next couple of years. We continue to recommend a below-benchmark duration stance in Canada, and a strategic underweight allocation to Canada within global government bond portfolios with the BoC likely to be one of the more hawkish developed market central banks over the next 12-18 months (Chart 16). We also advocate positioning for a bearish flattening of the Canadian yield curve given the potential for hawkish surprises from the BoC. Chart 15The BoC's Policy Stance Has Already ##br##Turned Chart 16Stay Cautious On Canadian Government Bond Exposure Bottom Line: The Canadian economy is performing strongly as the nation is finally reopening after a poor initial vaccine rollout earlier this year. Next month’s federal election will likely result in a re-election of Justin Trudeau’s Liberals and a continuation of expansive fiscal policy. The Bank of Canada is on track to begin interest rate hikes in 2022 with inflation likely to remain higher for longer than the central bank projects. Remain underweight Canadian government bonds within global (USD-hedged) fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Estimates of the COVID-19 effective reproduction rate in US states, calculated by public health researchers at Harvard and Yale universities, can be found here: https://covidestim.org/ 2 Please see BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy Report, " Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Report, "Some Bond Bearish Tales From Both Sides Of The 49th Parallel", dated April 20, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global oil demand will remain betwixt and between recovery and relapse through 3Q21, as stronger DM consumer spending and increasing mobility wrestles with persistent concerns over COVID-19-induced lockdowns in Latin America and Asia. These concerns will be allayed as vaccines become more widely distributed, and fears of renewed lockdowns – and their associated demand destruction – recede.  Going by US experience – which can be tracked on a weekly basis – as consumer spending rises in the wake of relaxed restrictions on once-routine social interactions, fuel demand will follow suit (Chart of the Week). OPEC 2.0 likely will agree to return ~ 400k b/d monthly to the market over the course of the next year and a hal. For 2021, we raised our average forecast to $70/bbl, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl. These estimates are highly sensitive to demand expectations, particularly re containment of COVID-19. Feature For every bit of good news related to the economic recovery from the COVID-19 pandemic, there is a cautionary note. Most prominently, reports of increasing demand for refined oil products like diesel fuel and gasoline in re-opening DM economies are almost immediately offset by fresh news of renewed lockdowns, re-infections in highly vaccinated populations, and fears a new mutant strain of the coronavirus will emerge (Chart 2).1 In this latter grouping, EM economies feature prominently, although Australia this week extended its lockdown following a flare-up in COVID-19 cases. Chart of the WeekUS Product Demand Revives As Economy Reopens Chart 2COVID-19 Infection And Death Rates Keep Markets On EdgeOur expectation on the demand side is unchanged from last month – 2021 oil demand will grow ~ 5.4mm b/d vs. 2020 levels, while 2022 and 2023 consumption will grow 4.1 and 1.6mm b/d, respectively (Chart 3). These estimates reflect the slowing of global GDP growth over the 2021-23 interval, which can be seen in the IMF's and World Bank's GDP estimates, which we use to drive our demand forecasts.2 Weekly data from the US seen in the Chart of the Week provide a hint of what can be expected as DM and EM economies re-open in the wake of relaxed restrictions on once-routine social interactions. Demand for refined products – e.g., gasoline, diesel fuel and jet fuel – will recover, but at uneven rates over the next 2-3 years. The US EIA notes the recovery in diesel demand, which is included in "Distillates" in the chart above, has been faster and stronger than that of gasoline and jet fuel. This is largely because it reflects the lesser damage done to freight movement and activities like mining and manufacturing. The EIA expects 4Q21 US distillate demand to come in 100k b/d above 4Q19 levels at 4.2mm b/d, and to hit an all-time record of 4.3mm b/d next year. US gasoline demand is not expected to surpass 2019 levels this year or next, in the EIA's forecast. This is partly due to improved fuel efficiencies in automobiles – vehicle-miles travelled are expected to rise to ~ 9mm miles/day in the US, which will be slightly higher than 2019's level. Jet fuel demand in the US is expected to return to 2019 levels next year, coming in at 1.7mm b/d. Chart 3Global Oil Demand Forecast Remains Steady Quantifying Demand Risks We use the recent uptick in COVID-19 cases as the backdrop for modelling demand-destruction scenarios in this month’s oil balances (Chart 2). We consider different scenarios of potential demand destruction caused by the resurgence in the pandemic (Table 1). Last year, demand fell by 9% on average, which we take to be the extreme down move over an entire year. In our simulations, we do not expect demand to fall as drastically this time. Table 1Demand-Destruction Scenario Outcomes We modelled two scenarios – a 5% drop in demand (our low-demand-destruction scenario) and an 8% drop in demand (our high-demand-destruction scenario). A demand drop of a maximum of 2% made nearly no difference to prices, and so, we did not include it in our analysis. In both cases, demand starts to fall by September and reaches its lowest point in October 2021. We adjusted changes to demand in the same proportion as changes in demand in 2020, before making estimates converge to our base-case by end-2022. The estimates of price series are noticeably distinct during the period of the simulation (Chart 4). Starting in 2023, the low-demand-destruction prices and base-case prices nearly converge, as do their inventory levels. Prices and inventory levels in the high-demand-destruction case remain lower than the base-case during the rest of the forecast sample. OPEC 2.0 and world oil supply were kept constant in these scenarios. World oil supply is calculated as the sum of OPEC 2.0 and Non-OPEC 2.0 supply. Non-OPEC 2.0 can be broken down into the US, and Non-OPEC 2.0, Ex-US countries. Examples of these suppliers are the UK, Canada, China, and Brazil. OPEC 2.0 can be broken down into Core-OPEC 2.0 and the cohort we call "The Other Guys," which cannot increase production. Core-OPEC 2.0 includes suppliers we believe have excess spare capacity and can inexpensively increase supply quickly. Chart 4Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios OPEC 2.0 Remains In Control We continue to expect the OPEC 2.0 producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to maintain its so-far-successful production policy, which has kept the level of supply below demand through most of the COVID-19 pandemic (Chart 5). This allowed OECD inventories to fall below their pre-COVID range, despite a 9% loss of global demand last year (Chart 6). We expect this discipline to continue and for OPEC 2.0 to continue restoring its market share (Table 2). Chart 5OPEC 2.0 Production Policy Kept Supply Below Demand Chart 6...And Drove OECD Inventories Down Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our expectation last week the KSA-UAE production-baseline impasse will be short-lived remains intact. We expect supply to be increased after this month at a rate of 400k b/d a month into 2022, per the deal most members of the coalition signed on to prior to the disagreement between the longtime GCC allies. This would, as the IEA notes, largely restore OPEC 2.0's spare capacity accumulated via production cutbacks during the pandemic of ~ 6-7mm b/d by the end of 2022 (Chart 7). It should be remembered that most of OPEC 2.0's spare capacity is held by Gulf Cooperation Council (GCC) states, which includes the UAE. The UAE's official baseline production number (i.e., its October 2018 production level) likely will be increased to 3.65mm b/d from 3.2mm b/d, and its output in 2H21 and 2022 likely will be adjusted upwards. As one of the few OPEC 2.0 members that actually has invested in higher production and can increase output meaningfully, it would, like KSA, benefit from providing barrels out of this spare capacity.3 Chart 7OPEC 2.0 Spare Capacity Will Return As we noted last week, we do not think this impasse was a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy. In our view, this impasse was a preview of how negotiations among states with the capacity to raise production will agree to allocate supply in a market starved for capital in the future. This is particularly relevant as US shale producers continue to focus on providing competitive returns to their shareholders, which will limit supply growth to that which can be done profitably. We see the "price-taking cohort" – i.e., those producers outside OPEC 2.0 exemplified by the US shale-oil producers – remaining focused on maintaining competitive margins and shareholder priorities. This means maintaining and growing dividends, and returning capital to shareholders will have priority as the world transitions to a low-carbon business model (Chart 8).4 For 2021, we raised our average forecast to $70/bbl on the back of higher prices lifting the year-to-date average so far, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl (Chart 9). These estimates are highly sensitive to demand expectations, which, in turn, depend on the global success in containing and minimizing COVID-19 demand destruction, as we have shown above. Chart 8US Shale Producers Focus On Margins Chart 9Raising Our Forecast Slightly Investment Implications In our assessment of the risks to our views in last week's report, we noted one of the unintended consequences of the unplanned and uncoordinated rush to a so-called net-zero future will be an improvement in the competitive position of oil and gas. This is somewhat counterintuitive, but the logic goes like this: The accelerated phase-out of conventional hydrocarbon energy sources brought about policy, regulatory and legal imperatives already is reducing oil and gas capex allocations within the price-taking cohort exemplified by US shale-oil producers. This also will restrict capital flows to EM states with heavy resource endowments and little capital to develop them. Our strong-conviction call on oil, gas and base metals is premised on our view that renewables and their supporting grids cannot be developed and deployed quickly enough to make up for the energy that will be foregone as a result of these policies. Capex for the metals miners has been parsimonious, and brownfield projects continue to dominate. Greenfield projects can take more than a decade to develop, and there are few in the pipeline now as the world heads into its all-out renewables push. In a world where conventional energy production is being forced lower via legislation, regulation, shareholder and legal decisions, higher prices will ensue even if demand stays flat or falls: If supply is falling, market forces will lift oil and gas prices – and the equities of the firms producing them – higher. As for metals like copper and their producers, if supply is unable to keep up with demand, prices of the commodities and the equities of the firms producing them will be forced to go higher.5 This call underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. We will look for opportunities to get long oil and gas producer exposure via ETFs as well, given our view on oil and metals spans the next 5-10 years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects growth in large-scale solar capacity will exceed the increase in wind generation for the first time ever in 2021-22. The EIA forecasts 33 GW of solar PV capacity will be added to the US grid this year and next, with small-scale solar PV increasing ~ 5 GW/yr. The EIA expects wind generation to increase 23 GW in 2021-22. The EIA attributed the slow-down in wind development to the expiration of a $0.025/kWH production tax credit at the end of 2020. Taken together, solar and wind generation will account for 15% of total US electricity output by the end of 2022, according to the EIA. Nuclear power will account for slightly less than 20% of US generation in 2021-22, while hydro will fall to less than 7% owing to severe drought in the western US. At the other end of the generation spectrum, coal will account for ~ 24% of generation this year, as it takes back incremental market share from natural gas, and ~ 22% of generation in 2022. Base Metals: Bullish Iron ore prices continue to trade above $215/MT in China, even as demand is expected to slow in 2H21. Supply additions from Brazil, which ships higher quality 65% Fe ore, have been slower than expected, which is supporting prices (Chart 10). Separately, the Chinese government's auction of refined copper earlier this month cleared the market at $10,500/MT, or ~ $4.76/lb. Spot copper has been trading on either side of $4.30/lb this month, which indicates the Chinese market remains well bid. Precious Metals: Bullish The 13-year record jump in the US Consumer Price Index reported this week for the month of June is bullish for gold, as it produced weaker real rates and sparked demand for inflation hedges. Fed Chair Powell continued to stick to the view that the recent rise in inflation is transitory. The Fed’s dovish outlook will support gold prices and likely will lead to a weaker US dollar, as it reduces the possibility that US interest rates will rise soon. A falling USD will further bolster gold prices (Chart 11). Chart 10 Chart 11     Footnotes 1     We highlighted this risk in last week's report, Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. Two events – in the Seychelles and Chile, where the majority of the populations were inoculated – highlight re-infection risk. Re-infections in Indonesia along with lockdowns following the spread of the so-called COVID-19 Delta variant also are drawing attention. Please see Euro 2020 final in UK stokes fears of spread of Delta variant, published by The Straits Times on July 11, 2021. The news service notes that in addition to the threats super-spreader sporting events in Europe present, "The rapid spread of the Delta variant across Asia, Africa and Latin America is exposing crucial vaccine supply shortages for some of the world's poorest and most vulnerable populations. Those two factors are also threatening the global economic recovery from the pandemic, Group of 20 finance ministers warned on Saturday." 2     Please see the recently published IMF World Economic Outlook Reports and the World Bank Global Economic Prospects. 3    If, as we suspect, KSA and the UAE are playing a long game – i.e., a 20-30-year game – this spare capacity will become more valuable as investment capex into oil production globally slows. Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by kapsarc.org on July 17, 2018. 4    Please see Bloomberg's interview with bp's CEO Bernard Looney at Banks Need ‘Radical Transparency,’ Citi Exec Says: Summit Update, which aired on July 13, 2021. In addition to focusing on margins and returns, the company – like its peers among the majors – also is aiming to reduce oil production by 20% by 2025 and 40% by 2030. 5    This turn of events is being dramatically played out in the coal markets, where the supply of metallurgical coals is falling as demand increases. Please see Coal Prices Hit Decade High Despite Efforts to Wean the World Off Carbon published by wsj.com on June 25, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the US and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. Real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the first quarter of 2021 point towards easing standards in developed markets (Chart 1). Credit standards for business loans eased outright in most regions except for the euro area and New Zealand where the pace of tightening slowed significantly. On the whole, banks expected the easing trend to continue into Q2. Chart 1Credit Standards Moving Towards Or Deeper Into Easy Territory With credit spreads at historical tights, banks across the board cited increased competition from other lenders as a reason behind easing standards, confirming that easy financial conditions are not limited solely to booming financial markets. This will help maintain a market-friendly economic growth backdrop as developed economies put pandemic restrictions behind them. At the same time, an absence of tightening lending standards by commercial banks puts incremental pressure on central banks to move towards bond-bearish tightenings of monetary policy. An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and, thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As loan officers have access to detailed, non-public information on a large number of borrowers, they are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q1/2021 (Chart 3). Nearly 20% of respondents cited an improving or less uncertain economic outlook as a very important factor behind the decision to ease standards, while roughly one-third cited increased competition from other lenders. Chart 3US Credit Conditions Chart 4High-yield Borrowers Are Exposed To A Widening In Spreads Although it did not strengthen on net, C&I loan demand did weaken at a much slower pace in Q1. The factors driving loan demand suggest a buoyant economic backdrop—about a quarter of banks reporting increased demand cited merger and acquisition needs and increased investment as very important reasons. Meanwhile, weaker loan demand was attributed to less precautionary demand for cash and an increase in internally generated funds among customers. On the consumer side, loan demand improved slightly on the whole, driven largely by a significant improvement in auto loan demand. While consumer loan demand has historically correlated well with the year-over-year growth in personal consumption expenditures, those two series diverged remarkably in Q1, with spending growth far outpacing loan growth. This divergence reflects the tremendous impact of pandemic-related transfer payments and benefits. We expect a continued recovery in consumer lending demand as unemployment benefits are withdrawn and consumers once again have to borrow to finance spending. As part of the special ad-hoc questions in this edition of the survey, respondents were asked about how lending standards had changed compared to the pre-pandemic period by borrower risk rating. Interestingly, large banks actually eased their standards for investment grade borrowers, reflecting the impact of Fed’s massive liquidity injections (Chart 4). However, despite spreads on high-yield having tightened to post-GFC lows, credit standards for below-investment grade borrowers remain much tighter than before the pandemic. So far, lower-quality borrowers have been able to go to public debt markets for financing, but this highlights a downside risk—if there is an event which causes corporate bond spreads to widen, high-yield borrowers may be starved of cheap financing options with banks still holding purse strings taut. Euro Area In the euro area, banks continued to tighten standards to enterprises, albeit at a much-reduced pace, in Q1/2021 (Chart 5). The tightening, however, was lower than expected in the previous quarter, possibly reflecting prolonged policy support and improving risk sentiment. Deteriorating risk perceptions related to the general economic and firm-specific situation were the primary contributing factor to tightening. But this was partly offset by increased competition from other lenders. The reduced pace of tightening does confirm the signal from the high-yield default rate, which is rolling over. Going forward, banks expect the pace of tightening to slow very slightly going into Q2. Chart 5Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Business credit demand continued to weaken at a faster pace in Q1, marking three consecutive quarters of deterioration. Weak fixed investment continued to be the biggest drag on demand, while the previous positive contribution from inventory and working capital needs has disappeared entirely. As we highlighted in the last edition of this chartbook, the continued drag on demand for investment reflects a lingering uncertainty regarding the pandemic which could possibly lower potential long-term growth in the euro area.2 As in the US, however, the reduction in demand also reflected already built-up liquidity buffers and the availability of internal and market-based financing. In Q2, banks expect a strong rebound in enterprise loan demand, especially from small and medium-sized enterprises (SMEs). Consumer credit demand continued to decline at a stronger pace in Q1, reflecting the continued pandemic-related restrictions in Europe over the quarter. The key drivers were lower durable goods spending and weakening consumer confidence. Banks also reported increased use of internally-generated funds, which is consistent with accumulated savings and pent-up demand during the lockdown. Assuming that the emerging Delta variant does not sidetrack the European return to normalcy, we will likely see the expected consumer credit demand rebound come to fruition. This would be consistent with recent strong consumer confidence prints out of the region. Looking individually at the four major euro area economies, credit standards for enterprises tightened in Germany, Italy, and Spain but were unchanged in France (Chart 6). In countries where standards tightened, worsening risk perceptions were the primary factor. In France, increased competition from other lenders contributed to easing on the margin. Going into Q2, standards are expected to tighten very modestly in the two core European economies while diverging in peripheral Europe—Spanish banks expect an increased pace of tightening while Italian ones expect standards to remain unchanged. UK In the UK, overall corporate credit standards, measured as an average of standards for medium and large non-financial firms, eased slightly in Q1/2021 (Chart 7A). This increase in credit availability was driven primarily by an improving economic outlook and sector-specific risk picture. As in the US and euro area, competition from capital markets also played a role and is expected to contribute to the further easing expected in Q2. Chart 7AUK Credit Conditions Chart 7BInvestment And Inventory Financing Expected To Pick Up In The UK Meanwhile, corporate loan demand is picking up at a pace not seen since Brexit, excluding the 2020 spike driven by emergency funding needs, signaling a buoyant picture. In particular, the surge in demand was driven by large non-financial firms which are also expected to drive the demand pick-up in Q2. Household loan demand fell slightly in the first quarter but is expected to rebound. Consumer confidence, which had initially lagged behind loan demand, appears to have caught up as the UK’s “Freedom Day” from pandemic restrictions approaches in July. Lenders are also expected to ease availability for unsecured household loans, primarily on the back of market share objectives. This should create the ideal backdrop for a consumption boom if the Delta variant does not further limit the UK government’s ability to deliver on its promise of a full reopening. Delving into the factors behind booming corporate loan demand, there are promising signs for the broader UK economy (Chart 7B). In a Special Report published earlier this year, we argued that UK real interest rates were depressed because the country suffered from a series of rolling economic and political shocks, the effects of which were now expected to fade.3 There are already some signs of this in the credit data, with capital investment and inventory financing demand expected to rebound in Q2. Despite work-from-home effects dampening the need for office space, on the margin, UK commercial real estate demand is strong and expected to further strengthen. Japan Chart 8Japan Credit Conditions In Japan, credit standards to firms and households eased at a slower pace in Q1/2021 (Chart 8). The vast majority of respondents indicated that standards were basically unchanged, with none of the firms reporting any tightening, and a small number reporting some degree of easing. The most important factors driving easing were aggressive competition from other bank and non-bank lenders, as well as strengthened efforts to grow the business. Going into Q2, the pace of easing is expected to continue to slow. Business loan demand, which behaves somewhat counter-cyclically in Japan, increased over Q1. The entirety of this pickup can be attributed to small firms; large and medium-sized firms on the whole decreased their loan demand. Counter to trends in other regions, firms in Japan actually saw a decrease in internally-generated funds, which was the most important factor contributing to increased loan demand. Consumer loan demand fell slightly on balance but was mostly unchanged from the previous quarter. Respondents reporting weaker demand saw a decrease in household consumption as the most important factor. Sentiment remains subdued and has lagged the recovery in loan demand seen last year. Our colleagues at BCA Research Foreign Exchange Strategy are eyeing a recovery for the Japanese economy as the government turns around its vaccination campaign and the Olympics jumpstart consumption.4 On that basis, the very modest recovery in loan demand expected by Japanese banks appears too pessimistic. Canada And New Zealand In Canada, business lending standards continued to ease at a faster pace in Q1/2021, coinciding with rebounding business confidence which is now back to pre-pandemic levels (Chart 9). This is in line with a remarkable vaccine rollout—68% of the population has already received its first dose and the pace of daily vaccinations is showing no signs of rolling over. Chart 9Canada Credit Conditions Chart 10New Zealand Credit Conditions However, housing is a major concern for Canadian policymakers. In a recent Special Report, co-authored with our colleagues at The Bank Credit Analyst, we highlighted both Canada and New Zealand as “higher risk” countries more exposed to ballooning house prices.5 In addition to low rates, mortgage lending standards, which have been easing since Q3/2020, have undoubtedly contributed to this issue. However, the Bank of Canada (BoC), with its hawkish messaging, has signaled that it will not idly stand by; there is also popular support behind raising rates to tamp down house prices. Expect mortgage standards to tighten and a pick-up in mortgage rates as the BoC nears liftoff, most likely in 2022. Credit standards in New Zealand were mostly unchanged in Q1/2021, reversing the tightening trend of previous quarters (Chart 10). Over the next six months, standards are expected to ease considerably. Business loan demand was unchanged on net, with corporates decreasing and SMEs increasing demand. SMEs are also expected to increase demand slightly over the next six months. Tepid loan demand is consistent with business confidence hovering around the neutral zero line. As in Canada, soaring house prices are a major issue for the New Zealand economy. Data on household lending is alarming on that front. Although consumer loan demand continued to weaken, demand for residential mortgages spiked to an all-time high in Q1. While demand is expected to normalize going forward, the Q1 datapoint indicates froth in the market. The Reserve Bank of New Zealand is considering a variety of macroprudential measures but will have to raise rates sooner rather than later to effectively cool down the housing market. Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q1 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery", dated February 16, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. 4 Please see BCA Research Foreign Exchange Strategy Report, "The Case For Japan", dated June 11, 2021, available at fes.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com.