Bubbles/Crises/Manias

Older workers have deserted the labour force in the US and the UK, but not so in the Euro area and Japan. The result is that wage inflation is red hot in the US and the UK, but not so in the Euro area and Japan. Hence, the Bank of Japan is right to remain a lone dove, the ECB must pivot from its uber-hawkish stance quite soon, but the Fed and the BoE must not pivot from their uber-hawkish stance too soon. We go through the major investment implications.

Special Report

Executive Summary The Recovery of Chinese Property Market Relies On Home Sales Property sales, starts, developers’ total financing, and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate. More supportive government policies will be released in the coming months, including mortgage rate cuts. It will take time for a recovery in sales and construction activity to occur, because of enormous excesses in the mainland property market/industry. Plus, China’s economy is challenged by the dynamic zero-COVID policy, a budding contraction in exports, and generally weak income growth.   Property developers started to shift their business model from “pre-selling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market by reducing financial stability risk. However, it means that the industry will take a longer time to contribute to growth in the broader economy. Bottom Line: We continue to hold a bearish view on the share prices of both onshore and offshore Chinese property developers in absolute terms and relative to China’s overall equity benchmark. A continued weakness in construction volume in the next few months implies less demand for commodities, such as iron ore, steel, cement, and glass.   Chart 1Low Sentiment in Both Current and Future Income The turmoil in China’s property market has not abated. Homebuyers remain unwilling to buy houses because of concerns over widespread sold but unfinished properties, falling confidence in future incomes, and worsening employment expectations (Chart 1). Property sales, starts, and completions have all collapsed by 25-45% from their mid-2021 peak (Chart 2 and 3). However, these variables will likely start to improve on a rate-of-change basis (i.e., the pace of contraction will moderate) in the months ahead (Chart 3). The rationale is that accelerated policy easing in the housing sector will help on the margin. Notably, policies curbing housing demand have loosened much more this year than they did in 1H2020. Plus, the authorities will introduce more accommodative real estate policy initiatives later this year and early next year, including additional mortgage rate cuts. Chart 2Property Sales, Starts, And Completions Will Further Decline In Their Level Terms… Chart 3...Albeit Improving On A Rate-Of-Change Basis Nevertheless, the construction industry, its suppliers, and the entire economy will take small consolation from the moderating pace of decline in the property sector. The basis for this response is that the level of activity will continue falling in the next three-to-six months, albeit at a slower rate than that of the present moment. Overall, aggressive policy easing will take time to produce a meaningful recovery in the mainland’s property market because it is occurring amid the structural breakdown in the real estate market and a confidence crisis among stakeholders. Policy Support Has Accelerated  Chinese authorities have accelerated their policy initiatives in the real estate sector to restore homebuyers’ confidence and stabilize the sagging domestic property market. Chart 4The Recovery of Chinese Property Market Relies On Home Sales A nearly 30% year-on-year decline in floor space sold in residential commodity buildings has exacerbated a liquidity crisis among property developers. Deposits, advanced payments, and mortgage payments originating from property pre-sales, have historically contributed to about 50% of property developers’ financing (Chart 4, top panel). Hence, renewed homebuyers’ confidence and a revival in house purchases would alleviate the liquidity crunch among cash-strapped developers (Chart 4, bottom panel), who could then complete more housing units under construction. Chinese authorities have introduced an assortment of supportive housing measures, including the following: Measures To Help Complete Pre-Sold Apartments In response to the homebuyer confidence crisis, the Politburo demanded that local governments be responsible for ensuring the delivery of housing projects. Since July, at least 36 local governments in 15 provinces have released concrete policies in this respect (Box 1).   Box 1 Local Governments:  The Delivery Of Pre-sold Housing Units Turns into a Political Task "Pre-sale fund supervision"1 is an important policy related to "guaranteed delivery" for presold properties. Real estate development enterprises must deposit pre-sale funds into a bank's special supervision account, which can only be used for the construction of a specific project and cannot be withdrawn or used at will. Another important policy is implementing "one building, one policy" and stipulating local government involvement to resolve problems. With the support of local government, a fund required to complete an unfinished building can be raised in various ways including, but not limited to the following: 1) increasing financing from local banks or asset management companies;2  2) encouraging good SOEs or high-quality homebuilders to take over stalled projects; 3) local governments purchasing back unused land from property developers; or 4) asking desperate buyers of those pre-sold and unfinished projects to contribute additional funds.3   Last month, the authorities also established a real estate fund of initially RMB 80 billion, which was funded by China Construction Bank and the central bank. In mid-August, China introduced procedures to ensure property projects are delivered to buyers through special loans from policy banks. The amount of this special loan will be about RMB 200 billion.4 This will be also a part of the real estate fund established last month, which could potentially be increased to RMB 300-400 billion and will be used only to ensure the delivery of presold but unfinished projects. Moreover, the government started to ease policies on property developers’ onshore bond issuance. In August, Chinese regulators instructed China Bond Insurance to provide guarantees for onshore bond issuance by private property developers. We expect more policy easing on developers raising funds though bank loans and more onshore bond issuance (Chart 5).  Measures To Increase Homebuyers’ Affordability The average mortgage rate has been decreased three times so far this year, falling to 4.3% for first-time home buyers. This is the lowest rate since 2009 (Chart 6).  Chart 5Chinese Developers Needs More Policy Easing On Their Borrowing Chart 6Easing Policies On Mortgage Rate Since the beginning of this year, over 80 cities relaxed their restrictive policies on loan borrowing. Among these cities, nearly 60 lowered their down payment ratio for a first home purchase, while about 40 reduced their down payment ratio for a second home purchase.5 Local governments also offered financial support for shantytown renewal and cash rebates for home purchases. Multiple cities have also issued incentives to encourage households with second or third children to buy additional properties. Bottom Line: Authorities have ramped up their supportive housing policies in recent months.  We expect more policy stimulus (e.g., another mortgage rate cut) to be announced over the next three-to-six months. Housing Turnaround Takes Time Despite considerable supportive policies in place, housing starts and construction activity will continue to contract and home prices will deflate further in the next three-to-six months. The policies will take time to work, especially ones related to ensuring the delivery of pre-sold housing. A significant amount of financing will be required for problematic projects that real estate developers are unable to build and deliver. Many local governments are also facing financial distress. Therefore, it will take time to arrange financing from third parties. Even after securing financing for incomplete housing projects, there will be delays in the construction and delivery of these units. Potential homebuyers may be willing to purchase in installments and provide funds to developers, but only if they witness increased deliveries of pre-sold homes. These funds are critical to developers as they account for about half of their total financing (Chart 4 above). The willingness to buy has been suppressed by falling confidence over future incomes, worsening future employment expectations and weakening growth of current income (Chart 1 on page 2). The willingness of households to save recently hit a record level; it is higher than during the first outbreak of COVID-19 in early 2020. Meantime, the propensity to invest has tumbled to a multi-year low (Chart 7). Chart 7More Chinese Households Intend To Save Rather Than Invest Chart 8Property Sales In Rich Eastern Provinces: Still In A Deep Contraction The growth of residential floor space sold in the eastern provinces often leads the rest of China (Chart 8). The Eastern provinces account for about 44% of China’s total residential floor space sales. Residential floor space sales in the Eastern provinces were still down by 30% in July.  The lack of an upturn in the Eastern provinces, especially after the re-opening in Shanghai and Shenzhen, indicates that a property market recovery will not be imminent or V-shaped. Chart 9A Majority Of Key Cities Have Declining Housing Prices Currently still 70% and 85% of the 70-city house price indexes are showing year-over-year price declines in newly constructed houses and secondary houses, respectively (Chart 9).  Shrinking pre-sales mean less financing for homebuilders and, ultimately, contracting property investment in the next three-to-six months (Chart 10). Many developers will continue to struggle to attract sufficient financing. Hence, they must cut their starts and completions (Chart 11). Chart 10Shrinking Pre-sales Will Lead To Falling Property Investment Chart 11Property Developers Have Been Starting And Preselling But Not Completing High prices/low affordability, speculative behavior of both developers and homebuyers, very high leverage and risky financing schemes, large volumes of supply and high inventories and vacancies , all need to be absorbed. A dynamic zero-COVID policy, a budding contraction in exports and generally weak income growth will challenge China’s economy in general.  Chart 12Insufficient Financing Will Lead To Weaker Construction Activity Ahead Bottom Line: The authorities’ supportive policies will take time to relieve the liquidity crisis among property developers and boost sentiment among homebuyers. Property sales, starts, developers’ total financing and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate (Chart 12). A Structural Shift In Developers’ Business Model Chinese property developers started to shift their business model from “preselling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market. It will lower the leverage of and curb real estate assets hoarding by developers and, thereby, improve stability in the industry. The old model of “preselling then completing” is not sustainable. In the past decade, Chinese real estate developers aggressively pursued a business model of “buying land, quickly starting property projects, and preselling unfinished homes but not completing them.”6  Chart 13A Structural Shift In Developers' Business Model As this model was essentially raising funds via launching property starts despite shrinking completions (Chart 13, top panel), it has resulted in a significant increase in Chinese property developers’ liabilities and unfinished construction carried on the balance sheet of developers. In short, as we have argued before, real estate developers have been involved in a massive carry trade. This is one of the root causes of the current crisis in China’s real estate sector. With this business model, developers carried real estate assets (land and started properties) on their balance sheets to benefit from the positive “carry”; i.e., the difference between the cost of funding and real estate asset price appreciation. However, the carry has turned negative as property asset prices are now flat or deflating rather than rising at double-digit rates. Hence, developers are under pressure to liquidate their assets and reduce their debts. Yet, to sell their not-pre-sold housing projects that are under construction, they first need new funds to complete unfinished homes before they can be sold. Furthermore, both the “three-red lines” policy for property developers and the new bank lending regulations limiting lending to the real estate sector – both put into effect in H2 2020 – remain in place. This means that Chinese real estate developers have no choice but to change their business model to a more sustainable one – the one with more sales coming from existing properties instead of pre-sales. The new model of “completing first, selling after” is a sustainable one. Homebuyers fear buying unfinished houses, preferring existing ones. Critically, increasing sales of existing houses will provide extra funds to debt-laden builders. In contrast, delivery of pre-sold units does not generate new cash for developers because most cash are received long before completion of a dwelling. Facing a liquidity crunch, there is no incentive for developers to complete pre-sold units. Chart 13 shows such a shift has been underway since mid-2021. Sales of completed houses increased considerably, while properties sold in advance plummeted. This trend also reflects a rising preference among homebuyers for completed properties. Buyers can visit and check the quality of a construction-completed unit versus paying for a future unknown unit. Meanwhile, property developers’ leverage will decline with this new business model. A caveat is that less financing from pre-sales means that developers will have a diminished ability to complete projects already started, and that they also need to reduce land purchases and land hoarding. Local government financing will remain tight as land sales account for 23% of local government aggregate expenditure. This will have negative ramifications on infrastructure spending. Bottom Line: Chinese real estate developers have begun shifting from an unsustainable and high-leverage business model to a new way of operating by which sales of completed properties will be prioritized at the expense of falling pre-sales. This will reduce financial stability risks in the future. Investment Implications We expect a continued decline in property sales, starts, completions, and property price deflation in the next three-to-six months. Thus, we maintain our bearish view of both onshore and offshore Chinese property developers’ share prices in absolute terms and relative to China’s overall equity benchmark (Chart 14).  Construction volume will be persistently weak in the coming months, which means less demand for commodities, such as iron ore, steel, cement, and glass. Hence, we expect prices for those commodities to drop further in the near run (Chart 15). Chart 14Chinese Property Developers' Stocks: Structural Breakdown Chart 15Bearish On Prices Of Construction-related Commodities   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     Supervision of pre-sale funds of presold properties refers to the third-party supervision of such funds by the real estate administrative department in conjunction with the bank. 2     This year, at least six asset management companies injected funds into stalled property projects. So far, the total funds raised for three projects amounts to RMB 17 billion. Source: https://m.huxiu.com/article/644633.html?f=rss 3    Desperate buyers face two options: either add funds to build an unfinished home or continue to wait for an indeterminate period. Buyers tend to increase funds to enable the resumption of construction. 4    Source: https://www.bloomberg.com/news/articles/2022-08-22/china-plans-29-billion-in-special-loans-to-troubled-developers  5    Source: https://news.stcn.com/sd/202208/t20220826_4822460.html  6    Please see China Investment Strategy Special Reports "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, and "China: Is The Property Carry Trade Over?" dated October 28, 2021, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations

Special Report

Highlights The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Feature Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.1 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,2 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Special Report

Executive Summary Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Chart 3BCyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Chart 6China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Special Report

Highlights The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Feature Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.1 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I   Indicators To Watch - Interest Rate Expectations III    

Special Report

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary China’s Property Bust To Dwarf Japan’s China’s confluence of internal and external risks will continue to weigh on markets in 2022. Internally China’s property sector turmoil is one important indication of a challenging economic transition. The Xi administration will clinch another term but sociopolitical risks are underrated. Externally China faces economic and strategic pressure from the US and its allies. The US is distracted with other issues in 2022 but US-China confrontation will revive beyond that. China will strengthen relations with Russia and Iran, though it will not encourage belligerence. It needs their help to execute its Eurasian strategy to bypass US naval dominance and improve its supply security over the long run. China will ease monetary and fiscal policies in 2022 but it has no interest in a massive stimulus. Policy easing will be frontloaded in the first half of the year. Featured Trade: Strategically stay short the renminbi versus an equal-weighted basket of the dollar and the euro. Stay short TWD-USD as well. Recommendation INCEPTION Date Return SHORT TWD / USD 2020-06-11 0.5% SHORT CNY / EQUAL-WEIGHTED BASKET OF EURO AND USD 2021-06-21 -3.9% Bottom Line: Beijing is easing policy to secure the post-pandemic recovery, which is positive for global growth and cyclical financial assets. But structural headwinds will still weigh on Chinese assets in 2022. China’s Historic Confluence Of Risks Global investors continue to clash over China’s outlook. Ray Dalio, founder of Bridgewater Associates, recently praised China’s “Common Prosperity” plan and argued that the US and “a lot of other countries” need to launch similar campaigns of wealth redistribution. He warned about the US’s 2024 elections and dismissed accusations of human rights abuses by saying that China’s government is a “strict parent.”1 By contrast George Soros, founder of the Open Society Foundations, recently warned against investing in China’s autocratic government and troubled property market. He predicted that General Secretary Xi Jinping would fail to secure another ten years in power in the Communist Party’s upcoming political reshuffle.2 Geopolitics can bring perspective to the debate: China is experiencing a historic confluence of internal (political) and external (geopolitical) risk, unlike anything since its reform era began in 1979. At home it is struggling with the Covid-19 pandemic and a difficult economic transition that began with the Great Recession of 2008-09. Abroad it faces rising supply insecurity and an increase in strategic pressure from the United States and its allies. The implication is that the 2020s will be an even rockier decade than the 2010s. In the face of these risks the Chinese Communist Party is using the power of the state to increase support for the economy and then repress any other sources of instability. Strict “zero Covid” policies will be maintained for political reasons as much as public health reasons. Arbitrary punitive measures will put pressure on the business elite and foreigners. The geopolitical outlook is negative over the long run but it will not worsen dramatically in 2022 given America’s preoccupation with Russia, Iran, and midterm elections. Bottom Line: Global investor sentiment toward China will remain pessimistic for most of the year – but it will turn more optimistic toward foreign markets, especially emerging markets, that sell into China. China’s Internal Risks Chart 1China's Demographic Cliff By the end of 2021, China accounted for 17.7% of global economic output and 12.1% of global imports. However, the secular slowdown in economic growth threatens to generate opposition to the single-party regime, forcing the Communist Party to seek a new base of political legitimacy. Most countries saw a drop in fertility rates in the third quarter of the twentieth century but China’s “one child policy” created a demographic cliff (Chart 1). At first this generated savings needed for national development. But now it leaves China with excess capacity and insufficient household demand. Across the region, falling fertility rates have led to falling potential growth and falling rates of inflation. Excess savings increased production relative to consumption and drove down the rate of interest. The shift toward debt monetization in the US and Japan, in the post-pandemic context, is now threatening this trend with a spike in inflation. China is also monetizing debt after a decade of deflationary fears. But it remains to be seen whether inflation is sustainable when fertility remains below the replacement rate over the long run, as is projected for China as well as its neighbors (Chart 2). China’s domestic situation is fundamentally deflationary as a result of chronic over-investment over the past 40 years. China’s gross fixed capital formation stands at 43% of GDP, well above the historic trend of other major countries for the past 30 years (Chart 3). Chart 2Will Inflation Decouple From Falling Fertility?​​​​​​ Chart 3Over-Investment Is Deflationary, Not Inflationary Like other countries, China financed this buildup of fixed capital by means of debt, especially state-owned corporate debt. While building a vast infrastructure network and property sector, it also built a vast speculative bubble as investors lacked investment options outside of real estate. The growth in property prices has tracked the growth in private non-financial sector debt. The downside is that if property prices fall, debt holders will begin a long and painful process of deleveraging, just like Japan in the 1990s and 2000s. Japan only managed to reverse the drop in corporate investment in the 2010s via debt monetization (Chart 4). Chart 4Japan’s Property Bust Coincided With Debt Deleveraging ​​​​​​ Chart 5China's Debt Growth Halts Looking at the different measures of Chinese debt, it is likely that deleveraging has begun. Total debt, public and private, peaked and rolled over in 2020 at 290% of GDP. Corporate debt has peaked twice, in 2015 and again in 2020 at around 160% of GDP. Even households are taking on less debt, having gone on a binge over the past decade (Chart 5). In short China is following the Japanese and East Asian growth model: the stark drop in fertility and rise in savings created a huge manufacturing workshop and a highly valued property sector, albeit at the cost of enormous private and considerable public debt. If the private sector’s psychology continues to shift in favor of deleveraging, then the government will be forced to take on greater expenses and fund them through public borrowing to sustain aggregate demand, maximum employment, and social stability. The central bank will be forced to keep rates low to prevent interest rates from rising and stunting growth. China’s policymakers are stuck between a rock and a hard place. New regulations aimed at controlling the property bubble (the “three red lines”) precipitated distress across the sector, emblematized by the failure of the world’s most indebted property developer, Evergrande. Other property developers are looking to raise cash and stay solvent. Property prices peaked in 2015-16 and are now dropping, with third-tier cities on the verge of deflation (Chart 6). Chart 6China's Property Crisis Weighs On Construction As the property bubble tops out, Chinese policymakers are looking for new sources of productivity and growth. Chart 7Productivity In Decline​​​​​​ Productivity growth is subsiding after the export and property boom earlier in the decade, in keeping with that of other Asian economies. And sporadic initiatives to improve governance, market pricing, science, and technology have not succeeded in lifting total factor productivity (Chart 7). The initial goal of the Xi administration’s reforms, to rebalance the economy away from manufacturing toward services, has stumbled and will continue to face headwinds from the financial and real estate sectors that powered much of the recent growth in services (Chart 8). Chart 8China’s Structural Transition Falters Indeed the Communist Party is rediscovering the value of export-manufacturing in the wake of the pandemic, which led to a surge in durable goods orders as global consumers cut back on services and businesses initiated a new cycle of capital expenditures (Chart 9). The party encouraged the workforce to shift out of manufacturing over the past decade but is now rethinking that strategy in the face of the politically disruptive consequences of deindustrialization in the US and UK – such that the state can be expected to recommit to supporting manufacturing going forward (Chart 10). Policymakers are emphasizing economic self-sufficiency and “dual circulation” (import substitution) as solutions to the latent socioeconomic and political threat posed by disillusioned former manufacturing workers. Chart 9China Turns Back To Exports​​​​​​ Chart 10De-Industrialization Will Be Halted Even beyond ex-manufacturing workers, the country’s economic transition risks generating social instability. The middle class, defined as those who consume from $10 to $50 per day in purchasing power parity terms, now stands at 55% of total population, comparable to where it stood when populist and anti-populist political transformations occurred in Turkey, Thailand, and Brazil (Chart 11). China’s middle class may not be willing or able to intervene into the political process, but the government is still concerned about the long-term potential for discontent. Otherwise it would not have launched anti-corruption, anti-pollution, and anti-industrial measures in recent years. These measures vary in effectiveness but they all share the intention to boost the government’s legitimacy through social improvements and thus fall in line with the new mantra of “common prosperity.” For decades the ruling party claimed that the “principle contradiction” in society arose from a failure to meet the people’s “material needs,” but beginning in 2021 it emphasized that the principle contradiction is the people’s need for a “better life.” Real wages continue to grow but the pace of growth has downshifted from previous decades. The bigger problem is the stark rise in inequality, here proxied by skyrocketing housing prices. Hong Kong’s inequality erupted into social unrest in recent years even though it has a much higher level of GDP per capita than mainland China (Chart 12). In major cities on the mainland, housing prices have outpaced disposable income over the past two decades. Youth unemployment also concerns the authorities. Chart 11Social Instability A Genuine Risk Bottom Line: The Chinese regime faces historic social and political challenges as a result of a difficult structural economic transition. The ongoing emphasis on “common prosperity” reveals the regime’s fear of social instability. The underlying tendency is deflationary, though Beijing’s use of debt monetization introduces a long-term inflationary risk that should be monitored. Chart 12Causes Of Hong Kong Unrest Also Present In China​​​​​​ China’s External Risks Geopolitically speaking, China’s greatest challenge throughout history has been maintaining domestic stability. Because China is hemmed in by islands that superior foreign powers have often used as naval bases, it is isolated as if it is a landlocked state. A stark north-south division within its internal geography and society creates inherent political tension, while buffer regions are difficult to control. Hence foreign powers can meddle with internal affairs, undermine unity and territorial integrity, and exploit China’s large labor force and market. However, in the twenty-first century China has the potential to project power outward – as long as it can maintain internal stability. Power projection is increasingly necessary because China’s economy increasingly depends on imports of energy, leaving it vulnerable to western maritime powers (Chart 13). Beijing’s conversion of economic into military might has also created frictions with neighbors and aroused the antagonism of the United States, which increasingly seeks to maintain the strategic anchor in the western Pacific that it won in World War II. Chart 13Import Dependency A Strategic Security Threat As China’s influence expands into East Asia and the rest of Asia, conflicts with the US and its allies are increasingly likely, especially over critical sea lines of communication, including the Taiwan Strait. China’s reinforcement of its manufacturing prowess will also provoke the United States, while the US’s erratic attempts to retain its strategic position in Asia Pacific will threaten to contain China. Yet the US cannot concentrate exclusively on countering China – it is distracted by internal politics and confrontations with Russia and Iran, especially in 2022. China will strengthen relations with Russia and Iran. As an energy importer, China would prefer that neither Russia nor Iran take belligerent actions that cause a global energy shock. But both Moscow and Tehran are essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. And yet, in 2022 specifically, the US and China are both concerned about maintaining positive domestic political dynamics due to the midterm elections and twentieth national party congress. This includes a desire to reduce inflation. Hence both would prefer diplomacy over trade war, with regard to each other, and over real war, with regard to Ukraine and Iran. So there is a temporary overlap in interests that will discourage immediate confrontation. China might offer limited cooperation on Iranian or North Korean nuclear and missile talks. But the same domestic political dynamics prevent a significant improvement in US-China relations, as neither side will grant trade concessions in 2022, and the underlying strategic tensions will revive over the medium and long run. Bottom Line: China faces historic external risks stemming from import dependency and conflict with the United States. In the short run, the US conflicts with Russia and Iran might lead to energy shocks that harm China’s economy. Japan never recovered its rapid growth rates after the 1973 Arab oil embargo. In the long run, while Washington has little interest in fighting a war with China, its strategic competition will focus on galvanizing allies to penalize China’s economy and to substitute away from China, in favor of India and ASEAN. China’s Macro Policy In 2022: Going “All In” For Stability In last year’s China Geopolitical Outlook, we maintained our underweight position on Chinese equities and warned that Beijing’s policy tightening posed a significant risk to global cyclical assets – and yet we concluded that policymakers would avoid overtightening policy to the extent of spoiling the global recovery. This view prevailed over the course of 2021. Policymakers tightened monetary and fiscal policy in the first half of the year, then started loosening up in the summer. Chinese equities crashed but global equities powered through the year. In December 2020, at the Central Economic Work Conference, policymakers stated that China would “maintain necessary policy support for economic recovery and avoid sharp turns in policy” in 2021. In the event they did the minimal necessary, though they did avoid sharp turns. For 2022, the key word is “stability.” At the Central Economic Work Conference last month, the final communique mentioned “stability” or “stabilize” 25 times (Table 1). Hence the main objective of Chinese policymakers this year is to prioritize both economic and social stability ahead of the twentieth national party congress. Authorities will avoid last year’s tight policies. Table 1Key Chinese Policy Guidance 2021-22 China’s quarterly GDP growth slipped to just 4% in Q4 2021, from rapid recovery growth of 18.3% in Q1 2021. Considering the low base effect of 2020, the average growth of 2020 and 2021 ranged from 5-5.5% (Chart 14). This growth rate is in line with the pre-pandemic trajectory of 2015-2019. In Jan 2022, the IMF cut China’s 2022 growth forecast to 4.8%, while the World Bank lowered its forecasts to 5.1%. Considering the two-year average growth and government’s goal of “all in for stability,” we see an implicit GDP target of 5-5.5%. Chart 14Breakdown Of China’s GDP Growth Does this target matter? Although China stopped announcing explicit GDP growth targets, understanding the implicit target helps investors predict the turning point in macro policy. Due to robust global demand, net exports are now making a sizable contribution to GDP growth. However, due to the high base effect of 2021, there is limited room for exports to grow in 2022. Hence economic growth has to rely on final consumption expenditure and gross capital formation. Yet as a result of policy tightening, gross capital formation’s contribution to GDP has decreased significantly, from positive in H1 2021 to a rare negative contribution to GDP in the second half. At the same time, the contribution from final consumption expenditure also slipped over the course of 2021, due to worsening Covid conditions, one of the three pressures stated by the government. What does that mean? It means that loosening up macro policies is the pre-condition for stabilizing growth and the economy. Just like the officials said (see Table 1), the Chinese economy is “facing triple pressure from demand contraction, supply shocks, and weakening expectations,” so that “all sides need to take the initiative and launch policies conducive to economic stability.” Bottom Line: It is reasonable to expect accommodative fiscal and monetary policies in 2022, at least until the party congress ends. In fact, authorities have already started to make these adjustments since Q4 2021. China Avoids Monetary Overtightening Credit growth can be seen as an indicator for gross capital formation. In the second half of 2021, China’s total social financing (total private credit) growth plunged below 12% (Chart 15), the threshold we identified for determining whether authorities overtightened policy. Correspondingly, gross capital formation’s contribution to GDP dropped into the negative zone (see Chart 14 above). However, money growth did not dip below the threshold, and authorities are now trying to boost credit growth. Starting from December 2021, the market has seen marginally positive news out of the People’s Bank of China: December 15, 2021: The PBOC conducted its second reserve requirement ratio (RRR) cut in 2021. The 50 bps cut was expected to release $188 billion in liquidity to support the real economy. December 20, 2021: The PBOC conducted its first interest rate cut since April 2020 by cutting 1-Year LPR by 5 bps on December 20 (Chart 16). Chart 15China's Money And Credit Growth Hits Pain Threshold​​​​​​ Chart 16China Monetary Policy Easing​​​​​​ January 17, 2022: The PBOC cut the interest rate on medium-term lending facility (MLF) loans and 7-day reverse repurchase (repos) rate both by 10 bps. January 20, 2022: The PBOC further lowered the 1-year LPR by 10 basis points and cut the 5-year LPR by 5 basis points, the first cut since April 2020. Chart 17China Policy Easing Will Boost Import Volumes The timing and size of the last two rate cuts came as a surprise to the market, signaling more comprehensive easing than was expected (confirming our expectations).3 The market saw a clear turning point: Chinese authorities are now fully aware of the need to loosen up monetary policy to counter intensifying downward pressure on the economy. Incidentally, the fine-tuning of the different lending facilities suggests the government aims to lower borrowing costs and stimulate the market without over-heating the property sector again. PBOC officials claim there is still some space for further cuts, though narrower now, when asked about if there is any room to further cut the RRR and interest rates in Q1. They added that the PBOC should “stay ahead of the market curve” and “not procrastinate.”4 Recent movements have validated this point. Going forward, M2 growth should stay above 8%. Total social financing growth should move up above our “too tight” threshold, although weak sentiment among private borrowers could force authorities to ease further to ensure that credit growth picks up. If the government is still committed to fighting housing speculation, as before, then we could see a smaller adjustment to the 5-Year LPR in the future. Otherwise the government is taking its foot off the brake for stability reasons, at least temporarily. Bottom Line: China will keep easing monetary policy in 2022, at least in the first half. This will result in an improvement in Chinese import volumes and ultimately emerging market corporate earnings, albeit with a six-to-12-month lag (Chart 17). China Avoids Fiscal Overtightening China will also avoid over-tightening fiscal policy in 2022. In December the government stressed the need to “maintain the intensity of fiscal spending, accelerate the pace, and moderately advance infrastructure investment.” In 2021, local government bond issuance did not pick up until the second half of the year. Considering the time lag of construction projects, it was too late for local government investment to stimulate the economy. By Q3 2021, local government bond issuance had just completed roughly 70% of the annual quota. By comparison, in 2018-2020, local governments all completed more than 95% of the annual quota by the end of September each year (Chart 18A). Chart 18AChina: No Pause In Local Bond Issuance In H1 2022​​​​​ Chart 18BChina: No Pause In Local Bond Issuance In H1 2022​​​​​​ There are several reasons behind the slow pace last year. The central government refused to pre-approve and pre-authorize the quota for bond issuance at the beginning of the year in 2021, in order to restore discipline after the massive 2020 stimulus measures. The quota was not released until after the Two Sessions in March, which means local government bond issuance did not pick up until April 2021, causing a 3-month vacuum in local government fiscal support (see Chart 18B). In contrast, for 2019 and 2020, the central government pre-authorized the bond issuance quota ahead of time to try to provide fiscal support evenly throughout the year. Starting from 2020, the central government strengthened supervision and evaluation of local government investment projects, again to instill discipline. Previously local governments could easily issue general-purpose bonds and the funds were theirs to spend. But now local governments are required to increase the transparency of their investment projects and mainly finance these projects via special-purpose bonds, i.e. targeted money for authorized projects (Table 2). In 2021 local governments were less willing to issue bonds. At the April 2021 Politburo meeting, the central government vowed to “establish a disposal mechanism that will hold local government officials accountable for fiscal and financial risks.” This triggered risk-aversion. Beijing wanted to prevent a growth “splurge” in the wake of its emergency stimulus, like what happened in 2008-11. The fiscal turning point came in the second half of the year. The central government called for accelerating local government bond issuance several times from July to October. The pace significantly picked up in the second half of 2021 and Q4 accounted for a significant portion of annual issuance (Chart 18). As a result, fixed asset investment and fiscal impulse should pick up in Q1 2022. Thus, unlike last year, authorities are trying to avoid a sharp drop in the fiscal impulse. The Ministry of Finance has already frontloaded 1.46 trillion yuan ($229 billion) from the 2022 special purpose bonds quota. This amount is part of the 2022 annual local government bond issuance quota, with the rest to be released at the Two Sessions in March. Pulling these funds forward indicates the rising pressure to stabilize economic growth in Q1 this year. That being said, investors should differentiate easing up fiscal policy and “flood-like” stimulus in the past. The government still claims it will “contain increases in implicit local government debts.” In fact, pilot programs to clean up implicit debts have already started in Shanghai and Guangdong. This means, China will not reverse past efforts on curbing hidden debts. Hence fiscal support will be more tightly controlled in future, like water taps in the hands of the central government. The risk of fiscal tightening is backloaded in 2022. The tremendous amount of local government bonds issued in Q4 2021 will start to kick in early 2022. These will combine with the frontloaded special purposed bonds. Fiscal impulse should tick up in Q1. However, fiscal impulse might decelerate in the second half. A total of $2.7 trillion yuan worth of local government bonds will reach maturity this year, with $2.2 trillion yuan reaching maturity after June 2022 (Table 3). This means that in the second half, local governments will need to issue more re-financing bonds to prevent insolvency risk, thus undermining fiscal support for the economy. And this last point underscores the threat of economic and financial instability that China faces over the long run. Table 2Breakdown Of China Local Government Bond Issuance Bottom Line: Stability is the top priority in 2022. China will continue to easy up monetary and fiscal policy in H1, to combat the economic downward pressure ahead of the twentieth national party congress (Chart 19). Policy tightening risk is backloaded. Structural reforms will likely subside for now until the Xi administration re-consolidates power for the next ten years. Table 3China: Local Government Debt Maturity Schedule​​​​​​ Chart 19Policy Support Expected For 20th Party Congress Note: An error in an earlier version of this report has been corrected. Chinese fixed asset investment in Chart 19 is growing at 0.1%, not 57.6% as originally shown. The chart has been adjusted. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com Footnotes 1      See Bei Hu and Bloomberg, “Ray Dalio thinks the U.S. needs more of China’s common prosperity drive to create a ‘fairer system,’” Fortune, January 10, 2022, fortune.com. 2     See George Soros, “China’s Challenges,” Project Syndicate, January 31, 2022, project-syndicate.org. 3     The 5-year LPR had remained unchanged after the December 2021 cut. At that time, only the 1-Year LPR was cut by 5bps. Furthermore, the different magnitudes of the January 20 LPR cut also have some implications. The 1-Year LPR mostly affects new and outstanding loans, short-term liquidity loans of firms, and consumer loans of households. In comparison, the 5-Year LPR has a larger impact, affecting the borrowing costs of total social financing, including mortgage loans, medium- to long-term investment loans, etc. The MLF rate was cut by 10 basis points on January 17; in theory the LPR should also be cut by the same size. However, the 5-Year LPR adjustments was very cautious and was only cut by 5 bps, smaller than the MLF cut and the 1-Year LPR cut. The 5-year LPR serves as the benchmark lending rate for mortgage loans. 4     To combat the negative shock caused by the initial outburst of COVID-19, altogether China lowered the MLF and 1-year LPR by 30 bps and 5-year LPR by 15 bps in H1 2020. This also suggests that there is still room for future interest rate cuts or RRR cuts in the coming months. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 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