BCA Indicators/Model

Once the debt ceiling soap opera ends, investors will likely turn their attention to some of the tailwinds supporting stocks. These include stronger earnings growth, diminished bank stresses, better housing data, early signs of an upleg in the manufacturing cycle, the prospects of an AI-driven productivity boom, and the fact that labor slack has managed to increase without rising unemployment. Investors should resist turning bearish on stocks for now but look to become more defensive later this year.

The US stock price / bond yield (SBY) correlation shifted into negative territory over the past year, significantly departing from the positive correlation regime of the past two decades. The inflation regime is the primary macro driver of the SBY correlation. History suggests that the inflationary threshold for the SBY correlation is nontrivially above the Fed’s target, suggesting that a shift back to a positive correlation is likely in the lead up to and during the next US recession. Whether the SBY correlation remains positive during the subsequent economic recovery will depend – importantly – on the magnitude of the recessionary effect on inflation, and whether investors will have reason to believe that the responsiveness of inflation to the output or jobs gap has permanently increased. A severe US recession does not appear necessary to bring inflation below the positive/negative SBY correlation threshold, but only so long as long-term inflation expectations remain anchored. Generally-speaking, cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. Our conclusions, alongside our economic expectations detailed in Section I of our report, support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. The fact that inflation was far more elevated last year than many investors expected led to negative performance from both stocks and bonds. That was a major departure from the better part of the past two decades, when government bonds provided portfolio protection during risky asset selloffs. Quantitatively, this shift manifested itself as a decline in the US stock price / 10-year government bond yield (SBY) correlation from positive to negative territory. While the SBY correlation has become less negative over the past several months, it has not yet durably reverted into positive territory. In this report, we present our best estimate of the inflationary threshold that results in a positive or negative SBY correlation, and whether inflation is likely to approach this level over the coming one-to-two years. We also examine the performance of major financial assets since the US SBY correlation turned negative last year, to understand the investment implications of a potential shift back to a positive SBY correlation. We conclude that core US inflation does not likely need to return to the Fed’s target in order for the SBY correlation to return to positive territory, which is good news for multi-asset investors. Additionally, some simple estimations of the modern-day Phillips curve suggest that a severe recession is not required to bring inflation back to its target. That that may be increasingly less true, however, the longer it takes for a recession to occur, as it risks the emergence of backward-looking inflation expectations. Cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. From an investment strategy perspective, our conclusions support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. Precious metals remain a wildcard, but we are sticking with a low-conviction recommendation to be overweight/bullish previous metals. The Inflationary Threshold Of The SBY Correlation Chart II-1Visualizing The Stock Price / Bond Yield Correlation Visualizing The Stock Price / Bond Yield Correlation Visualizing The Stock Price / Bond Yield Correlation Chart II-1 presents the rolling 1-year correlation between the S&P 500 and US 10-year Treasury yields. The chart illustrates that the SBY correlation was persistently negative from the mid-1960s until the late-1990s, when it shifted durably into positive territory. The SBY correlation was also modestly positive during the mid to late 1960s. Over the past year, the SBY correlation has been at its most negative since it moved durably into positive territory in the late-1990s and early-2000s. It has been a long-held view at BCA that the correlation between US stock prices and long-maturity US government bond yields turned positive in the late-1990s due to a shift in the inflation regime, and, it is thus not surprising to us that well above-target inflation has caused the SBY correlation to move back below the zero line. For example, our US Investment Strategy service presented a detailed analysis of the macro drivers of the SBY correlation in a 2012 special report,1 and more recently our Emerging Market Strategy service warned of a likely shift in the SBY correlation back to negative territory.2 Both reports underscored the importance of the inflation regime as the major driver of the SBY correlation with high (low) inflation associated with a negative (positive) correlation. It is not difficult to rationalize why the inflation regime is the primary driver of the SBY correlation. A negative correlation means that rising bond yields are bad for stocks, which was clearly the case from the late-1960s until the mid-1990s – because rising bond yields during this time reflected the Fed’s attempt to rein in inflation. In the parlance of fixed-income investors, this was the era when the inflation component of bond yields rather than the real component was the dominant driver of yields. This also explains why the correlation was modestly positive in the early-to-mid 1960s, given that core inflation averaged just 1.4% percent during that time. Chart II-2Inflation Expectations Did Not Stabilize Until The Late-1990s Inflation Expectations Did Not Stabilize Until The Late-1990s Inflation Expectations Did Not Stabilize Until The Late-1990s What changed in the late-1990s? We believe two factors were at play. First, while the idea of the “Greenspan put” had been around since the 1987 “Black Monday” stock market crash, the notion that the Fed would be quick to ease monetary policy in response to slowing economic growth was strongly reinforced by its reaction to the LTCM crisis – shown as the vertical line in Chart II-1 – as well as the 2001 recession. Second, while actual core PCE inflation essentially fell back to target levels by the early-to-mid 1990s, measures of long-term inflation expectations, such as the University of Michigan’s median 5-10 year household inflation expectation series, as well as our adaptive expectations model did not truly stabilize until the late-1990s (Chart II-2). That implies that investors were not truly convinced that inflation had reached low and stable levels until that point. Looking forward, the core question for investors is not whether the inflation regime will be the main determinant of the SBY correlation, but rather whether inflation needs to fall all the way back to the Fed’s 2% target in order for the correlation to turn durably positive again. This question is relevant to address not just whether investors can expect portfolio protection from falling long-maturity bond yields during the next recession, but also whether the SBY correlation is likely to be positive or negative on average over the coming few years. Looking at the empirical record, we address this question in two ways. First, we use a logistic regression approach to test for the inflationary threshold, using either headline or core CPI or the PCE deflator, that has the best power to predict when the rolling 1-year SBY correlation has been negative (Chart II-3). And second, using a quarterly SBY correlation (calculated using daily data), we simply calculate how often a negative correlation occurs alongside core inflation above a given value (Chart II-4). The results of Charts II-3 and II-4 are clear, and paint a somewhat positive picture for multi-asset investors over the coming year or two. Chart II-3 highlights that the core inflation regime is a more reliable predictor of a negative SBY correlation than headline, and that core CPI is a more important predictor than core PCE inflation. This likely reflects the fact that, typically, investors more closely follow the CPI data, given that it is released earlier than the PCE data. Chart II-3The Inflationary Threshold For A Negative SBY Correlation Is Higher Than The Fed’s Target… June 2023 June 2023 Chart II-4…And Is Possibly As High As 3.5% June 2023 June 2023 But, more importantly, Chart II-3 shows that the core inflation rate consistent with a negative SBY correlation has historically been higher than 2%, roughly between 2.5-3%. Chart II-4 echoes this point, by showing that negative quarterly SBY correlations have been more often associated with annualized core inflation rates of up to 3.5%. To us, this underscores that a negative SBY correlation does not reflect investor expectations of target inflation, but rather whether inflation is at a sufficiently high level that it becomes the dominant driver of monetary policy decisions. Charts II-3 and II-4 highlight that investors appear to believe that the inflationary threshold for the SBY correlation is nontrivially above the Fed’s target, suggesting that a shift back to a positive correlation is likely in the lead up to and during the next US recession. Whether the SBY correlation remains positive during the subsequent economic recovery will depend – importantly – on the magnitude of the recessionary effect on inflation, and whether investors will have reason to believe that the responsiveness of inflation to the output or jobs gap has permanently increased. Will The SBY Correlation Durably Shift Back Into Positive Territory? Determining the likely impact of the next US recession on inflation and the likely inflationary impulse of the subsequent recovery are analytically challenging exercises. The degree to which core inflation surged over the past two years underscores the inherent difficulty in estimating the magnitude of inflation over a cyclical time horizon, especially when unique circumstances – such as the supply chain impacts of the COVID-19 pandemic and its aftermath – are present. We noted in our January 2021 Special Report that the modern-day version of the Phillips curve expresses actual inflation as a function of expected inflation, economic or labor market slack, and other atypical shocks to prices. For headline inflation, these atypical shocks very often occur from sharp changes in food and energy prices. In core space, price shocks typically stem from changes in imported goods prices and the US dollar, as well as core feed-through effects from large or long-lasting shocks to food and energy prices. Despite the fact that pandemic-related effects are clearly still exerting an impact on core PCE inflation in the US, it is still worthwhile to estimate core inflation using the first two terms of the modern-day Phillips curve to gauge what kind of labor market adjustment may be required to bring inflation back to the Fed’s target. Chart II-5 presents a variety of estimates based on a linear regression of core inflation on different measures of inflation expectations, as well as the unemployment rate gap as defined by the CBO's estimate of NAIRU. We present the results of the regression calculated over two different estimation periods; in all cases, the inflation expectations component is the most significant driver, but the unemployment rate gap shows up as highly significant in all six models. Chart II-5As Long As Inflation Expectations Remain Forward-Looking, Only A Mild Or Average US Recession Will Be Needed To Bring Inflation Back To Target June 2023 June 2023 Chart II-5 indicates that the range of unemployment rate estimates that would be required to return core PCE inflation to the Fed’s 2% target is very large. Still, it highlights a very important point, which is that ostensibly forward-looking measures of inflation expectations (such as those reported by the University of Michigan’s Surveys of Consumers) imply a considerably lower unemployment rate needed to return core inflation back to the Fed's target. This is strongly consistent with academic research showing that the monetary policy response to a rise in inflation must be significantly greater the more that inflation expectations are adaptive (i.e., backward-looking). For investors hoping that long-maturity government bonds will once again provide some form of protection to a balanced portfolio during periods of falling equity prices, Chart II-5 is encouraging. It suggests that because households recognize a large part of the surge in inflation over the past two years was uniquely driven by pandemic related effects, a large rise in the unemployment rate will not be needed to bring inflation back to the Fed’s target. However, Chart II-5 does show that a recession will likely be needed for inflation to return to target given that even the smallest unemployment rates shown imply a recessionary shock to the labor market, unless disinflation or outright deflation from housing and goods inflation is more pronounced over the coming year than we currently expect. It also reinforces a crucial point about why we think a recession is likely over the coming year: the greater weight on inflation expectations from the models shown in the chart underscores that the Fed must prevent household inflation expectations from becoming backward-looking, or else it would require a much more severe recession in order to return to low and stable inflation. Chart II-6Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Disinflation from energy prices and global supply chain factors have bought the Fed some time in this regard, but Chart II-6 highlights that we have recently seen a concerning rise in both one-year and five-to-ten year expected inflation. To the extent that a recession would simply accelerate the housing and goods-related disinflation that is either already occurring or will soon, the Fed is likely to prefer a recession sooner rather than later – were they to conclude that an economic contraction is unavoidable in order to bring inflation back to 2%. So, while we agree that the SBY correlation is likely to turn positive over the coming 6 to 12 months, this will very likely occur in the context of falling stock prices. To us, the greater weight of inflation expectations in the models shown in Chart II-5 also supports the idea that a shift in the SBY correlation back into positive territory will likely be a durable one if a recession occurs over the coming year, as we expect. We acknowledge that demographic effects are likely to impact the US labor market structurally for years to come, and agree that US inflation may be above target on average over the course of the next economic recovery. However, unless long-term inflation expectations become unmoored, the implication is that US core inflation will probably grow at a 2-3% annual rate during the next economic recovery – which is below the negative SBY correlation threshold that we identified in Charts II-3 and II-4. This reflects our belief that the greatest threat to very elevated structural inflation in the US does not come from the demographic outlook, but rather from a tepid monetary policy response from the Fed to the currently elevated rate of inflation. This tepid response would likely be inadvertent, as we believe the Fed is truly serious about bringing inflation back down to target levels. Rather, it would stem from the Fed’s misguided views about the neutral rate of interest, which we have noted in past reports could cause the Fed to cut interest rates before the job of wringing out excess inflation from the system is complete. We have noted in past reports that monetary policy rules that are commonly-cited by Fed officials could justify a fed funds rate below our estimate of neutral if core PCE inflation falls below 3%, given that the Fed’s view of the neutral rate of interest is meaningfully below ours. For now, this is a plausible but not probable scenario. Were we to see mounting evidence of this scenario, we may shift our 6-12 month investment recommendations more in favor of a pro-risk stance, as interest rate cuts into easy territory would stimulate economic activity and meaningfully push out the onset of a recession. But as noted above, this would also significantly raise the odds of elevated structural inflation, suggesting that the SBY correlation would only briefly turn positive during the next US recession in such a scenario. Asset Performance And A Negative SBY Correlation Given the very large change in the SBY correlation over the past two years, one natural question for investors to ask is whether we have seen highly atypical cross-asset performance owing to this correlation shift. However, the surprising reality is that most of the examples of atypical asset performance since the beginning of 2022 have occurred for reasons other than the decline in the SBY correlation – besides some well-known performance dynamics like the failure of US stocks to outperform in the face of falling global stock prices. When analyzing this question, we use an admittedly quantitative approach, but one that we feel is still accessible and relatively easy for investors to understand. Essentially, we examine the beta of a variety of assets relative to global stocks since the beginning of 2022, and also look at beta-adjusted performance. Assets whose performance has been significantly driven by the shift in the SBY correlation into negative territory should have experienced a sharp change in their beta versus global stocks and beta-adjusted out/underperformance that is logically consistent with the asset’s relationship to inflation. Charts II-7 and II-8 present the results of our approach, and highlight several points. Chart II-7Only A Few Major Asset Classes… June 2023 June 2023 Chart II-8…Have Had Their Performance Materially Affected By The Shift In The US SBY Correlation June 2023 June 2023 First, while it is true that several assets experienced a significant change in their beta to global stock prices since 2022 versus the five years prior to the onset of the COVID-19 pandemic, several of these changes were related specifically to Russia's invasion of Ukraine or China's zero-COVID policy. This is especially true when examining the performance of euro area, UK, and emerging market equities, emerging market sovereign bonds, and oil and base metals prices. Chart II-9Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine China’s decision to pursue strict lockdown and control measures for most of 2022 had nothing to do with above-target inflation in the developed world, so it is clear that the underperformance of China-related assets since the beginning of last year has not been connected to a shifting US SBY correlation. And while it is clearly the case that Russia's invasion of Ukraine and its impact on the global energy market made the global inflation situation worse, it was the rise in core services ex-housing inflation that was the root cause of the shift in the US SBY correlation into negative territory, which was already well underway prior to the war (Chart II-9). To us, Charts II-7 and II-8 highlight just three major asset classes or investing styles whose performance appears to have been materially affected by the shift in the US SBY correlation from positive to negative territory: the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. In the case of tech/growth stocks and the yen, we have seen beta-adjusted underperformance since the beginning of 2022, whereas in the case of precious metals it has been the opposite. The abnormal performance of these three assets does appear to have been driven by the same factors that pushed the US SBY correlation into negative territory: The fact that bond yields were rising in conjunction with falling stock prices had an outsized impact on tech or growth stocks because of the perception by investors that these are comparatively longer duration assets. As we highlighted in Section I in last month’s report, this perception is still in effect given that the relative performance trend of tech versus ex-tech stocks continues to be strongly negatively correlated with long-maturity government bond yields. Given the US equity market’s heavy weight toward growth/tech stocks, it is thus unsurprising that US equities have failed to outperform global stocks since the beginning of 2022. Chart II-10The Yen's Decline Has Been Related To A Shift In The US SBY Correlation The Yen's Decline Has Been Related To A Shift In The US SBY Correlation The Yen's Decline Has Been Related To A Shift In The US SBY Correlation As the most prominent major country that has historically struggled with below target core inflation, Japanese interest rate differentials collapsed versus other DM economies last year as investors priced in a much more aggressive monetary policy response in the US and euro area than in Japan (Chart II-10). This resulted in significant underperformance of the yen on a broad trade-weighted basis (panel 2), despite the fact that the yen is typically a risk-off currency. Over the past year, gold has massively outperformed what its historical relationship with real government bond yields and the dollar would have implied (Chart II-11). Part of this outperformance may have been caused by a negative SBY correlation, in the sense that some investors may have flocked to gold as an alternative to stocks and bonds while both were falling in value. It is also likely that gold has benefited from a significant increase in central bank gold reserves (in lieu of US dollars) in the aftermath of Russia’s invasion of Ukraine and the US’ freeze on Russia foreign currency reserves. At the same time, it is also possible that gold is starting to benefit from fears of an eventual fiscal crisis in the US, given that US federal government interest payments are exploding higher as a share of GDP. This explosion in payments is the result of the sharp rise in the fed funds rate over the past year (Chart II-12). While it is true that the government’s interest expense will fall during the next US recession as the Fed cuts the policy rate, the key point is that investors have become more aware of the US government’s eventual interest burden based on normalized interest rates and may have increased their structural allocations to gold over the past year in response. Chart II-11Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Chart II-12Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Investment Strategy Conclusions Our analysis highlights several conclusions about the US SBY correlation: The historical evidence suggests that the US SBY correlation will shift back into positive territory once US core inflation falls back or below 3%. A full return to target inflation is not likely required. We expect that US core inflation will fall below 3% at some point over the coming year or two, but it is only likely to occur in the context of a recession. A severe US recession does not appear necessary to bring inflation below the positive/negative SBY correlation threshold, but only so long as long-term inflation expectations remain anchored. Generally-speaking, cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. From an investment strategy perspective, our conclusions support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. Precious metals remain somewhat of a wildcard, and we are conflicted about the outlook for gold and silver prices over the coming year. On the one hand, precious metals have significantly outperformed over the past year as the US SBY correlation has fallen into negative territory, implying a potential reversal of performance if the correlation becomes positive again. In addition, the real price of gold is extremely elevated relative to history, suggesting that precious metals are quite expensive. On the other hand, we expect real interest rates to fall meaningfully at some point over the coming 6-12 months as the US economy slips into recession, which has historically been bullish for precious metals. On balance, we are sticking with our recommendation to be overweight/bullish previous metals, but investors should note that this is a relatively low-conviction view. Investors who are heavily overweight precious metals should respond to increasing evidence of 1) an impending US recession and 2) a major technical breakdown in precious metals prices as a sign to reduce their exposure significantly. Finally, even though structurally elevated inflation has recently fallen off investors’ radars as a major source of concern, investors should continue to monitor long-term inflation expectations closely for further signs of a renewed breakout. While we strongly believe that the SBY correlation will turn positive during the next US recession regardless of its severity, a strong breakout in long term inflation expectations would increase the probability of a negative SBY correlation during the next economic recovery. It would also significantly raise the odds of a more severe recession than we expect. That would still justify conservative portfolio positioning, but it would imply meaningfully higher long-maturity government bond yields over the nearer term, and thus would delay the point at which long duration positions would be warranted. As noted in Section I of our report, fixed-income investors would lose money on 10-year Treasury positions over the coming year if yields rise above 4.2%, something that could occur if the odds of the “no landing” scenario increase further over the near-term. We are sticking with our view that investors should wait for meaningful labor market weakness or a rise in 10-year yields above 4% to shift to a long duration stance, but investors should be prepared to extend duration quickly and significantly in response to either of these events. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see “Shifting Sands: Why Are Stocks And Bond Yields Positively Correlated, And When Will This Change?”, US Investment Strategy, March 12, 2012, available at usis.bcaresearch.com 2  Please see “A Paradigm Shift In The Stock-Bond Relationship”, Emerging Markets Strategy, February 25, 2021, available at ems.bcaresearch.com

The Q1-2023 earnings season has surprised as companies’ results point to the end of the earnings recession. However, the good news is already priced in – the market has barely budged over the past six weeks. Earnings rebound may continue as long as the economy avoids a recession. However, inevitably, tighter monetary policy will weigh on demand, and recovery will come to a halt.

If the recession begins this year, it is unlikely to be mild, because inflation will not have fallen by enough to allow the Fed to cut rates aggressively. In contrast, if the recession starts in 2024 or later, when inflation is likely to be much lower, the Fed will be able to cushion the blow. Our base case remains a 2024 recession but the risks around that view have increased in light of recent banking stresses.

Indian EPS growth is set for major disappointments vis-à-vis the lofty expectations. Weak domestic demand amid tight fiscal and monetary policy entails more downside in stock prices. Stay underweight.

Cyclically-speaking, the risk of global indebtedness does not appear to be acute. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. Over the next one-to-three years, these risks are likely to be idiosyncratic. With the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. However, over the longer-term, there are several problems with global indebtedness that will eventually “come home to roost.” US government debt is now excessive, and we expect meaningful net interest pressure for the US government in three-to-four years, even if the US does not experience elevated structural inflation. In China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth, which is not good news for China-related financial assets. On balance, our conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin after the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of the structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. The global financial crisis of 2008-2009, as well as the subpar economic recovery that followed, demonstrated to global investors the threat posed by elevated private sector and government debt. There has been a substantial improvement in the risk of indebtedness in some sectors of some countries over the past 15 years, but the risks of excessive indebtedness have increased in other areas of the global economy. In this special report, we check in on the indebtedness risk of a list of major economies using the BIS’ credit to the nonfinancial sector database and examine whether these risks exist primarily in the household, non-financial corporate, or government sectors. We contextualize the indebtedness data from the BIS into a risk score using several risk factors (by sector and by country), based on how elevated a given sector’s risk factor is relative not only to its own history but also the history of other countries. The sector risk scores are presented on pages 24 to 29, and we present a synthesis of our analysis below.1 We conclude that, while there are limited cyclical implications of recent trends in global indebtedness, there are several problems that will eventually “come home to roost” – particularly in the US and China. This would be consistent with a structural bear market in the dollar and a long-term uptrend in the price of gold, and could point to structural euro area outperformance within a global equity portfolio. A Global Indebtedness Report Card Table II-1 presents the aggregate risk score for each country by sector that we examined in our report. Several themes are evident from Table II-1 and the tables shown on pages 24 to 29. Table II-1A Summary Of Our Debt Risk Scores By Country/Region And Sector May 2023 May 2023 Shifting Household Sector Indebtedness Risk Chart II-1Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness The risk of household sector indebtedness has rotated from countries like the US and Spain to several other countries/regions, including Hong Kong SAR, Australia, Canada, and Sweden (Chart II-1). These are relatively smaller countries/regions and thus theoretically pose less of a risk to global financial stability than excessive household sector debt in the US and select euro area economies did in 2008. Mainland China remains one important wildcard for investors to watch. Ostensibly, the risk of China’s household sector indebtedness is only moderate according to our risk score methodology, given that its household debt-to-GDP ratio is lower than in many other countries. However, it has grown at a very significant rate over the past decade. In addition, household disposable income is lower as a share of GDP in China than in most advanced economies, and China’s housing sector has experienced a significant shock over the past two years. The fact that interest rates in China are likely to remain comparatively low versus the pace of economic growth, and that China’s property market is stabilizing, suggest that a major debt crisis in China’s household sector is unlikely over the coming year. The recent property market crisis, however, serves as a reminder of the potential structural vulnerability posed by Chinese household sector debt, which would almost certainly cause a global recession were a major deleveraging event to occur. Chart II-2Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Some Surprises From The Trend In Corporate Debt Some countries with elevated nonfinancial corporate sector debt risk scores will not be surprising to investors. Chart II-2 highlights that Hong Kong's corporate sector indebtedness is massive and that mainland China's nonfinancial corporate sector debt risk is also very elevated. Mainland China's corporate sector debt risk is concentrated in state-owned enterprises, reflecting the significant quasi-fiscal spending (mainly in the form of infrastructure investment) that has occurred over the past decade in support of economic stability. However, Sweden and France also have very elevated nonfinancial corporate sector debt risk, whose corporate sector scores closely mirror their risk scores from the shadow banking sector. “Shadow credit” references credit that is not provided by domestic banks. A rise in shadow credit appears to be the source of the increase in nonfinancial corporate sector indebtedness in both Sweden and France. Shadow credit poses a risk to financial stability because credit availability from nonbank entities could tighten rapidly in a crisis; it thus points to potentially outsized economic weakness in Sweden and France in a bad economic scenario. Based on the IMF’s stress test results, we continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. Real Long-Term Risks From US Government Indebtedness Investor concerns about the rise in US government debt have prevailed for over a decade following the surge in the debt-to-GDP ratio that occurred following the global financial crisis. However, with interest rates having fallen to extremely low levels during the last economic expansion, the debt servicing burden of US government debt was minimal. The COVID-19 pandemic changed that reality in two ways. First, the fiscal response to the pandemic resulted in another surge in the debt-to-GDP ratio. Second, the surge in inflation that occurred in the latter half of the pandemic has caused both short-term interest rates and expectations for future interest rates to rise. We expect interest rates to fall meaningfully during the next US recession, so a US government debt crisis is not imminent. However, we doubt that the fed funds rate over the coming decade will be as low as it has been over the past ten years. Higher average interest rates point to net interest costs exceeding their early-1990s levels later this decade (Chart II-3), which could cause financial market participants to force fiscal adjustment via a crisis. Chart II-3The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US is not the only country with elevated government debt risks. China, the euro area (excluding Germany) and the UK also rank highly according to our aggregate risk score methodology, as does Canada – although this reflects our use of gross rather than net debt to facilitate international comparability (see page 27 for details). The recent mini fiscal crisis in the UK is a preview of what may occur in the US and other countries on a grander scale in three-to-four years, given our view that the next US recession is likely to be mild and that the neutral rate of interest in the US and euro area is not as low as many investors believed prior to the pandemic. China’s relatively elevated government debt risk score reflects a significant rise in local rather than central government debt over the past decade, but that too carries risks for China’s economy given the way Chinese economic policy is carried out. Admittedly, these risks are much more likely to pertain to the risk of economic stagnation rather than an acute crisis. The Presence of Fiscal Space As A Buffer Against Private Sector Indebtedness In several of the countries identified with excessive indebtedness, the debt is concentrated in either the private nonfinancial or the government sector. For example, in the case of Sweden, its very concerning private sector debt load is somewhat offset by a very low government debt risk score, suggesting the presence of fiscal space in Sweden that could allow its government to respond to any private sector deleveraging event. However, in a few countries/regions, debt appears to be elevated in both the private and public sector: chiefly in Hong Kong, mainland China, and France (Chart II-4). France is a core member of the euro area; a corporate sector debt crisis in France would have a meaningful impact on European economic activity, but China’s very sizeable debt load is obviously more concerning given the importance of China as one of the three pillars of the global economy. Chart II-4Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Investment Conclusions There are no real cyclical investment conclusions to be drawn from our analysis of global indebtedness. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. However, with the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. China’s nonfinancial corporate sector is indeed extremely leveraged, but much of this debt resides on the balance sheet of state-owned enterprises and thus is unlikely to pose a cyclical economic risk due to government support – especially given recent incremental easing in China. Tight monetary policy in the US and euro area is a much more proximate risk to the business cycle and, as described in Section I of our report, we expect a recession in the US to begin at some point over the coming six-to-twelve months. However, our analysis of global indebtedness highlights several problems that will eventually “come home to roost”. US government debt is now excessive. The likely future path for interest rates implies meaningful net interest pressure on the government in three-to-four years, even if the US does not experience elevated structural inflation. And in China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth. As we noted in last month’s report,2 that is not good news for China-related financial assets, as it implies that Chinese policymakers will remain reactive and that China will become a more insular economy with even broader state influence or control. The Xi administration’s paradigm shift implies a very different China than many investors became accustomed to between 2008 and 2014, and one that is far less likely to stimulate global economic growth. In short, this is not, and likely will not be, the China that you have been hoping for. On balance, these conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin following the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of a structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. Finally, once the next US administration is in place and a new high in the servicing costs of US government debt is within sight, investors should structurally monitor the spread between 10- and 30-year US Treasury yields for signs of an abnormally steep curve. An aggressive shift into short-duration positions will be warranted in response to any true signs of a budding fiscal crisis in the US. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Private Nonfinancial Sector The countries/regions most at risk from elevated private non-financial sector debt are Hong Kong SAR, Sweden, mainland China, France, Canada, and the Netherlands (Table II-2). Across all of the metrics shown in Table II-2 that measure the risk of indebtedness, Hong Kong consistently ranks as the riskiest market. This is particularly true based on debt service measures, which show an extremely large amount of income “lost” to repaying debt. Unlike the case of mainland China, Hong Kong’s sharp rise in private sector indebtedness over the past two decades (and especially since 2009) has not occurred due to government efforts to stabilize economic activity. Hong Kong’s pegged exchange rate effectively imports US monetary policy, which has been extraordinarily easy since the global financial crisis – particularly for an economy that did not suffer the same shock to household balance sheets that occurred in the US. The source of the risk from Sweden’s indebtedness is somewhat different than is the case in Hong Kong. Sweden’s private sector debt-to-GDP level is meaningfully below Hong Kong’s, although that is mainly indicative of how extreme the latter is. More importantly, the pace of leveraging in Sweden’s private sector indebtedness has been somewhat slower than in Hong Kong and indeed a few other countries/regions (such as Japan, France, and mainland China); it ranks third after Canada based on the first of our two debt service proxies. However, based on our second DSR that uses a measure of equilibrium interest rates, Sweden appears to be much riskier. Table II-2High Private Nonfinancial Sector Debt Risk In Hong Kong SAR, Sweden, China, France, And Canada May 2023 May 2023 The Household Sector The countries/regions most at risk from elevated household sector debt are Hong Kong SAR, Australia, Canada, Sweden, and the Netherlands (Table II-3). Relative to Hong Kong’s total private sector debt, the household sector is not the dominant contributor. When compared across countries/regions, however, Hong Kong’s household sector debt-to-GDP ratio is among the most extreme. Australia, Canada, and the Netherlands rank worse than Hong Kong in terms of household sector debt-to-GDP, but both economies have recently seen meaningfully slower household debt growth than has occurred in Hong Kong. Aside from the Netherlands, euro area economies rank quite low on the list of household sector indebtedness risk and nontrivially lower than in the UK. The risk of indebtedness posed by the household sector in mainland China may be understated in Table II-3. This is because China’s household disposable income is smaller as a share of GDP than most of the other countries/regions shown in the table, which causes artificially lower debt ratios when scaled relative to GDP. Relative to developed market economies, Chinese interest rates are meaningfully below the prevailing pace of income or GDP growth, so we still suspect that China’s household sector debt service ratio is not extremely high. Investors should acknowledge, however, that the risk posed by China’s household sector leverage is probably larger than conventional debt-to-GDP measures would indicate. Table II-3High Household Debt Risk In Hong Kong SAR, Australia, Canada, Sweden, And The Netherlands May 2023 May 2023 The Nonfinancial Corporate Sector The countries/regions most at risk from elevated nonfinancial corporate sector debt are Hong Kong SAR, Sweden, France, mainland China, and Canada (Table II-4). Unlike in mainland China, where most nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong’s corporate debt does not have the same defacto state backing and is enormously concentrated in the real estate and financial sectors. Hong Kong’s real estate sector does enjoy significant structural policy support from the government. It is also true that the region has been highly indebted for some time. But Table II-4 highlights that Hong Kong’s nonfinancial corporate sector is massively leveraged and is thus vulnerable to a permanent rise in US policy rates and/or a property market crisis in the region. Commercial Real Estate (CRE) debt constitutes a large portion of Sweden’s corporate debt. IMF stress tests of Sweden’s CRE sector show that the median interest rate coverage would drop below one in a severe scenario, resulting in 75% of firms with debt-at-risk.3 We continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. France ranks surprisingly high on the list of nonfinancial corporate sector indebtedness, the result of an M&A boom in the years prior to the COVID-19 pandemic. Our debt service ratio calculations suggest that the servicing burden of this debt may be lower than the BIS’ DSR would suggest, but it is still elevated even based on our measures. This suggests that the French nonfinancial corporate sector should be closely watched over the coming year, especially if the ECB were to keep its policy rate in restrictive territory. Table II-4High Corporate Sector Debt Risk In Hong Kong SAR, Sweden, France, China, And Canada May 2023 May 2023 The Government Sector The countries/regions most at risk from elevated government sector debt based on the BIS’ gross government debt data are Italy, the US, Canada, the UK, and Spain (Table II-5). If Canada were removed from the list, China would be the fifth most vulnerable country according to our methodology. We show gross debt-to-GDP in Table II-5 because of the lack of reliable net debt measures for China, but gross debt measures have many drawbacks. Canada is an example, as its gross debt-to-GDP ratio suffers from two international comparability problems. First, Canadian general government debt statistics include sizeable accounts payable (20% of GDP). In addition, the Canadian government holds significant financial assets; Canada’s net debt is very low compared to other developed economies. The gross/net debt issue also impacts the government indebtedness risk score for Japan, although Japan’s net government debt is still extremely elevated (160% of GDP). Very elevated debt levels in Italy, especially in net debt terms, underscore why the effective neutral rate of interest is likely lower in the euro area than would be the case if the euro area was one political and economic entity. The extraordinary US fiscal response to the COVID-19 pandemic underscores that the US will likely face a fiscal reckoning in the latter half of the decade as net interest costs eventually exceed their early-1990 levels. It is impossible to come up with a precise estimate of when the US will face market pressure for fiscal reform, but our best guess is that it will occur at the tail end of the next US administration. Table II-5High Government Debt Risk In Italy, The US, The UK, And Spain May 2023 May 2023 The Total Nonfinancial Sector (Private Plus Government) The countries/regions most at risk from total nonfinancial sector debt (private plus government) are Hong Kong SAR, mainland China, Sweden, Canada, and France (Table II-6). As noted above, Canada’s rank in Table II-6 is likely overstated due to the country’s much lower net debt ratio, although it would still rank relatively high given very elevated private nonfinancial sector debt. We agree that private sector debt is typically more of an economic risk than public sector debt. It is important to examine total debt, however, as it reflects the combined risk of a private sector deleveraging event that the government of that country will struggle to respond to because of a lack of fiscal space. The fact that Hong Kong and mainland China top this list underscores the risk of long-term economic stagnation in the region, and partially explains why the Xi administration is focused on improving China’s financial resiliency. Sweden’s government debt risk score is extremely low, but the country’s very elevated private nonfinancial sector debt is large enough for total nonfinancial sector debt to show up at an elevated level (similar to Canada). France’s comparatively high levels of government debt, even when measured in net debt terms, underscore the economic risks to the country were its highly leveraged nonfinancial corporate sector to experience a crisis following a period of meaningfully tight euro area monetary policy. Table II-6High Total Debt Risk In Hong Kong SAR, China, Sweden, Canada, And France May 2023 May 2023 Non-Domestic Bank Credit To The Private Nonfinancial Sector The countries/regions most at risk from excessive non-domestic bank credit (“shadow banking”) are Sweden, Hong Kong SAR, France, Japan, and Canada (Table II-7). The risk posed by shadow credit is that debt provided by non-bank entities is very rarely amortized, meaning that it needs to be periodically rolled over. The other risk is that lending standards or credit availability from these entities is more discretionary than is the case for banks and thus could tighten rapidly during a crisis. Combined with non-amortized loans/bonds that need to be rolled over, high levels of credit provided by the “shadow banking” sector could result in larger or more frequent credit “crunches.” Generally speaking, the list of countries with high shadow banking risk matches those that show up as high risk for the private nonfinancial sector. Japan is an exception. Global investors should be attuned to any potential credit availability issues that arise in Japan should JGB yields eventually rise, potentially in response to the end of the BOJ’s yield curve control policy. Table II-7High Shadow Bank Risk In Sweden, Hong Kong SAR, France, Japan, And Canada May 2023 May 2023 Appendix: Debt Risk Measures Our debt risk score tables present five measures of debt risk for three individual sectors and two aggregate sectors over fourteen countries/regions. The five sectors include: Households Nonfinancial corporations Government The private nonfinancial sector (aggregate of households and nonfinancial corporations) The total nonfinancial sector (aggregate of households, nonfinancial corporations, and the government) We also examine the private nonfinancial sector focusing on debt that is not provided by domestic banks (“shadow banking”). Our methodology scales each measure of debt vulnerability for each country across the matrix of histories of all fourteen[1] countries/regions for that debt vulnerability measure using a percentile rank. In that way, we compare each country’s measure to a range of country histories, rather than only its own history. We scale these measures as scores from 0 (best / lest vulnerable) to 10 (worst / most vulnerable) and present the most recent observations in the tables included in this report. Our five measures include: The BIS[2] Credit-to-GDP Ratio: Ratio of total credit provided to the sector to GDP The BIS Debt Service Ratio: Ratio of debt payment estimate to gross disposable income (GDI). This measure is not available for the government sector, the overall nonfinancial sector, as well as for nonfinancial corporations for China and Hong Kong SAR. The BCA Credit-to-GDP Gap: Measure of Credit-to-GDP relative to its 10-year moving average The BCA Debt Service Ratio (Proxy 1): Ratio of debt payment estimate 1 to gross domestic product (GDP) The BCA Debt Service Ratio (Proxy 2): Ratio of debt payment estimate 2 to gross domestic product (GDP) We also include an Aggregate Debt Risk Score, which aggregates the scores of all debt vulnerability measures available by sector for each country using an equal weight approach. Our BCA Debt Service Ratios are calculated in the following manner: We estimate principal payment schedules of 18 years for households and of 10 years for nonfinancial corporations. We then estimate a principal payment component of the total debt payment by dividing the stock of debt by the debt maturity. We do not consider a principal payment in cases where debt is exclusively not amortized, such as government debt. We then compute the measure of debt interest payment by multiplying the overall stock of debt by an interest rate proxy. For our DSR proxy 1, we use the 10-year government bond yield as a measure of effective interest rate plus a spread of 1.75% for household sector debt and 1% for nonfinancial corporate sector debt. One exception applies to Hong Kong SAR, where we use US 10-year Treasury yields given Hong Kong’s pegged exchange rate. For our DSR proxy 2, we use an estimate of the equilibrium interest rate instead of 10-year government bond yields with the same household/corporate sector spread estimates. Our estimate considers the median 10-year nominal GDP growth rate as the equilibrium interest rate, with exceptions for euro area members, Hong Kong SAR, and mainland China. For euro area economies, we use euro area GDP rather than the individual country GDPs due to the commonality of monetary policy. For Hong Kong SAR we use US GDP rather than Hong Kong GDP given its pegged exchange rate and its importation of US monetary policy. For mainland China we use half of the estimated equilibrium interest rate, given that China has consistently maintained a large gap between domestic interest rates and the prevailing rate of nominal GDP growth. We then add the interest payment estimate to the principal payment estimate (when applicable) to obtain total debt payment. We then express these debt payments as a percent of GDP. Gabriel Di Lullo Research Analyst   Footnotes 1 Please see the appendix on pages 30 and 31 for a description of our debt score methodology. 2 Please see The Bank Credit Analyst "April 2023," dated March 30, 2023, available at bca.bcaresearch.com 3 Sweden’s Corporate Vulnerabilities: A Focus on Commercial Real Estate, IMF Working Paper, Selected Issues Paper No. 2023/024, March 21, 2023

In Section I, we discuss why the rally in stock prices over the past month reflects the soft-landing view, and why that is not a likely economic outcome. US inflation is slowing, but target inflation remains elusive. Meanwhile, cracks in the US labor market are already apparent, and there is strong evidence against the view that US stocks are appropriately priced for an eventual US recession. This underscores that conservative investment positioning is still warranted. In Section II, we check in on the indebtedness risk of several major economies, and examine whether these risks exist primarily in the household, nonfinancial corporate, or government sectors. While there are limited cyclical implications of recent trends in global indebtedness, there are several problems that will eventually “come home to roost” – particularly in the US and China.

The Gulf’s political economy – particularly that of KSA – drives the supply side of oil-price discovery. This has been evolving since 2017, when OPEC 2.0 was formed. It is now fundamental to the market. We expect Brent to average $95/bbl this year, unchanged from last month, and $115/bbl (up $5/bbl vs. last month). WTI will trade $4-$6/bbl below Brent over the forecast interval. We remain long the XOP and COMT ETFs.

No, the secular rise in geopolitical risk has not peaked. EU-China trade ties underscore the multipolar context, but this multipolarity is unbalanced, as the US has not reached a new equilibrium with its rivals. While the second quarter is murky, investors should stay defensive this year on the whole.