Europe

Special Report

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Chart 2Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Chart 6Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 Chart 12Gas Production Is Rising In Importance Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I Chart 23The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency Chart 26NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021.

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Chart 2Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Chart 6Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 Chart 12Gas Production Is Rising In Importance Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I Chart 23The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency Chart 26NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights The Fed: The Fed will formally discuss tapering plans over the course of this summer and fall and announce the slowing of asset purchases before the end of 2021. Its labor market objectives will also be achieved in time to lift rates in 2022. Non-US Developed Markets: The central banks outside the US most likely to deliver tapering and/or outright rate hikes over the next 1-2 years are those facing housing bubbles – the Bank of Canada and Reserve Bank of New Zealand. The ECB will do nothing on rates while adjusting asset purchase programs to preserve the size of its balance sheet, while the Reserve Bank of Australia will also sit on their hands for longer. Bond Strategy Recommendations: Investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor exposure in markets where central banks will be more dovish than expected (core Europe, Australia), while limiting exposure to markets where hawkish surprises are more likely (the US, Canada, New Zealand). Feature The recovery from the 2020 COVID recession is now well underway and many investors are getting antsy about when central bankers might respond by removing monetary policy accommodation. Some central banks appear more eager than others. Both the Bank of Canada and Bank of England, for instance, have already started to reduce their rates of bond buying. Meanwhile, the US Federal Reserve is only just now starting to talk about the timing of its own tapering. This Special Report lays out a timeline for what central bank actions we should expect during the next two years. The first section focuses exclusively on the US Federal Reserve and the second section incorporates likely announcements from other central banks. Based on a comparison of our expected central bank timeline with current market prices, we conclude that investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor government bonds in countries where central banks are likely to be less hawkish than markets expect (core Europe, Australia) versus bonds from countries where hawkish surprises are more likely (US, Canada, New Zealand and, potentially, the UK and Sweden).   The Federal Reserve’s Timeline Chart 1 shows our anticipated timeline for when the Federal Reserve will make specific policy announcements between now and the start of 2024. Chart 1The Federal Reserve’s Timeline First, over the course of this summer, the Fed will initiate discussions about when to taper its asset purchases. Then, asset purchase tapering will be announced at the December 2021 FOMC meeting with purchases set to decline as of the beginning of 2022. We expect that net Fed purchases will fall to zero by the end of Q3 2022. That is, by that time the Fed will no longer be adding to its securities holdings. Rather, it will keep the size of its balance sheet constant. Then, with its balance sheet no longer growing, the Fed will begin the process of lifting interest rates. We expect the first rate hike to occur at the December 2022 FOMC meeting. Finally, some time after the fed funds rate is well above the zero bound, the Fed will try to reduce the size of its securities portfolio. How do we arrive at this timeline? Table 1A Checklist For Liftoff We start with the Fed’s forward guidance about the timing of the first rate hike (Table 1). The Fed has told us that it will lift rates off the zero bound once (i) PCE inflation is above 2%, (ii) the labor market is at “maximum employment” and (iii) inflation is expected to remain above 2% for some time. The first item on the Fed’s liftoff checklist has already been met and the third item logically follows from the other two. That is, if inflation is above 2% and the labor market is at “maximum employment” then the Fed will certainly expect inflation to remain high. This means that the second item on the Fed’s checklist is the most critical for assessing the timing of liftoff. In assessing the US labor market’s progress toward “maximum employment” we first have to define what “maximum employment” means. Based on the Fed’s communications, we infer that “maximum employment” means an unemployment rate between 3.5% and 4.5% - a range consistent with the Fed’s NAIRU estimates – and a labor force participation rate that has recovered back to pre-pandemic levels (Chart 2). Table 2 presents the average monthly growth in nonfarm payrolls that is required to reach that definition of maximum employment by specific future dates. For example, we calculate that average monthly payroll growth of 698k to 830k will cause the labor market to reach maximum employment by the end of this year. Average monthly payroll growth of 412k to 493k is required to hit the Fed’s target by the end of 2022. Chart 2Defining "Maximum Employment" Table 2Average Monthly Nonfarm Payroll Growth Required To Reach Maximum Employment By The Given Date The most recent issue of the Bank Credit Analyst posits several reasons why US employment growth will pick up steam in the coming months.1 We agree with this view and note that indicators of labor demand such as job openings, the NFIB “jobs hard to get” survey and the Conference Board’s “jobs plentiful” survey also point to accelerating employment gains.2 All told, we think that average monthly payroll growth of 412k to 493k is eminently achievable (Chart 3). This means that the Fed will hit its three liftoff criteria in time to hike rates before the end of 2022. Chart 3Max Employment By The End of 2022 Working backwards from the expected liftoff date, the Fed has said that it needs to see “substantial progress” toward the criteria listed in Table 1 before it will taper its pace of asset purchases. The definition of “substantial progress” remains somewhat unclear, but a few recent Fed communications provide some clues. First, Fed Chair Jay Powell said that he wants to see a “string of months” like the strong March employment report before it will be appropriate to reduce the pace of asset purchases. The question of how many months constitutes a “string” remains unclear, but it certainly seems plausible that we could see two or three more strong employment reports over the course of the summer. Other Fed Governors appear to agree with this timeline. Governor Randal Quarles: If my expectations about economic growth, employment, and inflation over the coming months are borne out, however, and especially if they come in stronger than I expect, then, as noted in the minutes of the last FOMC meeting, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings.3 Fed Vice-Chair Richard Clarida: I myself think that the pace of labor market improvement will pick up. […] It may well be the time that – there will come a time in upcoming meetings we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases …4 Fed Governor Christopher Waller: The May and June jobs report[s] may reveal that April was an outlier, but we need to see that first before we start thinking about adjusting our policy stance.5 Our takeaway from these comments is that two or three more strong employment reports, say 500k or higher, would be sufficient for the Fed to more formally discuss tapering plans. Further, several Fed Governors seem to agree with our forecast that nonfarm payroll growth will accelerate in the coming months. With that in mind, it seems reasonable to expect that the Fed will discuss tapering plans over the course of the summer and fall, and that it will have seen sufficient labor market gains to announce a formal plan before the end of this year. Assuming that a tapering announcement occurs before the end of this year and that asset purchases actually start declining as of Jan 1st 2022, we estimate that the tapering process will conclude by the end of Q3 2022. That is, the Fed will hold the size of its balance sheet constant as of that date. Chart 4Balance Sheet Growth Will End Before The First Rate Hike At the very least, the Fed will certainly bring its net purchases to zero before it lifts rates. This is because it would be incoherent for the Fed to be tightening policy through its interest rate actions while it eases policy with its balance sheet strategy. Indeed, this is the roadmap that the Fed followed leading up to the 2015 rate hike cycle (Chart 4). Finally, we note that the Fed will try to reduce the size of its balance sheet only after the process of rate hikes is well underway. This will be consistent with the last tightening cycle when the Fed waited until the funds rate was 1.5% before it pared the size of its securities portfolio (Chart 4). We also want to stress that the Fed will only try to reduce the size of its balance sheet. In fact, we doubt that this process will get very far. The main reason for our skepticism is that there is an ongoing structural issue in the Treasury market where the supply of securities keeps growing while stricter regulations make it more costly for primary dealers to intermediate trades.6 In this environment, there are strong odds that Treasury market liquidity will evaporate whenever there is a significant shock to financial markets. When that happens, the Fed will be forced to support Treasury market liquidity through large-scale purchases, as was the case during last March’s market turmoil (Chart 5). In essence, the likelihood of future shocks that will necessitate Fed intervention in the Treasury market makes it unlikely that the Fed will make much progress reducing the size of its balance sheet. Chart 5Fed Had To Support Treasury Market In March 2020 Market Expectations And Investment Implications We can get a sense of how our Fed timeline compares to consensus expectations by looking at the New York Fed’s Surveys of Market Participants and Primary Dealers (Tables 3A & 3B). Respondents to these surveys expect tapering to start in early 2022, in line with our expectations, though they generally see it taking longer for net purchases to fall to zero. Respondents also expect a later Fed liftoff date than we do and don’t see the Fed trying to reduce the size of its balance sheet until well after rate hikes have begun. Table 3ASurvey of Market Participants Expected Fed Timeline Table 3BSurvey Of Primary Dealers Expected Fed Timeline But more important for investors than survey results is what is currently priced into the yield curve. In that regard, the overnight index swap curve is priced for Fed liftoff in February 2023 and a total of 75 bps of rate hikes by the end of 2023 (Chart 6). We expect rate hikes to start earlier and proceed more quickly than that, and therefore recommend running below-benchmark duration in US bond portfolios. Chart 6Market Rate Expectations The Timelines For Other Central Banks Policymakers outside the US are facing many of the same issues that the Fed is – rapidly recovering economies coming out of the pandemic, inflation overshoots, and surging asset prices. However, not every central bank will respond at the same time, or same pace, as the Fed. In Charts 7a and 7b, we show additional timelines for two of the most important non-Fed central banks: the European Central Bank (ECB) and the BoE. We see the likely dates and policy decisions playing out as follows. Chart 7AThe ECB’s Timeline Chart 7BThe Bank Of England’s Timeline European Central Bank For the ECB, the timing of its upcoming inflation strategy review is the most critical element. That report is due to be delivered in the latter half of this year, most likely in September or October (no firm release date has been announced by the ECB). It is highly unlikely that any meaningful policy changes will be implemented before that strategic review is completed. Some ECB officials have hinted that a move to a Fed-like interpretation of the ECB inflation target, tolerating overshoots of the target to make up for past undershoots, could result from the strategy review. The more likely option will be a move to an inflation target range, perhaps a 1-3% tolerance band, that offers more policy flexibility than the current target of just below 2%. This will potentially “move the goalposts” for the ECB in a way that will make monetary tightening even less likely compared to previous cycles. Looking at past ECB tightening episodes dating back to the central bank’s inception in 1998, it is clear that a majority of countries within the euro area must be seeing inflation that is high enough, with unemployment low enough, before any policy tightening can take place. Chart 8 illustrates this point, by showing “breadth” measures for unemployment and inflation across the euro area.7 Chart 8The ECB Usually Tightens When Growth AND Inflation Are Broad Based Specifically, the chart shows the percentage of euro area countries with an unemployment rate below the OECD’s estimate of full employment (second panel), the percentage of euro area countries with headline inflation higher than one year earlier (third panel) and the percentage of euro area countries with headline inflation above the ECB’s 2% target (bottom panel). We compare those breadth measures to the actual path of policy interest rates and the size of the ECB’s balance sheet (top panel). The conclusion from the chart is that the euro area is still a long way from having the sort of broad-based rise in inflation or fall in unemployment necessary to trigger a reduction in the size of its balance sheet or actual interest rate hikes. Chart 9The ECB Is Under No Pressure To Tighten Pre-Emptively Nonetheless, our expectation is that the ECB will want to begin preparing the markets for the end of the Pandemic Emergency Purchase Program (PEPP) - which has been buying government bonds since March 2020 in a less constrained fashion than previous asset purchase programs - shortly after the inflation strategy review is concluded. Much of the euro area economy is already showing signs of rapid recovery from pandemic induced lockdowns, amid an accelerating pace of vaccinations. On top of that, the Next Generation European Union (NGEU) recovery fund is set to begin distributing funds in the final quarter of 2021, providing a meaningful lift to government investment and expected growth in 2022. It will be difficult for the ECB to justify the need for an “emergency” program like the PEPP to continue against such a growth backdrop, especially with euro area inflation no longer at the depressed levels seen in 2020. We expect the ECB to begin preparing the market for the end of PEPP heading into the December 2021 ECB policy meeting, when it will be announced that the program will not be renewed when it expires in March 2022 (Chart 9). As always for such major policy announcements, the ECB will wish to do so when there is a new set of economic forecasts used to justify any changes. This is why December – the first meeting after the strategic review is completed that will also have new forecasts – is the earliest realistic date for an announcement on the PEPP. The communication around the PEPP announcement will need to be delicate, as the PEPP has significantly increased the ECB’s footprint in European bond markets. The share of government bonds owned by the ECB has increased by anywhere from five to ten percentage points since the PEPP began (Chart 10). We expect the ECB will be forced to expand its existing Public Sector Purchase Program (PSPP) to make up for the eventual disappearance of the PEPP. This means that the PEPP will be effectively “rolled into” the PSPP, to limit the damage from a likely post-PEPP surge in bond yields in the more fragile markets like Italy, Spain and even Greece – especially with the euro now trading close to pre-2008 highs on a trade-weighted basis (Chart 11). Chart 10The PEPP Can Expire, But Cannot Disappear Chart 11ECB Must Avoid A 'PEPP Taper Tantrum' There is a chance that the ECB will want to avoid any “PEPP taper tantrum” in Peripheral European yields (and spreads versus Germany) by making an announcement on PEPP expiry and PSPP expansion at the same meeting. If that happens, we suspect it would happen in December of this year rather than sometime in the first quarter of 2022. Beyond that, the ECB will likely seek to keep financial conditions as accommodative as possible by keeping policy interest rates unchanged well into 2023, with an actual rate hike not likely until mid-2024 at the earliest. The ECB could deliver a more modest form of “tightening” before then by letting some of the cheap bank funding programs (TLTROs) expire. Although we suspect that even those programs will need to be renewed, perhaps at less attractive financing terms, to prevent an unwanted tightening of credit conditions in the euro area banking system. Bank Of England Chart 12BoE Forecasts Are Conservative Having already announced a tapering of the pace of its bond buying in early May, the BoE is likely to continue along that path over the next year. We expect the BoE, like the ECB, to make any future taper announcements when new sets of economic forecasts are published in Monetary Policy Reports. Thus, the next taper announcements are expected in August 2021, November 2021 and February 2022, with a full tapering down to zero net purchases (new buying only replacing maturing bonds) by May 2022 at the latest. The first rate hike will occur between 6-12 months after the end of tapering, possibly as early as November 2022 but, more likely in our view, sometime closer to mid-2023. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 12). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. The BoE has been one of the least active central banks in the developed world since the 2008 financial crisis. The BoE main policy rate, the Bank Rate, has been no higher than 0.75% since then, even with the BoE threatening to lift rates to higher levels many times under the leadership of former Governor Mark Carney when inflation was overshooting the bank’s 2% target. Of course, the Brexit uncertainty since mid-2016 effectively tied the hands of the central bank and prevented any possible policy tightening. Now that Brexit has actually happened, however, the BoE has more flexibility to respond to developments with UK economic growth and inflation, as needed. A possible path for the UK Cash Rate was laid out in a recent speech by BoE Monetary Policy Committee (MPC) member Gertjan Vlieghe.8 He triggered a selloff across the Gilt market with his comment that a BoE rate hike could occur as early as Q2 2022 – with the Bank Rate rising to 1.25% from the current 0.1% by 2024 - under more optimistic scenarios for UK growth and employment. His base case, however, was that the coming uptick in UK inflation will prove to be temporary, but that a move towards full employment will make the first hike more likely toward the end of 2022 with modest rate increases in 2023 and 2024 that will take the Bank Rate to 0.75% (Chart 13). Chart 13Gilts Are Vulnerable To A Hawkish Surprise Vlighe’s base case scenario on growth and interest rates is in line with the BoE’s current forecasts that call for spare capacity in the UK economy to be fully eliminated by mid-2022, with rate hikes to begin in mid-2023. That is broadly in line with our projected BoE timeline and with current pricing in the UK OIS curve, although we see risks tilted towards faster growth and inflation – and the BoE moving more aggressively than projected – over the next 12-18 months. Other Major Developed Market Central Banks Looking beyond the “Big Three” of the Fed, ECB and BoE, central bank timelines have become increasingly dependent on a single factor – the strength of domestic housing markets. House prices are booming in Canada, New Zealand and Sweden, with valuation measures like the ratio of median house prices to median incomes soaring to historical extremes according to the OECD (Chart 14). House prices are also climbing fast in the US and UK, but the valuation measures have not surpassed the peaks seen during the mid-2000s housing bubble. The housing boom has already motivated some central banks to respond by turning less dovish sooner than expected, even with unemployment rates still above pre-pandemic peaks (Chart 15).9 The BoC noted that soaring Canadian housing values motivated the taper announcement in April. The Reserve Bank of New Zealand (RBNZ) has come under political pressure over the growing unaffordability of New Zealand homes, with the government changing the central bank’s remit earlier this year to force the RBNZ to explicitly consider house price inflation when setting monetary policy. Chart 14Surging House Prices Can Turn Doves Into Hawks Chart 15These CBs Could Turn More Hawkish Before Reaching Full Employment We expect more tapering announcements from the BoC over the latter half of 2021, with a first rate hike likely sometime in the first quarter of 2022. We see the RBNZ moving aggressively, as well, tapering over the remainder of 2021 before lifting rates by the spring of 2022 at the latest. Sweden’s Riksbank will be the next central bank to turn more hawkish because of surging home values, although they will lag the pace of the BoC and RBNZ with Sweden only now beginning to emerge from lockdowns associated with a third wave of COVID-19 cases. Importantly, Australia – a country that has dealt with house price surges in the past – has seen house price valuations retreat over the past few years, even with the Reserve Bank of Australia (RBA) slashing policy rates to historic lows. The RBA also introduced yield curve control in 2020 to anchor the level of short-term bond yields, while also engaging in outright bond purchases to mitigate the rise in longer-term bond yields. With Australian inflation still remaining well below target in a year of rising global inflation, and with subdued labor costs likely to keep price pressures moderate over the next 12-18 months, we expect the RBA to move very slowly on both tapering and rate hikes. Finally, for completeness, we should note that we do not expect any policy changes from the Bank of Japan (BoJ) over the next two years, with inflation likely to remain far below the central bank’s 2% target. Non-US Investment Implications In Table 4, we show the timing of the first rate hike (i.e. “liftoff”), and the subsequent amount of total rate hikes to the end of 2024, as currently discounted in the OIS curves of the eight countries discussed in this report. We rank the countries in the table in order of liftoff dates, starting with the closest to today. Table 4The “Pecking Order” Of Central Bank Rate Hikes The RBNZ is expected to hike first in May 2022, followed by the BoC (September 2022), the Fed (February 2023), the RBA (April 2023), the Riksbank (May 2023), the BoE (May 2023), the ECB (June 2023) and the BoJ (October 2025). The cumulative amount of rate hikes discounted to the end of 2024 rank similarly: more rate increases are expected in New Zealand (167bps), Canada (150bps), the US (137bps) and Australia (113bps); while fewer rate increases are expected in the Sweden (63bps), the UK (61bps), the euro area (31bps) and Japan (7bps). According to our various central bank timelines discussed in this report, we see the risks of a rate hike coming sooner than discounted by markets in the US, Canada and New Zealand. We see central banks moving slower than markets expect in the euro area and Australia, while we see Sweden and UK priced in line with our base case views (although we see risks tilted towards a more hawkish turn faster than expected in the latter two). The story is the same in terms of cumulative rate hikes discounted in OIS curves, with markets not pricing in enough rate hikes in New Zealand, Canada and the US – and, possibly, Sweden and the UK – while pricing too many hikes in Australia and the euro area. This leads us to recommend the following country allocations in a global government bond portfolio: Underweight the US, Canada and New Zealand Overweight Australia and core Europe (and Japan) Neutral Sweden and the UK, but with a bias to downgrade. Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst June 2021 Monthly Report, "Global House Prices: A New Threat For Policymakers", dated May 27, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 https://www.federalreserve.gov/newsevents/speech/quarles20210526b.htm 4 https://ca.news.yahoo.com/federal-reserve-vice-chair-richard-clarida-yahoo-finance-transcript-may-2021-173007192.html 5 https://www.federalreserve.gov/newsevents/speech/waller20210513a.htm 6 For a longer discussion of Treasury market liquidity issues please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup 2: Shocked And Awed”, dated July 28, 2020. 7 For more details, please see Global Fixed Income Strategy Report, “ECB Outlook: Walking On Eggshells”, dated May 19, 2021. 8 The full speech can be found here: https://www.bankofengland.co.uk/speech/2021/may/gertjan-vlieghe-speech-hosted-by-the-department-of-economics-and-the-ipr 9 For more details on the global housing boom, see Global Fixed Income Strategy Special Report, “Global House Prices: A New Threat For Policymakers”, dated May 28, 2021. 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