Europe

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@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 The surge in European natural gas prices is a consequence of China’s effort to wean itself off its coal addiction and of the energy supply problems around the world. As long as the energy price surge does not threaten a policy response by the ECB, it will not plunge Europe into a significant downturn. So far, the ECB is unlikely to respond, because a wage-inflation spiral has not developed. Natural gas prices will decline significantly over the coming months, as a result of the Nord Stream 2 pipeline and other developments around the world; thus, the energy price shock will not spill over into a durable inflation wave across the continent. Without a significant risk of premature monetary tightening, European cyclical assets will perform well over the coming 18 months. EUR/USD will stabilize in the 1.15-1.12 zone, and peripheral bonds will continue to outperform the core. Feature Europe is amidst an unprecedented energy crisis, following the past three months’ 235% and 240% increases in natural gas prices in the UK and the Netherlands’ benchmarks, respectively. Investors now begin to fear that this energy crunch will threaten the European economic recovery and could even plunge Europe into a renewed recession. Underlying inflation must rise enough to prompt a hawkish monetary policy response for the energy price spike to topple the economy. Higher energy prices alone will not be enough. Despite the current panic, more supply will make its way to Europe. Future prices are skewed to the downside from here. As a result, investors should refrain from betting on a rapid removal of monetary accommodation from the ECB. Additionally, an end to the energy crisis will allow the euro to recover and will help European cyclical assets. A Multifaceted Crisis The extraordinary spike in European energy and electricity prices reflects a rare confluence of events. Chart 1China's Wean Off From Coal First, China’s intake of natural gas is surging because of two decisions made by Beijing. The Xi Jinping administration is fighting aggressively to improve air quality in the country, because pollution is one of the population’s main worries. As a result, China is aiming to curtail the role of coal (which today accounts for 63% of its electricity production) in its energy mix; coal production is not following electricity generation (Chart 1, top panel). Coal imports are not substituting for the lack of domestic supply growth. Instead, China has cut its intake of Australian coal dramatically (Chart 1, bottom panel) in response to tensions between the two nations. Natural gas is filling the gap. Second, the rest of the world is also voraciously absorbing natural gas. The Korean economy has greatly benefited from the global rebound in industrial activity, and Japan is increasingly re-opening, a result of its accelerating vaccination campaign. Latin America has become an unusual buyer of LNG. Low rainfalls in Brazil have caused hydro-power generation to be well under normal levels this summer. As a result, natural gas shipments were also called upon to fill this gap. Third, Europe’s investment in alternatives is facing difficulties. As Chart 2 highlights, the EU generates 26% of its electricity generation from renewables; wind accounts for 55% of this category. However, as BCA’s commodity strategists recently showed, wind power generated low levels of output last summer across the EU and the UK, which occasioned a scramble for natural gas and coal power generation.  This process forced Europe to bid up LNG prices to compete with China, which caused European natural gas inventories to fall below the seasonal range of the past five years (Chart 3). Chart 2Europe’s Reliance On Renewable Chart 3Low Nat Gas Inventories Chart 4There's A Reason Why Energy Is Not Attracting Capital Fourth, the lack of investment in the energy sector over the past seven years is slowing the supply response. Much of the blame for this phenomenon has been laid on rising ESG standards, which have disincentivized banks, insurance companies, and pension plans from putting money in the energy sector. This is only partially true. The main culprit behind this lack of investment is the poor return generated in the energy sector over the past twelve years, especially compared to the tech sector. As an example, in Europe, ASML surged by more than 5000% since March 6 2009, whereas Royal Dutch Shell rose 19% (Chart 4). The former naturally attracted significantly more capital than the latter. Fifth, utilities are fearing a cold winter and are trying to stock up natural gas ahead of the cold season. The US Climate Prediction Center assigns a 70% to 80% chance of a La Niña event this winter. La Niña is a complex weather pattern that results in colder surface temperatures in the Pacific Ocean; it often produces colder temperatures across much of Western and Northern Europe. The effort to shore up depressed inventory levels ahead of this potential threat increases the pressure on natural gas prices. Bottom Line: The surge in European natural gas prices reflects a confluence of unusual forces. China is trying to move away from polluting coal electricity generation, while global demand has been buoyed by the re-opening of the economy and exceptional weather patterns. Moreover, the supply response of the energy sector is tepid following seven years of low capital investment because of low rates of returns. To add insult to injury, EU CO2 emission allocation prices reached a record of EUR64.3/ton in September, which adds to the pressure on electricity prices created by record natural gas prices. From Energy Crunch To Recession? This rapid climb in energy prices is bound to affect European economic activity in the fourth quarter as some firms must curtail production. However, important counterbalances will limit this pain. Hence, on its own, the energy crisis is unlikely to cause a major slowdown or recession. Natural gas, oil, and coal consumption only represent a small share of output at 2% of GDP, or the lowest level since 1999 (Chart 5). If we assume that all energy prices average their 2008 peaks for the next 12 months, the energy spending as a share of GDP will hit 5%, still below the 2008 apex. We do not believe average energy prices will be that high for that long (see European Nat Gas Prices Have Downside section). Thus, while the current energy prices surge is painful for many, the effective tax on the overall European economy remains manageable. Robust income expansion compensates for this small growth-tax increase. The Eurozone Gross National Income is rebounding smartly since its Q2 2020 trough. Exports outside the Eurozone are near all-time highs, and the goods and services balance of the current account is strong (Chart 6). Chart 5Energy Spending Is Small Chart 6Offsets To Rising Energy Costs Chart 7Resilient Confidence Confidence surveys remain unphased by the tumult in the energy market. The European Commission Consumer and Business Confidence Surveys stand near 3- and 14-year highs, respectively (Chart 7, top panel). The Belgian Business Confidence Survey, which historically acts as a bellwether for the whole of Europe, still stands near its all-time high. Even more surprising, the retail sales survey continues to climb higher (Chart 7, second panel). In Germany, which is historically sensitive to energy prices, the Ifo Business Climate index is remarkably stable (Chart 7, third panel). Even Italy, which is exceptionally reliant on natural gas, is resilient: Consumer confidence hit a ten-year high, and business confidence remains close to its recent record (Chart 7, bottom panel). Fiscal policy is creating another important offset to higher energy prices. Underlying government deficits are tabulated to decrease from 3.8% of GDP for the Eurozone in 2020 to 3.6% in 2021 and 1.5% in 2022. However, this is happening as private sector savings decline rapidly, the result of the re-opening of the economy and robust confidence. Instead, what matters is that the deficit will remain large by historical standards and is creating more aggregate demand than in the pre-pandemic period (Chart 8). Moreover, the NGEU funds will spend an envelop worth EUR750 billion, mostly for vulnerable economies, such as Italy or Spain. Ultimately, it requires more than just rising energy prices to prompt an economic contraction. The US provides an interesting example. As Chart 9 illustrates, when previous sharp increases in commodity prices were associated with a rapid tightening in monetary policy, a recession followed. This time around, monetary policy is looking through the surge in input prices, because global central bankers firmly believe that the recent increase in inflation is transitory. Similarly, because credit spreads remain very narrow, equity prices remain elevated, and global bond yields are still very low, global financial conditions will remain extremely accommodative. Thus, if inflation does not broaden and central bankers do not panic, growth will turn out to be fine. Chart 8No More Budget Surpluses Chart 9Higher Commodity Prices Alone Won't Cause A Recession Bottom Line: The European energy crisis is causing investors to worry, and many now fear that a major slowdown or even another contraction in output is in the offing. However, carbon-based energy represents too small a share of GDP to cause such a dire outcome, especially when income growth remains strong, confidence is elevated, and fiscal policy is broadly accommodative. Ultimately, the reaction of central bankers will determine the outlook for economic activity. Will The ECB Respond To Inflation? The hurdle is very high for the ECB to respond to the recent increase in HICP to 3.4%. To begin with, the ECB is still reeling from its decision to lift the repo rate twice, to 1.5% in 2011 when HICP reached 3% on the back of strong energy prices (Chart 10). This decision is now widely considered a policy mistake that accentuated the European sovereign debt crisis. Beyond a fear of repeating history, the ECB is constrained by the narrow nature of European inflation. As Chart 11 shows, trimmed mean CPI, which includes 84% of the consumer prices index components, remains extremely depressed by historical standards, highlighting the role of a few components in driving up overall inflation. Moreover, shelter inflation remains a tepid 1.1%. Hence, the surge in CPI reflects higher commodity prices and base-effects from the pandemic. Chart 10The 2011 Mistake Chart 11Inflation Is Still Narrowly Based Wage dynamics will determine when energy prices will cause a broad-based increase in inflation. Without significantly higher wage growth, higher energy prices are a relative price shock that saps spending in other areas. For now, the de-linking of Bund yields and European energy prices confirms we are still facing such a price shock (Chart 12, top panel). Trends in hourly earnings and negotiated wages are currently also inconsistent with generalized inflation (Chart 12, second and third panel). Obviously, the situation may change. It will require a large adjustment in expectations. For now, European inflation expectations are trending higher, but they remain mostly a function of dynamics in the energy market (Chart 13, top panel). Similarly, the fluctuations in energy prices strongly influence the perception of firms about their ability to raises prices (Chart 13, bottom panel). Chart 12A Relative Price Shock, Not Generalized Inflation Chart 13Inflation Expectations Will Follow Energy Prices Ultimately, energy price inflation must remain elevated for several more months before inflation expectations become permanently unhinged. Thus, if energy prices stabilize or decrease in the new year, then no wage-inflation spiral will develop, and the ECB will not lift policy rates and prompt a severe slowdown in economic activity. Bottom Line: Due to the memory of the 2011 policy mistake and the lack of broad-based inflationary pressures in Europe, the ECB will continue to ignore the rise in headline inflation. However, if energy price increases perdure long enough, inflation expectations and wages will become problematic. Only in this context will the ECB tighten policy and prompt a severe slowdown. European Nat Gas Prices Have Downside We expect European natural gas prices to decline significantly over the coming months, which will prevent the ECB from tightening policy too early and cause a significant growth slowdown. The opening of the Nord Stream 2 pipeline early next year is a game changer. German regulators still have to announce whether to allow deliveries to flow to the domestic market, but Russia is already filling the pipeline completed last month. Moreover, the German public widely supported the project in May (Chart 14), and the recent energy crunch must have only solidified this trend. Nord Stream 2 is key for another reason. Russia limited the inflow of gas to Europe ahead of the pipeline opening to improve its negotiation position and put pressure on Germany to accept the project. Most importantly, the IEA estimates that Russia has ample capacity to supply European gas markets, and the trend in Russian gas production remains healthy (Chart 15). Chart 14Broad-based Support For Nord Stream 2 Chart 15Nat Gas Production Profiles Outside of Russia, other gas producers will continue to ramp up production. Australia is becoming an increasingly important player in the global LNG market and its production is rising (Chart 15, second panel). Qatari production has been flat for nine years. However, recent permit auctions point toward a strong increase in production in the North Field, in the order of 40% by 2026, buttressed by $60 billion in capex from 2021 to 2025. Saudi Arabia, too, is expected to increase natural gas production from next year to 2025. Finally, US production is still expanding; the IEA expects this country to become the world’s largest LNG exporter by 2025. A large part of the fears about higher European natural gas prices over the coming months relate to La Niña. Investors understand full well that it could generate a cold winter and are focusing on this risk, which is already reflected in natural gas prices. However, La Niña also causes wetter winters in Brazil, which would allow a resumption of hydro-power generation in this market. Additionally, La Niña also results in unstable winter conditions in Northern Europe, which suggests that wind will increase; the latter would alleviate some of the problems linked to renewable power that have forced natural gas prices higher. The growth in LNG demand from Asia should also slow in the near term. China is committed to its shift away from coal-powered electricity production, but the inability to produce enough electricity has caused occasional blackouts and electricity rationing around the country. In response to these pressures, Chinese authorities have recently started to allow deliveries of Australian coal. Moreover, in Japan, Fumio Kishida, the recently elected head of the LDP, is a big supporter of nuclear energy, and he plans to re-open nuclear plants rapidly after becoming prime minister. Such a move would quickly decrease Japan’s appetite for LNG. Finally, Iran remains a wild card. Iran possesses the second largest natural gas reserves in the world after Russia and is the world’s third-largest producer. Europe currently cannot access that gas because of the US post-JCPOA sanctions. However, Israel and the US are now in favor of returning to the conditions of the JCPOA, which means that, if a deal is hastened, Iranian natural gas will find its way into the global market. While it is not a base case for 2021, it is a positive tail outcome that would have a large impact on the natural gas market and help Europe greatly. Bottom Line: European natural gas prices have likely already peaked or will do so soon. The Nord Stream 2 pipeline, which should begin deliveries this winter, is an important development, especially because Russia has the capacity to supply Europe adequately. Moreover, global production of natural gas is set to increase meaningfully over the coming years. While La Niña would result in lower winter temperatures in Europe, which boost demand, it would also help in terms of the supply of hydropower in Brazil and wind in Northern Europe; meanwhile, Japan looks set to restart nuclear power generation under a Kishida administration. Finally, both the US and Israel are warming up to a return to the JCPOA with Iran, which would result in a great increase in international supply. This last point is more a downside risk for natural gas prices than a factor we are banking on. Investment Implications We expect natural gas prices to depreciate over the coming months, and thus, the current shock will have little enduring impact on European economic activity. The lack of recession risk suggests that our 18-month preference for markets like Germany, Sweden, and small cap remains appropriate. It also means that the tactical window for Spain to outperform remains open. Peripheral spreads will also remain well behaved, and Italian, Portuguese, Greek, and Spanish bonds will outperform German and French bonds further. Without higher natural gas prices, inflation expectations will not become unanchored to the upside, and the ECB will maintain a very accommodative monetary policy. Not only will the ECB lag well behind the Fed in terms of increasing interest rates, it will also remain an active buyer of European bonds next year. We continue to be a buyer of EUR/USD in the 1.15-1.12 region. The ECB is unlikely to come to the rescue of the euro; however, tighter peripheral spreads, continued growth convergence with the US, and a rebound next year in global economic activity will help the common currency.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades   Currency Performance Fixed Income Performance Equity Performance

Highlights Q3/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +8bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +4bps, led by the timely downgrade of UK Gilts to underweight in early August. Spread product allocations outperformed by +4bps, coming entirely from the overweights to high-yield in the US and Europe. Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries. Feature Global bond markets have had a lot of sources of uncertainty to digest over the past few months. Renewed COVID fears due to the spread of the Delta variant, slowing global growth momentum, supply chain disruptions leading to surging realized inflation, the ongoing US fiscal policy debate in D.C., concerns over Chinese corporate debt and the increasingly hawkish monetary policy signals sent by global central banks, most notably the Fed. The net result of these narratives has been some major swings in government bond market performance during the third quarter of 2021. The benchmark 10-year government bond yield in the US started the quarter at 1.48%, fell to an intraday low of 1.12% on August 4, then soared higher to end the quarter back at 1.50%. Even bigger moves were seen in other countries, with the 10-year UK Gilt yield doubling from its Q3 low of 0.48% on August 4 while the 10-year German bund yield is now 30bps above its low for the quarter. Despite this yield volatility, however, spreads for riskier credit market assets like US high-yield have remained generally well behaved. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during Q3/2021. 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. We anticipate that bond investor uncertainty will switch from concerns about global growth to worries that stubbornly elevated inflation will elicit bond-bearish monetary policy responses from central banks. 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. Q3/2021 Model Bond Portfolio Performance: Positive Returns In An Uncertain Environment Chart 1Q3/2021 Performance: Riding The Duration Roller Coaster The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was +0.21%, slightly outperforming the custom benchmark index by +8bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +4bps of outperformance versus our custom benchmark index while the latter also outperformed by +4bps. Those small positive excess returns should be considered a victory, given the huge yield swings within the quarter, particularly for government bonds. We maintained a significant underweight position to US Treasuries in the portfolio during Q3, given our view that markets were underestimating the risks that the US economy would weather the summer Delta storm. As Treasury yields declined steadily during July and August, so did the relative performance of our model bond portfolio. The government bond portion of the portfolio was underperforming the benchmark by as much as -30bps before global bond yields bottomed out in early August. In the end, there was only a slight underperformance (-2bps) from the US Treasury portion of the portfolio during the quarter (Table 2). Table 2GFIS Model Bond Portfolio Q3/2021 Overall Return Attribution Our biggest government bond overweights have been concentrated in the euro area. There, the sum of active returns during Q3 from our government bond allocations was +3bps, although that came entirely from above-benchmark allocations to inflation-linked bonds in Germany, France and Italy. We did make one major shift in our government bond allocations during the quarter, and it was both timely and successful. We downgraded our recommended UK Gilt exposure to underweight on August 11.2 We observed that the Bank of England (BoE) was starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge was losing momentum. The BoE rhetoric has proven to be even more hawkish than we anticipated, hinting at a possible rate hike before the end of 2021, leading Gilts to be the worst performing government bond market in our model portfolio universe during the quarter. The result: our UK underweight contributed +4bps to the portfolio performance during the quarter. Turning to the credit side of the portfolio, the most successful positions were our overweight tilts on high-yield in the US (+3bps) and euro area (+1bps). All other exposures contributed little to returns, an unsurprising development given our neutral allocations to investment grade corporates in the US, UK and euro area, as well as for USD-denominated EM corporates. 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 Q3/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q3/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Overweight UK Gilts with a maturity greater than 10-years (+4bps) Overweight Italian inflation-linked bonds (+2bps) Overweight US high-yield: Ba-rated (+2bps) and B-rated (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10-years (-2bps) Overweight Japanese Government Bonds in longer maturity buckets: 7-10 years (-1bps) and greater than 10-years (-1bps) Overweight UK inflation-linked bonds (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2021. 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 Q3 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q3/2021 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. As can be seen in the chart, the bars look very close to that ideal for Q3/2021. Among the markets that represent our overweights, the most notably positive returns came from all euro area government bonds (a combined +136bps) and euro area corporates (a combined +20bps from investment grade and high-yield). Returns within our recommended underweight positions were even more notable: UK Gilts (-302bps), New Zealand government bonds (-103bps), EM USD-denominated sovereigns (-85bps), and Canadian government bonds (-45bps). Bottom Line: Our model bond portfolio slightly outperformed its benchmark index in the third quarter of the year by +8bps – a moderately positive result coming equally from underweight positions in government bonds and overweight allocations to spread product. Future Drivers Of Portfolio Returns Chart 5Negative Real Yields: The Biggest Mispricing In Global Bond Markets Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by our below-benchmark overall duration tilt – focused on our underweight stance on US Treasuries – and our overweight stance on high-yield corporates. 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). While our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, has peaked, the overall level of 10-year bond yields within the major developed markets remains well below levels implied by the Indicator (top panel). That is most clearly evident when looking at the large gap between deeply negative real bond yields and the still-elevated level of the global manufacturing PMI, which typically leads real yields by around six months (second panel). We continue to view this gap between real yields and growth as the biggest mispricing in global bond markets – one that will eventually be rectified by the incremental reduction in monetary accommodation that is signaled by our Global Central Bank Monitor (bottom panel). The combined message from our Central Bank Monitor, Duration Indicator and the manufacturing PMI is that global bond yields are still 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, UK and Canada). We have the highest conviction on the US and UK underweights, with a curve-flattening bias for both markets relative to the rest of the major developed markets (Chart 6). The bond-friendly (and risk asset-friendly) impact of global quantitative easing programs is fading, on the margin, with the annual growth rate of central bank balance sheets having already slowed sharply (Chart 7). The pace of tapering, and any subsequent rate hikes, will differ by country and support our government bond country allocations in the model portfolio. Chart 6Expect More Relative Curve Flattening In The US & UK Chart 7The 'Great Global Taper' Has Begun   Chart 8Less Scope For Wider Global Inflation Breakevens We expect the Fed to taper its pace of bond purchases over the first half of 2022, setting up a first Fed rate hike late next year. The Bank of Canada and the BoE will be the other developed market central banks that will both end QE and lift rates before the Fed does the same. On the other hand, the ECB, Bank of Japan and the Reserve Bank of Australia will maintain a more relatively dovish stance in 2022, with very modest tapering (at worst) and no rate hikes. Turning to inflation-linked bonds, we are maintaining an overall neutral allocation given the competing forces of rising global inflation and rich valuations. 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 Italy, France, Canada and Japan (Chart 8). On the back of this, we are maintaining our overweight allocations to inflation-linked bonds in the euro area and Japan in our model portfolio, while staying neutral on US TIPS. Chart 9Fading Support For Credit Markets From Global QE In 2022 Moving our attention to the credit side of our model portfolio, a moderate overweight stance on overall global corporates (focused on high-yield) versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets is flashing a warning sign for the future 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 (by about twelve months) of the annual excess returns of both global investment grade and high-yield corporates during the “QE Era” since the 2008 financial crisis (Chart 9). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond outperformance around February 2022, particularly for high-yield versus government bonds and investment grade (top two panels). At the same time, our preferred measure of the attractiveness of credit spreads - the historical percentile ranking of 12-month breakeven spreads – shows that lower-rated high-yield credit tiers in the US and euro area offer spreads that are relatively high versus their own history compared to other credit sectors in our model bond portfolio universe (Chart 10). Using this metric, investment grade corporate spreads look much more fully valued, particularly in the US. Chart 10Lower-Rated High-Yield & EM Sovereigns Offer Relatively Attractive Spreads Given sharply reduced default risks in the US and Europe, with strong nominal growth supporting corporate revenues alongside low borrowing rates, the fundamental backdrop for riskier high-yield corporates is still positive. Thus, we are maintaining our overweights to high-yield bonds in both the US and euro area, while sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce that exposure in the model portfolio sometime in early months of 2022, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that means about the future path for global monetary policy and risk asset performance. Within the euro area, we are maintaining overweights to Italian and Spanish government bonds given the likelihood that the monetary policy backdrop will remain supportive (Chart 11). We expect the ECB to be one of the most accommodative central banks within our model portfolio universe in 2022. At worst, the ECB could deliver a modest reduction of total asset purchases, but with no rate hikes. Chart 11A Relatively Dovish ECB Will Be Positive For European Credit Chart 12EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering Finally, we are sticking with a cautious stance on emerging market (EM) spread product in our model bond portfolio. Slowing Chinese economic growth, a firming US dollar, rate hikes across EM in response to high inflation, and the coming turn in the Fed policy cycle are all headwinds to the relative performance of EM USD-denominated corporates and sovereigns (Chart 12). We are sticking with our overall modestly underweight stance on EM USD-denominated credit. However, rebounding global growth and some potential policy stimulus in China could prompt us to consider an upgrade in the coming months.   Summing it all up, our overall allocations and risks in our model portfolio leading into Q4/2021 look like this: An overall below-benchmark stance on global duration, equal to -0.75 years versus the custom index (Chart 13). A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 14). This overweight comes almost entirely from allocations to US and euro area high-yield corporates. The tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is relatively low at 55bps (Chart 15). This fits with our desire to maintain only a moderate level of absolute portfolio risk, while focusing exposures more on relative tilts between countries and credit sectors. Chart 13Overall Portfolio Duration: Stay Below Benchmark Chart 14Overall Portfolio Allocation: Small Spread Product Overweight The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry” of 16bps (Chart 16).   Chart 15Overall Portfolio Risk: Moderate Chart 16Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts 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. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries We see global growth momentum, the stickiness of supply-driven inflation pressures and the Fed monetary policy outlook as the three most important factors for fixed income markets over the next six months, thus our scenarios are defined along those lines. Base case Global growth rebounds from the dip seen during July and August as fears over the spread of the Delta variant subside. Unemployment rates across the developed economies continue to decline on the back of ongoing demand/supply imbalances in labor markets. China is a relative growth laggard, but this will trigger fresh macro stimulus measures (credit, monetary, perhaps fiscal) from policymakers concerned about missing growth targets. Global supply chain disruptions will remain stubbornly persistent, keeping upward pressure on realized inflation rates in most countries even as commodity price momentum cools a bit on a rate of change basis. Most developed market central banks will move to dial back pandemic monetary policy stimulus to varying degrees, most notably the Fed and the Bank of England. The Fed will begin tapering its asset purchases around the turn of the year, to be completed during Q4/2021 thus setting the stage for a Fed rate hike in December. In this scenario, we expect the US Treasury curve to see some initial mild bear-steepening alongside moderately wider longer-term TIPS breakevens, before entering a more typical cyclical bear-flattening as the Fed begins tapering and rate hike expectations get pulled forward. The net result over the next six months: the entire US Treasury curve shifts higher in roughly parallel fashion, with the 10-year reaching 1.70% by next March. The VIX drifts a bit lower from the current 21 to 18, the US dollar is flattish (faster global growth offsets more USD-favorable real yield differentials versus other developed markets), the Brent oil price goes up +5% on the back of stronger global demand, and the fed funds target rate is unchanged at 0-0.25%. Upside growth & inflation surprise Global growth accelerates amid sharply diminished COVID risks and rallying stock and credit markets that loosen financial conditions. Consumer & business confidence recover smartly, as do hiring and capex. Global inflation rates accelerate from current elevated levels, but less from supply squeezes and more from fundamental pressures and faster wage growth. China loosens macro policies, but developed market central banks shift in an even more hawkish direction. The Fed signals a rapid 2022 taper and a funds rate liftoff well before year-end. In this scenario, 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 shifts much higher than in our base case, led by the 5-year maturity with bear-flattening beyond that point. The 10-year US Treasury yield climbs to 1.90% by the end of Q1/2022. The VIX moves higher to 25, the US dollar falls -3% (faster global growth offsetting a relatively modest increase in US/non-US real yield differentials), the Brent oil price goes up +10% and the fed funds target range is unchanged at 0-0.25%. Downside growth & inflation surprise Global growth loses additional momentum as consumer and business confidence stay muted. Supply/demand mismatches in labor markets remain unresolved, leading to a slower pace of employment growth. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration implements a much smaller-than-expected US fiscal stimulus. Supply chain disruptions persist, keeping inflation elevated even as growth slows (stagflation). Developed market central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to slower growth. The Fed chooses a slower drawn-out taper with liftoff delayed to 2023. 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, 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 target range stays at 0-0.25%. The inputs into the scenario analysis are shown in Chart 17 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 18. 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). Chart 17Risk Factor Assumptions For The Scenario Analysis Chart 18US Treasury Yield Assumptions For The Scenario Analysis     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 +60bps in the base case scenario and +57bps in the optimistic growth scenario, but is projected to underperform by -26bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries.   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. 2 Please see BCA Research Global Fixed Income Strategy/ European Investment Strategy Weekly Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns