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Executive Summary China’s Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing wave of local Omicron infections and city lockdowns pose the largest macro risk in China post Q1 2020. The current lockdowns in major cities - including Shanghai - may shave one percentage point from China’s 2022 GDP growth. Restrictions on activity and travel in Shanghai and surrounding areas in the Yangtze River Delta have led to severe supply-chain disruptions, created by both port and highway transportation congestion and manufacturing plant shutdowns. Unlike in 2H20, chances are lower for a quick and strong post-lockdown recovery in China’s economy and stock prices because the nation’s policy easing will be less aggressive and is less effective than two years ago. The scale of China’s monetary easing will be smaller than in H1 2020 given the Fed is rising interest rates. The country’s fiscal balance sheet is also in worse shape than in 2020, particularly at the local level.  Bottom Line: The wave of lockdowns in China’s major cities will pose substantial risks to China’s economy this year. The post-lockdown recovery will likely be more muted than in 2H20 because there is limited room for the country to stimulate its economy and policy easing measures will likely be less effective than two years ago.   Chart 1China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing lockdowns linked to the spike in Omicron and China’s zero tolerance towards COVID are exacting a heavy toll on China’s economy. While the situation is fluid and official data is lagging, China’s economy faces the largest macro risk since early 2020. In the past four months, China has imposed more lockdowns, with full and partial mobility restrictions, than in the past two years combined (Chart 1). In particular, this round of citywide shutdowns occurred in some of China’s largest and most prosperous cities, such as Shanghai and Shenzhen, and several manufacturing hubs including Jilin province and cities in the Yangtze River Delta region. Furthermore, the post-lockdown recovery this year will likely be more muted than two years ago. Beijing has less room to ease policy and stimulate the economy than in early 2020. In addition, policy easing measures will be less effective in boosting domestic demand, given that private sector sentiment was already downbeat prior to the lockdowns and the country’s zero-COVID policy may lead to more stringent confinement measures in the rest of the year. Serious Economic Implications China’s aggregate economy is suffering significant damage from the current round of city- and province-wide lockdowns in some of China’s most populous and prosperous regions. Chart 2The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Economic data following the shutdown of Hubei province in early 2020 can serve as a roadmap to illustrate what to expect from lockdowns in Shanghai, which accounts for 4% of China’s GDP and is the same size as Hubei. During a 60-day lockdown in Q1 2020, Hubei’s retail sales growth nose-dived by 43 percentage points (ppt) and fixed-asset investment growth tumbled by 83ppt in Q1 2020 compared with the previous three months (Chart 2). The aggregate economy in Hubei shrank by 40% in Q1 2020 from a year ago and the decline likely reduced Chinese GDP growth by 1.5% in that quarter alone (Chart 3). The lockdown also dragged Hubei’s government revenues, tourism income and corporate profits into a deep contraction for 2020 (Chart 4). Chart 3The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Chart 4The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy A recent study estimating the economic impact of lockdowns by analyzing the flow of intercity trucking found that freight traffic would plummet by 54% under a full lockdown for a month, versus a 20% drop under a partial lockdown. In addition, the ripple effect of a lockdown would be felt by surrounding cities. According to the article, if the four most important economic centers of the country - Beijing, Shanghai, Guangzhou and Shenzhen - are shut down for one month at the same time, then their real income in that month would decrease by a whopping 61%. Meanwhile, the national real income in the same period would shrink by 8.6%, which translates into a 1ppt decline in China’s annual GDP growth. The scenario that China’s four major cities would be locked down was inconceivable before the onset of Omicron. However, as of April 15, it is estimated that local cities that have experienced full or partial lockdowns account for about 40% of China’s GDP, affecting more than 250 million residents. As such, the aggregate economic losses from the current round of lockdowns could reach 1ppt of China’s 2022 GDP growth. Bottom Line: The economic impact from the current lockdowns has the potential to reduce China’s GDP growth by 1ppt in 2022. Supply Chain Disruptions Shanghai’s lockdown has had economic repercussions on the Yangtze River Delta region, an important manufacturing hub and key supplier in the automobile and electronic equipment industries. Cross-regional travel restrictions have led to supply-chain disruptions through transportation blockades and manufacturing plant shutdowns. These obstacles include: Table 1Top Ten Ports In China The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Increased port congestion. The Ports of Shanghai and its nearby Ningbo handle nearly 30% of China’s total ocean shipping volume and are key barometers of China’s foreign trade and logistics chain (Table 1). Data from VesselsValue shows an almost fivefold increase in the number of ships waiting to load or discharge at Shanghai in the second half of March (Chart 5). Port congestion worsened in April after the Shanghai lockdown began on March 28. Chart 5Ships Waiting To Load Or Discharge At Shanghai Port The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Chart 6Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Road transport blockades. Road traffic in the Yangtze River Delta has been restricted, causing significant delays in suppliers’ delivery times (Chart 6). By April 7, nationwide vehicle logistics freight flow fell by 32% from a year ago and plunged more than 80% in the Shanghai area. Highway traffic mobility tracked by Gaode dipped to the same level as in early 2020. Production suspensions. A significant number of businesses from automakers Tesla and Volkswagen to notebook manufacturer Quanta Computer Inc. reportedly suspended operations at their Shanghai plants to comply with government restrictions for virus control. ​​​​​​​The city, together with Jilin and Guangdong provinces, account for more than 30% of China’s auto production. Even if employees at auto and chip makers in Shanghai can return to production plants and work through a “closed-loop” system whereby they live on-site and test regularly, a more serious challenge would be how manufacturers can secure trucks to get materials and products delivered on time.1 Supply-chain disruptions are starting to impact China’s trade. The country’s import growth in nominal value in March dropped sharply to a 0.1% contraction (on a year-on-year basis) (Chart 7). Even though China’s exports in March expanded by 14.7% from a year ago, exports are below that of its Asian manufacturing neighbors, such as South Korea and Vietnam (Chart 8). Chart 7Chinese Import Growth Fell Into Contraction In March Chinese Import Growth Fell Into Contraction In March Chinese Import Growth Fell Into Contraction In March Chart 8China's Export Growth Has Dropped Below That Of Vietnam And South Korea China's Export Growth Has Dropped Below That Of Vietnam And South Korea China's Export Growth Has Dropped Below That Of Vietnam And South Korea Bottom Line: The Shanghai lockdown is having spillover effects on the Yangzte River Delta region through supply-chain disruptions. Strong Post-Lockdown Rebound? Chart 9China Will Need A Stimulus That Is Comparable To 2020 China Will Need A Stimulus That Is Comparable To 2020 China Will Need A Stimulus That Is Comparable To 2020 China’s economic growth and stock prices will unlikely repeat the quick and strong recovery registered following the early 2020 lockdown. Beijing has stepped up policy supports, but the challenges from both domestic conditions and the external environment are greater than in 2020. Thus, the country’s stimulus (measured by credit growth including local government bond issuance) will need to at least be similar to that of two years ago to shore up the economy (Chart 9). We are skeptical about both the magnitude and effectiveness of the stimulus in 2022, despite policymakers’ mounting efforts to support the economy. Therefore, we maintain a cautious view on Chinese risk assets (in both onshore and offshore markets).  Our view is based on the following: There may be more frequent shutdowns of business activity as China continues upholding its zero-COVID approach.  Even as we go to press, a few cities that recently recovered from COVID outbreaks have failed to resume their business and social activities. A flareup of COVID cases in the low double digits has dragged cities back to either mass COVID testing or partial city lockdowns. China’s COVID-containment measures escalated when the country’s business activity was already weak which was vastly different from prior to Q1 2020 when the economy was improving (Chart 10). Sentiment among the corporate and household sectors has been beaten down following two years of struggling with COVID, and the sectors’ propensities to invest or spend have been further dampened from last year’s harsh regulatory crackdowns (Chart 11).  Chart 10Business Cycle Was On A Downtrend When Omicron Hit... Business Cycle Was On A Downtrend When Omicron Hit... Business Cycle Was On A Downtrend When Omicron Hit... Chart 11...Sentiment Among Private Sector Has Been Downbeat ...Sentiment Among Private Sector Has Been Downbeat ...Sentiment Among Private Sector Has Been Downbeat Input costs are much higher now than two years ago, while demand is weaker (Chart 12). Global energy and commodity prices will remain elevated this year, while external demand for Chinese manufactured goods will dwindle (Chart 13). China’s exports as a share of the global total peaked in July last year; a strong RMB and frequent supply-chain disruptions will likely reduce competitiveness of Chinese exports. Chart 12Elevated Input Costs, Subdued Domestic Demand Elevated Input Costs, Subdued Domestic Demand Elevated Input Costs, Subdued Domestic Demand Chart 13Demand For Chinese Export Goods Will Likely Dwindle This Year Demand For Chinese Export Goods Will Likely Dwindle This Year Demand For Chinese Export Goods Will Likely Dwindle This Year Granted the Fed’s tightening, unless China is willing to tolerate meaningful currency depreciation, the PBoC has limited room to cut interest rates. The US Federal Reserve is expected to raise interest rates by 270bps over the coming 12 months, which will further tighten US dollar liquidity conditions and may exacerbate capital flows out of emerging economies. China’s 10-year government bond yield in nominal terms dropped below that of the US for the first time in a decade, prompting global investors to offload Chinese bonds at a record pace (Chart 14). The PBoC refrained from a policy rate cut last week. The move underwhelmed investors and was a sign that the central bank may be cautious in adopting a monetary policy stance that further diverges from the Fed.  Chart 14A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year Chart 15Growth In Gov Revenue From Land Sales In Deep Contraction Growth In Gov Revenue From Land Sales In Deep Contraction Growth In Gov Revenue From Land Sales In Deep Contraction The room for further fiscal expansion is also more limited than two years ago as local governments are more constrained by funding. An expansionary fiscal policy in the past two years has pushed local governments’ debt ratios2 up by more than 20 percentage points to above the international standard of 100%, while the property market slump has led to a deep contraction in local government revenues from land sales (Chart 15). ​​​​​​​ Bottom Line: Business activity will likely rebound when restrictions are eventually lifted, and the existing and/or forthcoming stimulus will work their way into the economy. However, the above mentioned hurdles suggest that China has limited room to further loosen its monetary and fiscal policies compared with two years ago, and the effectiveness of policy easing on the economy will be more muted. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1     Recently the consumer and auto division head of Huawei Technologies warned that “If Shanghai cannot resume production by May, all of the tech and industrial players that have supply chains in the area will come to a complete halt, especially the automotive industry.” "China’s Auto Industry May Grind to a Halt Amid Shanghai Lockdown", Caixin Global 2     Measured by local governments’ total debt including general and special-purpose bonds, divided by their overall fiscal balance. ​​​​​​​ Strategic Themes Cyclical Recommendations

Executive Summary We have been constructive-to-bullish on financial markets and the economy since policymakers marshaled the full force of their resources to protect the economy from the pandemic in the spring of 2020. The policymakers-versus-the-virus framework, and the view that policymakers would triumph, stood us in good stead across 2020 and 2021. Now, however, the Fed is shifting from countering COVID’s adverse economic effects to reinforcing them. The near-term silver lining is that monetary policy works with a lag, just like fiscal transfers that are saved for future use. Although the Fed is in the process of dialing back monetary stimulus, it will be a while before the fed funds rate reaches a level that restrains economic activity. In the meantime, the lagged effects of extraordinarily stimulative monetary and fiscal policy are likely to keep the economy growing above trend. Runaway inflation is the clear and present danger to our base-case view, and the war in Ukraine and a COVID outbreak in China could exacerbate inflationary pressures. We expect that equities and high-yield corporate bonds will outperform Treasuries and cash over the rest of the year, but inflation could spoil the party. It's Not A Spiral Yet It's Not A Spiral Yet It's Not A Spiral Yet Bottom Line: We remain constructive on the economy and financial markets over a six-to-twelve-month timeframe, though we have more conviction in our view at the near end of the range. We fully expect that the Fed will kill this expansion, but not before the middle of 2023 unless geopolitics and/or China’s COVID response accelerate the timetable. Feature Policymakers versus the virus, and our conviction that the Fed and Congress had the means and the will to do whatever it took to protect the economy from the ravages of COVID, proved to be the right macro template for making investment decisions in 2020 and 2021. Now a new battle has been joined – the Fed versus inflation – and we anticipate that it will end in a recession and an equity bear market. Before Russia invaded Ukraine, crimping global supplies of grains, base metals, crude oil, natural gas and coal, and China began experiencing its worst COVID outbreak, imperiling the nascent improvement in global supply chains, we were confident that the party wouldn’t break up before the second half of 2023 at the earliest. Although we remain constructive over a cyclical 3-to-12-month timeframe, we recognize that Eurasian developments may foreshorten the current expansion. The Global Unknowns The indirect effects of the war in Europe are readily apparent but it is difficult to predict if Russian actions will lead to more sanctions and/or extend hostilities to a wider theater, deepening the European slowdown, exerting additional upward pressure on commodity prices and casting a larger shadow over global activity. China’s confrontation with COVID is riddled with unknowns: How effective is its Sinopharm vaccine against the currently dominant strain of the virus, and how effective will it be against subsequent mutations? When will China abandon its zero-tolerance policy? How stringent will lockdowns be? Could they be localized, allowing most industrial activity to continue, or will they be more sweeping? Is there any chance that the country will license the proven mRNA vaccine technology or the Pfizer pills that neutralize the severity of the disease in those who have become infected? The Eurasian factors are important, albeit hard to forecast, and we will have to monitor them in real time to get the soonest possible jump on their impacts. Several threats closer to home keep surfacing in our ongoing conversations with investors, however, and the rest of this week’s report examines them in the context of our constructive base-case view. The Wage-Price Spiral Employment data have consistently pointed to an increasingly tight labor market. Job openings are at record levels and consumer and small business surveys indicate that it is unusually easy for job seekers to find a job, and unusually difficult for employers to attract workers. All else equal, the dearth of labor supply strengthens workers’ bargaining power and supports further wage growth acceleration. With the US labor market already so tight that it squeaks, many observers are convinced that a wage-price spiral is a foregone conclusion. They can cite various wage series as evidence that a spiral might already have begun. The Atlanta Fed Wage Tracker and comprehensive measure of the Employment Cost Index are growing by 6% and 4.4% year-on-year, respectively. As large as the nominal gains are, however, they’re lagging the increase in consumer prices. Despite the voracious demand for workers, wage growth adjusted for inflation has decelerated since the early days of the pandemic, when front-line workers received the equivalent of combat pay in bonuses and temporary hourly increases, and has mostly contracted since last spring (Chart 1). Chart 1They're Not Exactly Chasing Each Other Higher Now They're Not Exactly Chasing Each Other Higher Now They're Not Exactly Chasing Each Other Higher Now Amidst the disruptions of the pandemic, many workers left the labor force. Census Department surveys attributed many of the departures to a lack of childcare or fear of infection, while print media and the Internet were awash with stories of people who’d re-examined their lives and determined that their existing work was unfulfilling. Supported by generous fiscal transfers, the subjects of the stories regularly professed indifference about returning to work. The Great Resignation narrative gained currency as an explanation of declining labor force participation and suggested that the shortage of workers might endure until today’s high school and college students grew old enough to step in themselves. Recent evidence undermines the idea that the Great Resignation marked a structural change in labor force participation. It looks much more like the decline was cyclical, tied to the ups and downs of infection rates and fiscal appropriations. The prime-age (25-to-54-year-old) participation rate has recovered to within a percentage point of its pre-pandemic high and appears to have plenty of momentum (Chart 2). Workers in the 55-to-64 age group, fueling the Great Retirement unit of the Great Resignation battalion, have come back to the workforce in droves, with the 55-to-59 cohort setting a 10-year participation high (Chart 3, middle panel) and its 60-to-64 peer group nearing one (Chart 3, bottom panel). Workers over 65 may remain on the sidelines, but the early retirement thesis is faltering as well. Chart 2The Great Resignation Is Unwinding ... The Great Resignation Is Unwinding ... The Great Resignation Is Unwinding ... Chart 3... And So Is The Early Retirement Wave ... And So Is The Early Retirement Wave ... And So Is The Early Retirement Wave     Finally, a resumption of more normal immigration patterns may also boost labor supply. The Department of Homeland Security states that it granted 228,000 lawful permanent residencies in the first quarter of 2022, a 72% increase from one year ago.1 Widespread pandemic business closures led some immigrants to return home, while keeping others who may have emigrated from crossing the border. We have no illusions that immigration is on the cusp of a step-function increase, but any uptick will help at the margin, especially in low and unskilled jobs where supply is especially strained. The bottom line for investors is that the labor market is tight, but real declines in wages and further supply relief may keep a wage-price spiral from taking root. It is too soon to conclude that wages and prices will chase each other higher in a repeat of the bad old days of the seventies. Inflation And The US Consumer Chart 4An Unprecedented Divergence An Unprecedented Divergence An Unprecedented Divergence Consumer confidence has been flagging, especially in the University of Michigan survey, which is approaching all-time lows two standard deviations below its mean (Chart 4, top panel). Though the Conference Board’s measure has come off of its pandemic highs, it is considerably more optimistic and remains above its mean (Chart 4, bottom panel). The Michigan survey places much more emphasis on inflation, which may explain why the two series are sending such sharply divergent messages. The implication is that high and/or rising inflation dents households’ confidence as it erodes their purchasing power, posing a dual threat to consumption and overall economic growth. In our view, the lagged effects of emergency pandemic stimulus measures have fortified households with enough dry powder (via fiscal transfers) and provided a powerful enough financial conditions tailwind (via low interest rates and asset appreciation) to ensure that their spending will underpin potent 2022 growth. We estimate that US households in the aggregate have $2.2 trillion in excess pandemic savings2 (Table 1). They have begun to deploy those savings, fueling consumption above our estimate of no-pandemic baseline consumption by $30 billion in both January and February, and they have ample capacity to spend more. The excess savings derive nearly equally from increased income and foregone consumption and are predominantly held by households in the bottom seven deciles of the income distribution because they received nearly all of the fiscal transfers that drove income increases across 2020 and the first half of 2021. Table 1Tracking Excess Savings Risks To Our View Risks To Our View Those households have a higher marginal propensity to consume than the wealthiest households, but the wealthy have benefitted mightily from the surge in the value of equities and other financial instruments. Most of the stellar eight-quarter increase in real household net worth (Chart 5) has thus been reserved to households in the top deciles but the home-price-appreciation boom has helped the two-thirds of households across the income distribution who own their homes (Chart 6). The bottom line is that American consumers are flush and the entire cross-section of households has shared in the bounty. The gains are unprecedented, just like the fiscal and monetary stimulus packages that gave rise to them, and they provide a buffer of dry powder that can withstand some purchasing power erosion from the 5.2% annualized increase in consumer prices since February 2020. Chart 5Household Wealth Has Never Grown So Much, So Fast ... Household Wealth Has Never Grown So Much, So Fast ... Household Wealth Has Never Grown So Much, So Fast ... Chart 6... And Ordinary Joes Benefitted, Too ... And Ordinary Joes Benefitted, Too ... And Ordinary Joes Benefitted, Too Quantitative Tightening Clients ask about the potential adverse effects of quantitative tightening (QT) in nearly every meeting, regularly citing the way the stocks swooned at the end of 2018, about a year into the FOMC’s previous balance sheet reduction foray. QT was at the scene of the crime in December 2018 and may well have been an accessory to the near murder of the equity bull market, but we would argue that a too-high fed funds rate was the true culprit. Although most investors recollect that the Fed ceased QT when equities hit an air pocket, the balance sheet continued shrinking until the summer of 2019, when the Fed resumed cutting rates. After the stock swoon, the Fed only stopped hiking the fed funds rate (at 2.5%). Related Report  US Investment StrategyHawks, Houses And Harried Workers As we discussed last week, we don’t think changes in the size of the Fed’s balance sheet lead to much more than marginal changes in the level of long-term interest rates. They fall a little when a large, price-insensitive buyer enters the marketplace, and they rise a little when it exits. Ultimately, we think asset purchases (QE) have the most impact as a signaling device: they communicate to investors and economic actors that zero interest rate policy will remain in place as long as QE continues and for some period after it ends. QE is therefore a leading indicator, while QT is no more than a coincident indicator, playing a nearly undetectable supporting role. QT may contribute to volatility in the rates market, but investors shouldn’t let it take their focus from the Fed’s more powerful fed funds rate lever. The Vulnerable Housing Market We discussed our constructive take on the housing market and residential investment last week, noting that homes are still affordable and mortgage rates are still low from a historical perspective, while the single-family home market remains undersupplied. Talk of a housing bubble has died down, but we still hear occasional references to housing’s role in the financial crisis and concerns about the economy’s vulnerability to a rate-induced decline in home prices. In our view, those concerns can easily be put to rest. Investors should remember that the subprime bust was principally a story about prodigally extended credit; houses just happened to be the collateral against which the loans were made. Chart 7Flight To Quality Risks To Our View Risks To Our View Those loans, the worst of which exceeded underlying property values and were extended to buyers who were not even remotely creditworthy, were tantamount to a house of cards by 2007. From 2004 through 2007 (Chart 7), more than a fifth of all new home mortgage originations went to near-prime (credit score between 620 and 659) and subprime (less than 620) borrowers, while not much more than half were issued to super-prime (greater than 720). Since the pandemic, near-prime and subprime borrowers have been limited to an average 5% share of loans, while super-primes have accounted for 84% of them and the upper tier of super-primes, with credit scores of 760 and above, have accounted for 70%. The change in lending standards can also be seen from using the Fed’s household balance sheet data to calculate an aggregate loan-to-value ratio (LTV) for the entire stock of owner-occupied single-family homes. The aggregate LTV currently stands at 31%, in the middle of the tight range it observed in the seventies and eighties, before policymakers began actively encouraging banks to make mortgage loans available to an expanded pool of borrowers (Chart 8). LTV exploded higher from 2006 through 2009 as lending peaked in 2006-7 and home values subsequently fell faster than mortgage balances in the 2008-9 bust. The record LTV of the subprime crisis, ginned up by loans that matched or exceeded underlying home values, amplified the distress from a downturn in home prices; today’s ‘70s-style LTV will help to absorb them. Chart 8High Prices Weren't The Problem, High LTVs Were High Prices Weren't The Problem, High LTVs Were High Prices Weren't The Problem, High LTVs Were Portfolio Construction Takeaways Our Global Fixed Income and US Bond Strategy services have adjusted their recommended tactical positioning on Treasuries and spread product and we are adjusting our ETF portfolio to align with their view with a slight exception. Our in-house bond strategists recommend a modest tactical overweight in Treasuries and we are curing our Treasury underweight while maintaining benchmark duration. We are reducing our allocation to hybrid debt securities by halving our position in variable-rate preferreds (VRP) on the rationale that we have less need for credit exposure and duration protection over the immediate term. We are trimming our high yield overweight (JNK) to a mere 100 basis points and allocating our sales proceeds that aren’t going to Treasuries into mortgage-backed securities (MBB) to reduce that underweight by 140 basis points. We are parting company with our fixed income team by maintaining a small high yield overweight on the grounds that above-trend economic growth will hold down delinquencies and defaults until a recession is nearly at hand. The position is vulnerable to spread widening, but we expect the positive carry over duration-matched Treasuries will allow high yield to generate positive excess returns for the rest of the year. All of the changes are detailed in Table 2 and will be reflected on BCA’s website soon after today’s New York open. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com   Footnotes 1     https://www.dhs.gov/immigration-statistics/special-reports/legal-immigr…, accessed April 12, 2022. Data obtained from Table 1A. 2     Table 1 calculates household excess savings by subtracting our estimate of baseline no-pandemic savings from actual savings as compiled by the Bureau of Economic Analysis in its monthly Personal Income report. Our baseline estimate assumes that personal income would have grown at an annualized 4% pace (2% real trend growth plus 2% inflation) and that the savings rate would have remained constant at its 8.3% February 2020 level.

Executive Summary The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Is A Recession Inevitable? Is A Recession Inevitable? Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones Is A Recession Inevitable? Is A Recession Inevitable? To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Is A Recession Inevitable? Is A Recession Inevitable? Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Is A Recession Inevitable? Is A Recession Inevitable? Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Image Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Is A Recession Inevitable? Is A Recession Inevitable? Special Trade Recommendations Current MacroQuant Model Scores Is A Recession Inevitable? Is A Recession Inevitable?

Executive Summary Fed officials maintained the drumbeat of hawkish commentary last week, reiterating their commitment to use the full might of their tools to bring inflation to heel. Stock and bond markets reacted adversely when dovish Governor Brainard joined the chorus, but no one should have been surprised. The FOMC is unanimous in its resolve to combat inflation before long-run expectations become unmoored. Markets may also have been discomfited by the coming shrinking of the Fed’s balance sheet. Though balance sheet runoff should exert some modest upward pressure on bond yields, we do not expect markets to dwell on it for long. Housing activity is squarely in the crosshairs of tighter monetary policy. Mortgage rates are extremely low relative to history, however, and homes remain quite affordable. We expect the housing market will weather the backup in rates. A plucky band of first-time organizers spurred workers in a New York City Amazon warehouse to vote to form a union. Labor advocates rejoiced, but it is premature to mark the event as a turning point for organized labor. What Goes Up Must Come Down What Goes Up Must Come Down What Goes Up Must Come Down Bottom Line: Last week’s Fed “news” was not particularly newsworthy. The FOMC will prioritize its inflation mandate over its full employment mandate until further notice, but the economy is well suited to withstand higher rates and even the housing market won’t buckle in the face of them. Feature Just when you thought it was safe to go back in the water, Fed speakers roiled rates markets again last week, pushing the 10-year Treasury yield over 2.6% for the first time in three years. Although Fed Governor Brainard was simply lining up behind every other governor and district president who’s been in range of a microphone over the last several weeks, her tough talk on inflation in a Tuesday morning speech jolted the 10-year yield 10 basis points (bps) higher, from 2.45% to 2.55%, and it tacked on another 10 bps overnight, hitting 2.65% as New York-based fixed income traders switched on their terminals Wednesday morning. Stocks tumbled after Brainard’s remarks, as well, with the S&P 500 shedding 1% in back-to-back sessions. Both markets got a respite after the March FOMC meeting minutes contained no further revelations but the 10-year yield marched to 2.70% on Friday. The market action demonstrated that investors remain on edge, despite the S&P 500’s 10% bounce. From our perspective, there was nothing too notable in Brainard’s comments. She may be seen as one of the more reliably dovish members of the FOMC, but Chair Powell has been at pains to stress that the entire committee is “determin[ed],” as the minutes put it, “to take the measures necessary to restore price stability.” With inflation readings persisting well above the FOMC’s target level, one participant after another has hammered home the message in speeches and interviews that the committee is unanimously resolved to wield its tools to bring it to heel. Related Report  US Investment StrategyIt All Depends On Whom You Ask Hiking the fed funds rate is the committee’s foremost weapon in the fight against inflation, and it has guided investors to discount a more rapid pace of 2022 increases and a modestly higher end point for this tightening cycle. We think the fixed income market is underestimating the terminal, or peak, rate but expect that it will require hard evidence before it reassesses its conviction that the economy cannot withstand a fed funds rate above 2.5%. It will take time to gather that evidence, as it won’t be available until the funds rate is at least 2%, so we expect that the 10-year yield will soon peak in tandem with inflation, but investors are especially uncertain and volatile financial markets reflect it. The FOMC can also adjust the size of its balance sheet to regulate the stimulus it’s providing to the economy. This tool pales in importance relative to the funds rate and despite Ben Bernanke’s smug remark at BCA’s 2015 conference that “quantitative easing works in practice but not in theory,” definitive evidence of its effects remains elusive. We therefore do not expect that curtailing reinvestment of principal repayments from the Fed’s stockpile of securities holdings will have a meaningful direct effect on the economy. Last week’s guidance that the runoff will be faster than it was in 2018-19 makes sense, given that the Fed’s securities holdings are twice as large (Chart 1), and that flush households and businesses are in markedly better shape than they were in the aftermath of the crisis. Chart 1The Funds Rate Matters More Than The Size Of The Balance Sheet The Funds Rate Matters More Than The Size Of The Balance Sheet The Funds Rate Matters More Than The Size Of The Balance Sheet There is no settled consensus on what the Fed’s balance sheet reduction will mean for the economy and markets. The US Investment Strategy view is that asset purchases are mainly a signaling device; they let economic participants and investors know that zero interest rate policy will remain in place until some period after they end. Balance sheet runoff doesn’t provide any similar information about the future; it simply indicates that the FOMC will be pursuing a supplemental stimulus reduction measure alongside its far more influential increases in short rates. Removing a price-insensitive buyer from the marketplace should put modest upward pressure on interest rates because they should have to rise, all else equal, to induce other buyers to step in to replace it. We expect, therefore, that the runoff will tighten financial conditions at the margin and exert a modest drag on economic activity. Some of that marginal tightening must have already occurred, as the Fed has taken pains to telegraph the balance sheet runoff, but it will likely contribute to volatility as markets try to settle on the proper outcome to discount. What About Housing? Interest rates affect the entire economy, but housing is the most rate-sensitive industry. Houses are the ultimate big-ticket items – they are the most expensive purchase most households will make and nearly all of them are financed via mortgages. Demand for single-family housing, away from the post-GFC phenomenon of investment buyers paying cash, is acutely sensitive to interest rates. The tide of available buyers ebbs and flows as monthly mortgage payments rise and fall. The housing market therefore finds itself in the crosshairs of the Fed’s tough talk about inflation and the homebuilder stocks have been demolished so far this year, losing a third of their value to lag every other subindustry group in the S&P 500 except closely related home furnishings (Chart 2). The stock rout contrasts with the upbeat housing market outlook we offered two months ago. Though we acknowledge that housing’s prospects have dimmed somewhat since mid-to-late February, we remain more optimistic than the consensus and are confident that a pronounced slowdown is not in store. Chart 2A Brutal Selloff ... A Brutal Selloff ... A Brutal Selloff ... The subsequent 75-bps surge in Freddie Mac’s national 30-year fixed-rate mortgage proxy (Chart 3, middle panel) has made homes less affordable for the median buyer (Chart 3, top panel). The drop in affordability has been modest, however, as it has been cushioned by a narrowing of the gap between median income and median home prices (Chart 3, bottom panel). Despite the last two months’ dip, homes remain quite affordable relative to history. Chart 3... Despite Solid Affordability ... Despite Solid Affordability ... Despite Solid Affordability ​​​​​ Since its predecessor index began in 1971, affordability had only ever surpassed the 140 level that has marked the bottom of the post-crisis range for a brief period in the early seventies (Chart 4, top panel). While mortgage rates are clearly moving in the wrong direction, they remain extremely low. One must squint to register their current advance in the context of the series’ entire history (Chart 4, third panel). Despite rising rates, median income gains have kept the mortgage servicing burden steady – and historically light – for several months (Chart 4, second panel). Though we expect that mortgage rates will stop vaulting upward and possibly even retrace some of their advance as inflation peaks, their recent move has been unfriendly to the housing market. Viewed from the perspective of the National Association of Realtors’ affordability index, however, their level remains quite favorable, and we do not worry that great swaths of would-be buyers are going to be shut out of the market. The respondents to the NAHB’s homebuilder sentiment survey agree. While the forward sales component swooned by ten points from January to February (Chart 5, bottom panel), current sales largely kept pace (Chart 5, second panel) and potential buyer traffic rose (Chart 5, third panel). The overall index slipped a bit since January but – stop us if you’ve heard this before – remains very strong relative to history (Chart 5, top panel). Chart 4The American Dream Is Not Out Of Reach The American Dream Is Not Out Of Reach The American Dream Is Not Out Of Reach ​​​​​​ Chart 5Homebuilders See Clear Skies Ahead ... Homebuilders See Clear Skies Ahead ... Homebuilders See Clear Skies Ahead ... ​​​​​ Though demand has surely waned, as rising rates sideline some marginal buyers, we expect it will remain robust, especially as the sizzling rental market offers little relief. Supplies of new and existing homes remain constrained. Restrictive zoning laws, sporadically soaring input costs, supply chain issues and difficulty finding skilled workers have hampered new home construction. Inventories of existing homes remain historically depleted (Chart 6, middle panel) and the share of homes that are vacant remains at all-time lows (Chart 6, bottom panel). Chart 6... As Their Product Is In Short Supply ... As Their Product Is In Short Supply ... As Their Product Is In Short Supply ​​​​​​ Chart 7Real Mortgage Rates Are Not A Problem Real Mortgage Rates Are Not A Problem Real Mortgage Rates Are Not A Problem ​​​​​​ The bottom line is that the housing picture has worsened somewhat but we still believe conditions are better than the gloomy consensus perception. Construction and sales activity will surprise to the upside over the rest of the year and residential investment will augment economic activity, not detract from it. Although the ITB homebuilder ETF has been a drag on performance since we added it to our cyclical ETF portfolio last month, we will continue to hold it as a pure play on the resilience of domestic demand. It is hard to see demand evaporating in the fashion implied by the homebuilders’ skid when real mortgage rates are at such extreme lows, no matter how they are adjusted for inflation (Chart 7). David Wins A Round Against Goliath Workers at a fulfillment center in Staten Island voted two weeks ago to become the first domestic Amazon employees to form a union. The vote, along with a concurrent re-vote at a Bessemer, Alabama warehouse that union organizers lost, was closely watched by labor relations experts. Amazon is the second-largest private employer in the US, with more than a million employees, and its size and reputedly trying working conditions make it an especially appealing target for unions. Labor advocates were quick to characterize the vote as a watershed moment, but it is far too early to call an inflection point. The outcome of the Amazon vote was front-page news because it was so improbable. Despite a cyclically favorable labor market, wage earners trying to unionize confront a gaping structural resource disparity with multinational companies. The fledgling Amazon Labor Union’s (ALU) victory in Staten Island was startling but it still faces an arduous climb to bring Amazon to the negotiating table and work out a contract agreement. Amazon will be able to introduce delays at every step of the process, eroding ALU’s meager resources while pursuing a strategy of running out the clock on the current labor-friendly administration. One of the key takeaways from our January-February 2020 Special Reports on US labor relations history was that employees are only to achieve gains when the government – courts, legislatures and the executive branch – does not favor employers. The series of reports were meant to alert investors to the possibility that Democratic wins in the 2020 election could send the pendulum swinging back in employees’ favor after 40 years of tilting toward employers, carrying important implications for corporate profit margins and inflation. Chart 8The Tortoise And The Hare The Tortoise And The Hare The Tortoise And The Hare The election did mark a change in the White House’s attitude toward labor, installing the self-declared “most pro-union president leading the most pro-union administration in American history.1” Since President Biden took office, the National Labor Relations Board has forcefully asserted itself in its role as the official referee of union elections to the point that Amazon has accused it of taking the unions’ side instead of serving as a neutral arbiter. The president himself would seem to have been taking sides last week when he took the rare step of calling out Amazon by name during remarks to a group of unionized workers. “The choice to join a union belongs to workers alone,” he said. “By the way, Amazon, here we come. Watch.” The White House press secretary quickly walked back the comments, placing them in the context of the president’s established support for unionization and collective bargaining. “What he was not doing is sending a message that he or the U.S. government would be directly involved in any of these efforts or take any direct action.2” Regardless of whether President Biden was attempting to send a message or had ventured off-topic as is his wont, it is unclear how much his administration can do to tilt the scales in workers’ favor. New Deal-era laws endowed workers with the right to organize and employers are not allowed to obstruct their efforts to do so. There are multiple gray areas in union election campaigns, however, and employers regularly deploy a wide range of actions that are not explicitly prohibited to keep unions out of their workplace. Most importantly, this administration may only be in charge until January 2025. It can use the NLRB, OSHA, the Department of Labor and the Department of Justice to try to advance workers’ cause for four years but labor has been on the back foot for four decades. It is likely to lose its legislative majorities in November’s midterms, the federal bench is populated by a majority of judges disposed to see things from employers’ point of view and many state legislatures are markedly anti-union. Without another term, the jury is out on the administration’s ability to effect durable change. The takeaway for investors is that a wage-price spiral has not yet taken hold and our bet is that it won’t. The tight labor market has endowed workers with more leverage than they’ve had in many cycles, but structurally the labor relations landscape bears more characteristics of the Reagan Era (1980-2020) than the New Deal Era (1933-1980). Real average hourly earnings have risen since the pandemic arrived in the US (Chart 8, top panel), but we find it telling that all of the real wage growth occurred in the first year of the pandemic. Across Year 2, nominal wages have failed to keep up with consumer price inflation (Chart 8, bottom panel), despite White House support in the midst of a labor market so tight that it squeaks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Remarks by President Biden in Honor of Labor Unions | The White House Accessed April 7, 2022. 2     Biden Appears to Show Support for Amazon Workers Who Voted to Unionize - The New York Times (nytimes.com) Accessed April 7, 2022.

Highlights The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Feature The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.1 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand March 2022 March 2022     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,2 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk March 2022 March 2022 Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1 For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 2 Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Highlights The Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that equities and other risk assets will ultimately recover. We continue to expect above-trend growth and above-target inflation in the US and other developed economies this year. Q1 growth in the US is likely to be closer to 4% after removing the effect of changing inventories, and incoming information still points to the view that the pandemic will continue to recede in importance over the coming several months. Given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has recently occurred. There are legitimate arguments in favor of a very aggressive pace of Fed tightening. Still, our view is that seven rate hikes from the Fed over the coming 12 months is likely too aggressive: A peak in headline inflation over the coming months will help restrain longer-term household inflation expectations, the surge in wage growth continues to reflect pandemic-driven labor market distortions that could unwind, and a significant further flattening of the yield curve – despite likely being a false signal of a recession – would probably cause a temporary period of tighter financial conditions that the Fed would respond to. We believe it is likely that the Fed will initially seek to raise interest rates at a pace that is in line with current market pricing, but that it will likely slow the pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. The case for aggressive ECB hikes was weak even before Russia’s invasion of Ukraine. European core inflation is nowhere near as strong as it is in the US, and nominal output in the euro area has not yet recovered to its pre-pandemic trend (in heavy contrast to the US). Russia’s invasion has caused a disruption of natural gas flows that will keep European gas prices at elevated levels, and aggressive tightening in response risks repeating the mistakes the ECB made in 2008 and 2011 when it raised rates in the face of an ultimately deflationary supply shock. On a 6-12 month time horizon, we are only likely to recommend downgrading global stocks once 5-year/5-year forward US Treasury yields break above 2.5%, barring a more severe shock to global economic activity from the Ukrainian crisis than currently appears likely. On Russia’s Invasion Of Ukraine Yesterday, BCA Research published a Special Alert in response to Russia’s invasion of Ukraine.1 In the report, we outlined Russia’s motivation for invading, and noted that it will not withdraw troops until it has changed the government and seized key territories – such as coastal regions to ensure the long-term ability to blockade the country. Crucially, we noted that while the US and EU will levy sweeping sanctions against Russia, that the EU would not halt Russian energy exports. We regard the decision to maintain Russia’s access to the SWIFT system as consistent with that view. Given this, we believe that the Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that growth, inflation, and monetary policy will ultimately return as the drivers of equities and other risk assets over the coming weeks and months. Beyond Ukraine: Growth, Inflation, And Monetary Policy In The DM World Chart I-1Recent US Data Has Looked Smoewhat Stagflationary Recent US Data Has Looked Smoewhat Stagflationary Recent US Data Has Looked Smoewhat Stagflationary BCA Research presented three possible growth and inflation scenarios for this year in our 2022 Annual Outlook report. Our base case scenario, to which we assigned 60% odds, was one of above-trend growth and above-target inflation. We assigned 30% odds to a “stagflation-lite” scenario of above-target inflation with below-trend growth, and a 10% chance of a recession. Since we published our Annual Outlook, we raised the odds of the second, stagflation-lite scenario – mostly due to the impact that the Omicron variant of COVID-19 could have on the Chinese supply chain. But until recently, US economic data was also looking somewhat stagflationary: US real GDP only grew at a 2.3% annualized basis in Q3, and the strong Q4 number was mostly boosted by inventories. Real goods spending has slowed over the past few months without a major increase in services spending, and US auto production continues to be restrained by semiconductor shortages (Chart I-1). Supply-side constraints on production and spending have occurred against the backdrop of a significant acceleration in US consumer prices, the combination of which seemingly points more to the second growth and inflation scenario that we outlined, rather than our base case. However, our view is that above-trend growth in the US and other developed economies remains the most likely outcome this year, even given ongoing supply-side constraints and Russia’s invasion of Ukraine. In addition to the sizeable amount of excess savings that have been accumulated during the pandemic and the enormous increase in household net worth that has occurred over the past two years, two other factors point to above-trend DM growth. In the US, following the release of the January retail sales report, the Atlanta Fed GDPNow model is forecasting below-trend growth for Q1, but with a -2.3% contribution from the change in private inventories. Chart I-2 highlights that the Atlanta Fed’s model is projecting 3.6% annualized growth in Q1 of final sales of domestic product, a measure of GDP that excludes the effect of changing inventories (whose contribution to growth averages to zero over time). This would be above the trend rate of real GDP growth, and would represent an acceleration relative to the past few quarters. Beyond the next few months, the other factor pointing to above-trend growth is the indication that the pandemic will indeed continue to recede in importance over the course of the year, in line with what we laid out in our Annual Outlook. Chart I-3 highlights that the Omicron-driven surge in hospitalizations in G7 countries has been short-lived, and Chart I-4 highlights that deliveries of Pfizer’s anti-viral treatment Paxlovid, while still in their early stages, have begun. Chart I-2Q1 US Economic Growth Likely To Be Above-Trend Q1 US Economic Growth Likely To Be Above-Trend Q1 US Economic Growth Likely To Be Above-Trend Chart I-3Hospitalizations Are Falling Sharply Hospitalizations Are Falling Sharply Hospitalizations Are Falling Sharply In a recent study, Paxlovid was found to have an 89% efficacy in preventing COVID hospitalizations and deaths, with less serious adverse events or discontinuations than the placebo group.2 Its high effectiveness against all SARS-CoV-2 variants suggests that its increased deployment over the course of the year should significantly reduce the impact of COVID-19 on the medical system as well as lower the fear of the disease amongst consumers, even as new variants of the virus emerge and spread around the world. Consequently, it is likely that the output gap in advanced economies will turn positive this year despite ongoing supply-side constraints unless Russian energy exports to the EU are ceased, triggered either by a European boycott or a Russian embargo. Prior to Russia’s invasion, consensus growth expectations implied above-trend growth for this year (Chart I-5), which we see as consistent with the base case growth and inflation view that we presented in our Annual Outlook if Russian energy exports continue. However, given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has occurred over the past 2 months. Chart I-5We Agree With Consensus Expectations For Growth This Year We Agree With Consensus Expectations For Growth This Year We Agree With Consensus Expectations For Growth This Year Chart I-4US Paxlovid Deliveries Are Creeping Higher US Paxlovid Deliveries Are Creeping Higher US Paxlovid Deliveries Are Creeping Higher   The Case For, And Against, Aggressive Fed Tightening Just since the beginning of the year, investors have moved to price in an additional 100 basis points of rate hikes from the Fed (Chart I-6). Earlier this month, comments by St. Louis Fed President James Bullard signaling his desire for a full percentage point of interest rate hikes by July had a sizeable effect on US Treasury yields, with market participants still pricing in meaningful odds of a 50 basis point rate hike in March despite recent pushback from key Fed officials and Russia’s invasion of Ukraine. Chart I-6The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction Last year, The Bank Credit Analyst service warned on several occasions that a return to maximum employment was likely to occur faster than investors expected, and that a hawkish shift from the Fed was probable. We noted in our July report that the cumulative odds of a rate hike by some point in Q2 2022 were close to 40%,3 and in our September Special Report we reinforced the view that a mid-2022 rate hike was likely.4 Still, even relative to our (then) comparatively hawkish expectations, the monetary policy outlook has shifted very aggressively towards more and earlier rate hikes. This shift has partially occurred due to the labor market dynamics that we projected last year, but also due to a significant broadening of inflation over the past four months. Chart I-7 highlights that the 6-month rate of change in US core CPI excluding cars and COVID-impacted services was not meaningfully different in October than it was in the latter half of late-2019, in heavy contrast to overall headline and core inflation. However, over the past four months this measure has accelerated by 175 basis points, highlighting that inflationary pressures are becoming broader – and that an earlier and more forceful response from the Fed may be warranted. Chart I-7US Inflation Has Broadened, And Quickly So US Inflation Has Broadened, And Quickly So US Inflation Has Broadened, And Quickly So Does the broadening in US inflationary pressure that has occurred over the past few months justify the seven rate hikes currently expected by investors over the coming year? We present the detailed case for and against that view below, and conclude that seven rate hikes over the coming 12 months is likely too aggressive. The Case For Aggressive Tightening The most prominent argument in favor of aggressive Fed rate hikes is not just to slow the pace of inflation, but to address the fact that broadening inflationary pressures risk unanchoring inflation expectations. As we discussed in our January 2021 Special Report,5 inflation is determined not just by the output gap, but as well by inflation expectations. Economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to cyclically fluctuate, but those fluctuations are relative to a level that is determined by inflation expectations – not the Fed’s inflation target. It is only if inflation expectations are consistent with the Fed’s target that actual inflation will equal that target, abstracting from the business cycle and other distorting events. A deeply negative output gap for several years following the global financial crisis caused inflation expectations to be vulnerable to shocks, and the collapse in oil prices in 2014 served as a large enough surprise that expectations unanchored to the downside. This event ultimately motivated the Fed’s introduction of its average inflation targeting policy, but Chart I-8 highlights that inflation expectations are no longer chronically low and that they may unanchor to the upside without meaningfully tighter monetary policy. A temporary period of higher food prices stemming from Russia’s invasion of Ukraine also raises the risk of unanchored inflation expectations among households. The second argument in favor of aggressive Fed rate hikes is that the unemployment rate has essentially fallen back to its pre-pandemic level, and median wage growth has already risen to its strongest level in 20 years (Chart I-9). Given that a large amount of excess savings and a very significant wealth effect are likely to continue to support aggregate demand, the inference is that overall wage growth may accelerate significantly further as the unemployment rate continues to fall. Chart I-8Inflation Expectations Are No Longer Depressed Inflation Expectations Are No Longer Depressed Inflation Expectations Are No Longer Depressed Chart I-9Wage Growth Has Risen Very Significantly Wage Growth Has Risen Very Significantly Wage Growth Has Risen Very Significantly The third argument in favor of rapid tightening is that the natural/neutral rate of interest is likely higher than both investors and the Federal reserve believe, meaning that monetary policy is even easier today than is generally recognized. We have written about this issue at length: in March 2020 we explained why the most cited measure of “R-star” was wrong,6 and noted in our April 2021 Special Report why we no longer believe that a gap between interest rates and trend rates of economic growth are justified. This perspective also suggests that investors should look past the quasi-recessionary signal currently being flagged by the 2/10 yield curve, as curve inversion is likely to be a false signal of a recession – as it was in 2019 (see Box I-1). BOX I-1 The Sino-US Trade War, The Yield Curve, And The COVID-19 Pandemic The US yield curve has historically provided a highly reliable signal of the likelihood of a recession. Investors have taken an inverted yield curve as a sign that short-term interest rates have risen to a level that is not likely to be sustained over the longer term, meaning that monetary policy has become tight. An inverted yield curve has indeed preceded several US recessions, although its track record at predicting contractions globally has been less reliable. While it is a counterfactual assertion, we believe that the yield curve provided a false signal when it inverted in 2019. Clearly the inversion did not predict the COVID-19 pandemic; the question is whether the US would have experienced a recession had the pandemic not occurred. In our view, the evidence does not point to that conclusion. Charts I-B1 and I-B2 highlight that the yield curve responded to an economic slowdown that was mostly caused by the Sino-US trade war, as well as an ongoing slowdown in Chinese credit growth and economic activity. It does not appear to have occurred due to interest rates having risen to a level that would be unsustainable absent these non-monetary shocks. Chart I-B1The Yield Curve Inverted Well After The Trade War Hit… March 2022 March 2022 Chart I-B2…And The Economy Started Improving After The Inversion March 2022 March 2022 In addition, the signal from the yield curve lagged that of the equity market: Chart I-B1 highlights that the US equity market fell just shy of 20% eleven months before the yield curve inverted. In fact, stock prices were rising sharply just prior to the emergence of the pandemic in response to expectations of monetary easing and the Phase I US trade deal, and the US Markit manufacturing and services PMIs were also turning up. None of these signs point to the likelihood of a contraction in US output had the COVID-19 pandemic not emerged. The key point for investors is that an inversion of the yield curve, were it to occur over the coming 12-18 months, would not necessarily signal a recession unless it were coupled with a major non-monetary shock. It would, however, be significant from a strategy standpoint, as the Fed would likely take it as a sign of tightening financial conditions. The Case Against Aggressive Fed Action Chart I-10Inflation Expectations Have Risen, But Are Not Out Of Control Inflation Expectations Have Risen, But Are Not Out Of Control Inflation Expectations Have Risen, But Are Not Out Of Control There are several counterpoints to the arguments noted above, as well as a few additional reasons to suggest that 7 rate hikes over the coming year is too aggressive. First, on the issue of inflation expectations, while it is true that expectations are no longer chronically low, longer-term expectations have not yet exceeded their pre-global financial crisis (GFC) range (Chart I-10). In addition, despite the temporary spike in energy and food prices stemming from Russia’s invasion of Ukraine, headline inflation is likely to peak at some point over the coming months, which will act to restrain longer-term household inflation expectations. Importantly, inflation is likely to peak even without any Fed tightening. A comparison of the recent pace of advance in both headline and core CPI suggests that the former has up to 200 basis points of downside if crude oil prices remain at $100/bbl. Our Commodity & Energy Strategy team expects that Russia’s invasion of Ukraine will prompt increased production from core OPEC producers to reduce the elevated risk premium and allow refiners to boost inventories. We now expect Brent oil to average $85/bbl in the second half of 2022, implying eventual deflation from energy prices and a slowdown in the pace of advance in headline CPI over the coming months – potentially below that of core. That would represent a very significant easing in headline inflation relative to current levels, and we do not expect that long-term household expectations for inflation would rise much further in such a scenario. The easing in the prices paid component of the ISM manufacturing index also points to an imminent peak in headline inflation and, by extension, household inflation expectations (Chart I-11). Second, while it is true that overall wage growth has recently accelerated quite significantly, it is still the case that this is being driven by the lowest-paid workers. Chart I-12 highlights that 1st and 2nd quartile wage growth are between 0.4-1.2% higher than they were prior to the pandemic, but that 3rd and 4th quartile wage growth is either the same or lower. Chart I-12Lower-Pay Wage Inflation Is Due To The Pandemic... Lower-Pay Wage Inflation Is Due To The Pandemic... Lower-Pay Wage Inflation Is Due To The Pandemic... Chart I-11The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation   This surge in wages for low-paid workers largely reflects pandemic-driven labor market distortions, rather than excess demand. Chart I-13 highlights that real US services spending remains close to 5% below its pre-pandemic trend, and Table I-1 highlights that the leisure & hospitality industry now accounts for the vast majority of the jobs gap relative to pre-pandemic levels. Chart I-14 also highlights that while the leisure & hospitality jobs gap is smaller in red states than in blue states (which may be disproportionately affected by lost services jobs in central business districts due to work-from-home policies), it is still larger today that it was during the depths of the 2008/2009 recession. Chart I-13...Not Excessive Services Demand ...Not Excessive Services Demand ...Not Excessive Services Demand The key takeaway from Table I-1 and Charts I-13 and I-14 is that rising 1st and 2nd quartile wage growth is being caused by labor scarcity in low paying industries, which we attribute to the fact that working conditions in these jobs became more difficult during the pandemic and the fact that many of these positions involve close contact with customers. And clearly, raising interest rates will not hasten the return of leisure & hospitality workers to the labor market.   Table I-1Leisure & Hospitality And Education Now Make Up Almost All Of The US Jobs Gap March 2022 March 2022 Chart I-14The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends Third, even though we think the natural/neutral rate of interest is higher than both investors and the Federal reserve believe and that the yield curve provided a false signal of a recession in 2019, a significant further flattening of the yield curve would probably cause a tightening in financial conditions, at least for a time. The Fed is unlikely to be dissuaded from raising rates due to a valuation-driven decline in equity prices, but it is likely to respond to market-based signals of a material slowdown in economic activity – even if those signals ultimately prove to be false. The yield curve is an important reflection of how far bond investors believe the economic cycle has progressed (Chart I-15), and an increase in short-term interest rates at the pace that investors are currently expecting would flatten the 2/10 yield curve very close to (or into) negative territory. It seems likely that a rapid flattening in the curve would precipitate a growth scare in financial markets for a time, leading to falling equity prices (due to concerns about earnings, not just valuation), a rising US dollar, and a widening in corporate credit spreads. Chart I-15For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession To conclude on this point, the Fed will feel that it is justified in hiking rates aggressively while inflation is well above its target levels and the unemployment rate is low and falling, but it is likely to change this assessment if financial markets begin to behave in a way that signals a rising risk of a significant slowdown in jobs growth. That would lead to a tactical period of weakness for risky asset prices, but it would ultimately be cyclically positive if the Fed revises its pace of tightening to a rate that is slower than investors currently expect. Our View Netting out the arguments presented above, the Fed may initially seek to raise interest rates at a pace that is in line with current market pricing, but it will likely slow that pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. Our view also has important implications for the euro area interest rate outlook, given the significantly weaker case for aggressive ECB action that existed even before Russia’s invasion of Ukraine. A Flimsy Case For Aggressive ECB Rate Hikes, Even Before Russia’s Invasion Chart I-16The European Inflation Situation Is Not As Bad As In The US The European Inflation Situation Is Not As Bad As In The US The European Inflation Situation Is Not As Bad As In The US At the early-February ECB meeting, President Christine Lagarde signaled a more hawkish outlook for euro area monetary policy than investors had been expecting. Since the beginning of the year, the OIS market has moved to price-in roughly 70 bps of hikes over the coming 12 months, German 2-year bund yields have risen 20 basis points, and 10-year yields have risen back into positive territory. Italian and Greek 10-year yield spreads (relative to Bunds) have risen by 35 and 90 basis points, respectively. From our perspective, investors are pricing a too-aggressive path for the ECB policy rate, and we would probably characterize an ECB decision to raise rates in line with current market expectations as a policy mistake. As highlighted in a recent report by my colleague Mathieu Savary, BCA’s Chief European Strategist, several arguments support this view. First, Chart I-16 highlights that euro area core inflation is running at a considerably slower rate than headline inflation or core inflation in the US, and that our core inflation diffusion index for the euro area has peaked. It is true that core inflation is much higher in Germany than in other key euro area economies, and it is also true that aggregate euro area core inflation is above the ECB’s 2% target. But high German core inflation is seemingly driven by particularly acute passthrough effects from high natural gas prices, and recent IMF research underscores that over half of the increase in German manufacturing price inflation has occurred due to supply shocks rather than demand (Chart I-17). Chart I-18 shows that expectations for euro area inflation and actual wage growth do not, in any way, suggest that the ECB’s 2% target is under threat, underscoring that aggressive tightening over the coming several months risks repeating the mistakes the ECB made in 2008 and 2011 when it tightened policy in the face of an ultimately deflationary supply shock. Chart I-17German Core Inflation Is Being Disproportionately Driven By Supply Shocks March 2022 March 2022 The second argument is that nominal output in the euro area has not yet recovered to its pre-pandemic trend, in heavy contrast to the US (Chart I-19). This is particularly true for Italy and Spain, and reflects the nature of the euro area fiscal response to the COVID-19 pandemic. Chart I-20 highlights that the cumulative growth in euro area disposable income has been lower than what would have been expected absent the pandemic, unlike what occurred in the US and Canada – two countries that provided sizeable direct transfers to households as part of their fiscal response. Chart I-19Key Euro Area Economies Have Recovered Far Less Than The US Has Key Euro Area Economies Have Recovered Far Less Than The US Has Key Euro Area Economies Have Recovered Far Less Than The US Has Chart I-18Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat     Third, Russia’s invasion has caused a disruption of natural gas flows via Ukraine that will keep European gas prices at elevated levels even beyond the winter period, which will have a negative impact on the euro area economy. Chart I-21 highlights that European natural gas prices are now seven times as high as they were at the beginning of 2021. Unlike the prior rise in European natural gas prices, which was somewhat related to global demand for goods, the post-invasion surge is a pure supply shock – echoing our point about the ECB’s previous policy mistakes. Chart I-20Euro Area Disposable Income Is Lower Than Its Pre-Pandemic Trend, In Contrast To The US March 2022 March 2022 Chart I-21Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock The fact that Italy’s nominal economic recovery has been comparatively weak has helped explain the rise in its 10-year government bond yield relative to 10-year German Bunds. Allowing for a further economic recovery in those countries before raising rates would let the ECB ultimately increase rates further down the road – and thus exit more cleanly from negative policy rates in Europe. Our European Strategy Team continues to expect that the ECB is on track to raise interest rates only once in Q4 2022, to be then followed by more aggressive hikes in 2023. Investment Conclusions For fixed-income investors, the investment implications of policy rates moving higher over the coming year at a pace that is less rapid than currently expected would normally imply that an at or above-benchmark duration stance is warranted. However, Chart I-22 highlights that there is still upside for 10-year US Treasury yields even in a scenario where the Fed raises rates at a pace of 100 basis points per year. As such, we continue to recommend that investors remain short duration on a 6-12 month time horizon, although we agree with BCA’s fixed-income team’s recommendation to tactically raise duration to neutral given the potential for the European energy crisis to worsen further and the fact that 10-year US Treasury yields do not have as much upside on a cyclical basis as they did when we published our Annual Outlook.7 For equities, we do not find the case for a tactical downgrade to be compelling at current levels, given that global stocks have already fallen 10% from their mid-November highs. Over the near term, we expect the continued underperformance of euro area equities, be we doubt that the negative economic impact of higher natural gas and oil prices would persist beyond a 0-3 month time horizon. On a 6-12 month time horizon, our expectation that monetary policy will tighten at a less aggressive pace than investors expect suggests that the earnings risk to global stocks is not substantial, underscoring that a meaningful contraction in equity multiples would likely be required for stocks to register negative 12-month returns from current levels. In the US, business surveys suggest that sales growth is set to slow to a still-healthy level, and that profit margins are likely to be flat over the coming year (Chart I-23). This is in line with the view that we presented in our Annual Outlook, namely that US earnings growth in 2022 would be driven mainly by top-line growth. Chart I-22Investors Should Still Be Cyclically Short Duration Investors Should Still Be Cyclically Short Duration Investors Should Still Be Cyclically Short Duration Chart I-23Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Chart I-24Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Similarly, the risk of a serious interest rate-driven contraction in equity multiples over the coming year does not appear to be elevated. Investors are far more inclined to use long-maturity bond yields to discount future cash flows than short-term interest rates, and we have noted that the rise in long-maturity bond yields is necessarily self-limiting unless investor expectations about the natural/neutral rate of interest change. Chart I-24 highlights that despite an extremely rapid shift in monetary policy outlook amid the highest US headline inflation in 40 years, 5-year/5-year forward US Treasury yields remain only fractionally above 2%. This underscores that fixed-income investors will need to see evidence that a progressively higher Fed funds rate is not disrupting economic activity before they are likely to abandon the secular stagnation narrative. While the equity risk premium will remain elevated over the near term due to the situation in Ukraine, the bond market’s continued belief in secular stagnation will likely support equity multiples – at least for the remainder of the year. As such, we recommend that investors position in favor of the following over the coming 6-12 months: Overweight equities versus long-maturity government bonds Overweight value versus growth stocks Short duration within a fixed-income portfolio, with a neutral tactical overlay Overweight speculative-grade corporate bonds with a credit portfolio Overweight non-resource cyclicals versus defensives and small caps versus large Short the US dollar versus major currencies Jonathan LaBerge, CFA Vice President The Bank Credit Analyst February 25, 2022 Next Report: March 31, 2022 II. Canada: How High Can Rates Rise? The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.8 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand March 2022 March 2022     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,9 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk March 2022 March 2022 Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off and Russia’s invasion of Ukraine, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1     Please see BCA Special Alert "Russia Takes Ukraine: What Next?," dated February 24, 2022, available at bca.bcaresearch.com 2    Jennifer Hammond et al. “Oral Nirmatrelvir for High-Risk, Nonhospitalized Adults with Covid-19.” The New England Journal of Medicine, February 16, 2022. 3    Please see The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 4   Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 6    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 7    BCA Webcast Positioning For A Rate Hike Cycle, February 15, 2022. 8   For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 9    Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Executive Summary While inflation has unquestionably surprised to the upside, the US will not enter a self-reinforcing spiral unless an inflation mindset takes hold throughout the economy. The two leading surveys have wildly different takes on consumer confidence. The available evidence sides with the Conference Board’s robust reading rather than the University of Michigan’s dismal one. We are not concerned about housing’s near-term outlook. There is an undersupply of homes in America and mortgage rates have not backed up enough to put a meaningful dent in demand. Financial markets are jumpy and will likely remain hypersensitive to speculation about the Fed’s policy choices. We nonetheless continue to favor risk assets over the next twelve months and will look out for tactical buying opportunities whenever volatility is on the cusp of easing. Consumers Aren't Chasing High Prices And That's A Good Sign Consumers Aren't Chasing High Prices And That's A Good Sign Consumers Aren't Chasing High Prices And That's A Good Sign Bottom Line: The ride is likely to be bumpy for financial markets this year, but we expect it will ultimately be rewarding. Growth will hold up despite recurring fears. Feature Our recent discussions with colleagues and investors indicate that US financial market participants are preoccupied with one of three issues: a potential inflation breakout, a slowdown induced by a consumption shortfall or, worse yet, both. We add to our thoughts on inflation and consumption after digging into some less-watched series, and check in on the housing market following the surge in mortgage rates. Our conclusion remains unchanged: we still expect potent growth in 2022, and we think investors should maintain at least equal weight exposures to risk assets. Amidst elevated volatility brought on by Fed uncertainty, however, investors should be willing to act more opportunistically. Consumers Are Not Adding Fuel To The Fire … We have spoken repeatedly about the inflation mindset, a concept lifted from Japan’s ongoing experience with chronic stagnation. The malaise ailing Japan is in large part attributable to the deflation mindset that has swept consumers, businesses and investors. Economic participants conditioned to expect continuously falling prices change their behavior to adapt to them, so consumers have put off discretionary purchases, anticipating that goods will be cheaper (and better) next year; businesses confronting steadily falling revenue have shunned investment in favor of shrinking their cost bases to preserve profit; and investors have been willing to funnel capital to the lowest-yielding sovereign bonds in the world, content with meager purchasing power accretions. The central theorem of macroeconomics – my spending is your income and your spending is my income – has sentenced the economy to quietly wither in a self-reinforcing loop. Conversely, we believe an inflation mindset in which economic actors expect continually rising prices is a necessary precondition for an upward inflation spiral. The spiral is stoked by a chain reaction of worker and investor demands for increased compensation, wholesale and retail price hikes, and consumers’ rush to maximize their declining purchasing power by buying ahead of the next inevitable increase. Despite all the inflation agita, Treasury investors are untroubled about its long-run prospects, as their 5-year inflation expectations five years from now remain below the bottom end of the Fed’s target range (Chart 1). The hedgers, speculators and market makers who compose the CPI swaps market are also serene (Chart 2). Though all parties see intense price pressures lasting for another year, they expect them to dissipate over time (Table 1). Chart 1Long-Run Inflation Expectations Are Subdued, ... Long-Run Inflation Expectations Are Subdued, ... Long-Run Inflation Expectations Are Subdued, ... Chart 2... Despite Big Near-Term Swings It All Depends On Whom You Ask It All Depends On Whom You Ask Per the University of Michigan’s sentiment survey, consumers also anticipate that near-term inflation pressures will fade in the intermediate term (Chart 3). They are consequently wary about making large purchases at a price they’ll later come to regret. Viewing today’s high prices as temporary, they think it is a historically inopportune time to buy cars, houses and large household durables. Their responses suggest that the inflation mindset has yet to make any headway with consumers; for now, there is no danger that shoppers harbor inflation fears that could become self-fulfilling. Table 1The Inflations Expectations Curve Is Sharply Inverted It All Depends On Whom You Ask It All Depends On Whom You Ask Chart 3Survey Says: Temporary! Survey Says: Temporary! Survey Says: Temporary! The share of respondents citing sticky/rising prices as a reason for buying cars now is at very low levels (Chart 4, top panel) while those citing high prices as a reason not to buy continues to make record highs (Chart 4, middle panel). The spread between the two has never been wider (Chart 4, bottom panel) – a sizable majority of consumers with discretion over when they buy is committed to waiting out the conditions that have sent prices zooming higher. Chart 4Resisting A Spiral Resisting A Spiral Resisting A Spiral Michigan respondents have been on the right side of chronically deflating new car prices, as those who think prices won’t come down have been nearly continuously outnumbered for the last 40 years (Chart 5, bottom panel). Since vehicle buying conditions became a regular survey component, there have been only three stretches when consumers reported a net urgency to buy, all of which coincided with real increases in new car prices (Chart 5, top panel). The chart is silent on the direction of causality, though we would suspect that consumer urgency follows from observed price increases, which it then amplifies and/or extends. Chart 5Just Say No Just Say No Just Say No The Michigan surveyors also ask consumers about the timeliness of buying houses and major household durables. Charts for houses (not shown) and durables (Chart 6) look much like cars, though the Good-Won’t Come Down/Bad-Prices Are High spread for houses is as persistently negative as it is for cars (ex-the 2012 to 2015 recovery from the aftermath of the housing bust). Consumer demand for the biggest-ticket items is apparently more elastic than it is for major appliances. Chart 6Consumers Aren't Chasing Household Durables Prices Higher,Either Consumers Aren't Chasing Household Durables Prices Higher,Either Consumers Aren't Chasing Household Durables Prices Higher,Either Bottom Line: Consumers are disinclined to go along with surging prices on big-ticket items. An inflationary spiral will not take hold while they are committed to putting off major purchases with the expectation that they will get a better deal in the future. … But Could They Be Losing Their Nerve? Consumers’ discipline has positive inflation implications, but the bombed-out vehicle buying conditions chart in the Executive Summary could be sending a worrisome growth signal. Foregone spending is lost income, and if enough buyers defer purchases, a recession could be just around the bend. True enough, but investors should keep in mind that the buying conditions indexes measure demand urgency, not overall demand. Those with discretion over the timing of their purchases may be holding off, but American consumers are not turning Japanese. Surging home and new and used car prices eloquently testify to fierce competition among buyers. We do not therefore see cause for concern in the diverging consumer confidence surveys. Over time, the indexes produced by the Conference Board and the University of Michigan have tended to send similar messages (Chart 7). The relationship has frayed over the last five years, however, and the two series completely diverged last spring. That would be of no more than passing interest if the composite average of both surveys’ expectations component had not formerly been such a reliable coincident indicator of real consumption growth (Chart 8). Chart 7Parting Company Parting Company Parting Company Chart 8The Confidence-Consumption Link Has Been Severed The Confidence-Consumption Link Has Been Severed The Confidence-Consumption Link Has Been Severed Investors may wonder whether consumption will take its lead from the Conference Board’s cheer or Michigan’s gloom. The Conference Board survey consists of just five questions asking respondents to assess current business and employment conditions and offer their six-month expectations about business conditions, employment conditions and their family’s income. The more extensive Michigan survey runs to twelve full pages, touching on business conditions; personal finances; economic policy; unemployment, interest-rate, inflation and home-price expectations; and buying conditions for homes, household durables and motor vehicles. A layperson reading through the Michigan survey might think it was designed to provoke anxiety in unsuspecting respondents – what are the chances your income will keep pace with inflation, that you or your spouse will involuntarily lose a job over the next five years, that you will have enough money for retirement, etc. – but its readings are not uniformly bleak. Since the financial crisis, it has tended to be cheerier than the Conference Board survey when inflation is low or negative while its relative nosedive has coincided with inflation’s breakout (Chart 9). The relationship would logically follow from the Michigan survey’s explicit focus on inflation and one’s personal relation to it. The Conference Board survey is linked much more closely to perceptions of the job market (Chart 10) and it may therefore be expected to lag during disinflationary/deflationary periods but outperform when inflation accelerates. Chart 9The Michigan Survey Is Sensitive To Inflation, ... The Michigan Survey Is Sensitive To Inflation, ... The Michigan Survey Is Sensitive To Inflation, ... Chart 10... While The Conference Board's Tracks Strength In The Labor Market ... While The Conference Board's Tracks Strength In The Labor Market ... While The Conference Board's Tracks Strength In The Labor Market Bottom Line: Given the robust growth outlook, we are inclined to side with the Conference Board’s upbeat consumer confidence reading. We do not expect that flush households with pent-up demand will turn into misers. The 2,400-Square-Foot Gorilla Chart 11Level Trumps Direction Level Trumps Direction Level Trumps Direction The sharp backup in mortgage rates so far this year has many observers concerned about the potential consequences of a housing slowdown. A major slump would idle construction workers, pressure housing industry suppliers, and dampen demand for the furnishings and major appliances that fill homes. We think the concerns are overdone and believe that the housing market will be well supported through the rest of the year. Affordability concerns come back to the level-versus-direction debate that has flared ever since real economic growth began to decelerate from its torrid 6.5% pace in the first half of last year. 3% or 4% is nothing to sneeze at for an economy with a long-run trend growth rate of 1.75 – 2%, however. Deceleration from an extremely high level to a very high level still leaves room for ample corporate earnings gains and risk assets duly delivered chunky excess returns across last year’s second half. 30-year fixed mortgage rates have risen 100 basis points from their pandemic low but remain extremely low relative to history (Chart 11, middle panel). As a result, homes remain quite affordable (Chart 11, top panel), despite the relative increase in median home prices (Chart 11, bottom panel). The horizontal line across the affordability series puts its level into a fuller context. Except for a few years in the early seventies, when the median home price was just two-and-a-half times median household income, affordability never exceeded 140 before the global financial crisis ushered in zero interest rate policy. A supply shortfall will bolster the market. Household formations have outstripped housing starts by a wide margin over the last two years (Chart 12, top panel) and available inventory (Chart 12, middle panel) and vacant units (Chart 12, bottom panel) are at all-time lows. Homebuilder sentiment is firing on all cylinders (Chart 13, top panel), as current sales are strong (Chart 13, second panel), buyer traffic remains elevated (Chart 13, third panel) and future sales expectations are rosy (Chart 13, bottom panel). Chart 12There Isn't Enough Supply ... There Isn't Enough Supply ... There Isn't Enough Supply ... ​​​​​​ Chart 13... And Builders Know It ... And Builders Know It ... And Builders Know It ​​​​​​ Bottom Line: Despite the backup in mortgage rates and twelve months of turbo-charged home price appreciation, housing will do just fine this year. A slump weighing on employment and activity is not in store. Investment Implications 2022 has so far been characterized by the serial emergence of issues that have roiled financial markets. Rising rates/falling tech stocks, impending Fed rate hikes, persistent upside inflation surprises and Ukraine have combined to push the VIX into the 20s and 30s, knock the S&P 500 down 9% and drive losses in Treasuries and spread product. We expect that concerns about Fed policy, growth and inflation will linger throughout the year and across the entirety of the Fed’s rate hiking cycle, waxing and waning with the news and data flow. Our base case is that 2022 growth will be quite strong, boosted by avid consumption and investment underpinned by savings and wealth gains, easy monetary conditions, and a tight job market. We expect that stout macro fundamentals will support earnings gains and that a dearth of alternatives to equities that can be expected to generate positive inflation-adjusted returns will keep earnings multiples elevated. If the mildness of Omicron variant infections points to a future in which COVID-19 becomes no more than a nuisance, global growth will get an additional fillip and some supply-chain pressures should ease, allowing inflation to come off the boil. While we reiterate our constructive view on financial markets and the economy, however, we do not expect a smooth ride to our year-end destination. Most investors lack first-hand experience managing against an inflation backdrop that has not been in place since the early ‘80s and volatility will likely be elevated as they find their footing. We are therefore adopting a more tactical perspective, seeking out opportunities to exploit temporary volatility, and we advise that clients consider shortening timeframes and increasing turnover to the extent their individual mandates will allow it. We do not think that the major inflection point marked by a shift from accommodative to restrictive monetary policy settings will arrive until the second half of 2023 at the earliest, but the run-up to it will likely be bumpy.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

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? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? 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... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An 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 ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...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 Spending On Durables Is Driving Inflation Spending 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 Inflation Is Driving The 30-Year T-Bond Inflation 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 Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get 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 Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get 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 Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get 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 Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get 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 Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get 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 Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get 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 Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Image CAD/SEK At A Top CAD/SEK At A Top CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face 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 - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed 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 Indicators To Watch - Interest Rate Expectations Image   Indicators To Watch - Interest Rate Expectations III A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face Image    

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Feature This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook – a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the last quarter of 2021 were mixed, with business credit standards easing in the US, Japan, Canada, and New Zealand while remaining mostly unchanged in the euro area and UK (Chart 1). Supply chain disruptions have had a two-pronged effect on borrowing. While they have hurt business confidence and prospects, they have also created loan demand as firms look to replenish depleted inventory stocks. The overall picture is one of solid economic fundamentals that are nonetheless perturbed by inflation concerns and lingering uncertainty regarding Covid-19 infections. Chart 1Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice-versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q4/2021 (Chart 3). This marks the fourth consecutive quarter of easing standards. However, banks did report a slower pace of easing, which correlates with tighter financial conditions on the margin (top panel). While we are still in a period of easy financial conditions in absolute terms, this could soon start to change as hot inflation prints and booming economic data cause the Fed to turn increasingly hawkish. Despite this, banks expect to ease standards further over 2022, indicating confidence that underlying economic fundamentals and corporate health will be able to weather monetary tightening. US banks also reported stronger C&I loan demand from all firms in Q4, marking three consecutive quarters of improvement (middle panel). The picture was optimistic, with banks attributing increased loan demand to inventory financing, mergers & acquisitions, and fixed investment. Meanwhile, only 4.2% and 12.5% of banks saw a decrease in internal funds and increasing precautionary demand, respectively, as somewhat important. Inventories accounted for all but 2% of the 6.9% annualized GDP growth in Q4. With inventory stocks still depressed in absolute terms, we expect inventory restocking will continue to buoy demand over 2022. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions ​​​​​ Chart 4US Loan Demand Outlook For 2022 Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? On the consumer side, banks reported easier standards across the board, with standards easing for credit card, auto, and other consumer loans (bottom panel). However, the pace of easing, which has historically been good at calling turning points in consumer confidence (on a rate-of-change basis), appears to have peaked. Consumer sentiment has already been battered by rampant inflation and falling real wage expectations; tighter credit standards down the road could prove to be a further headwind. As part of the one-off special questions in this edition of the survey, respondents were asked about the reasoning behind their outlook for loan demand over 2022 (Chart 4). Of those that expected higher demand, 70% cited higher spending and investment demand from borrowers as their income prospects improved. Meanwhile, only 33% thought that precautionary demand for liquidity would be a factor. Lenders thought that both, a worsening or an improvement in supply chain disruptions, could contribute to increased demand. 53% expected that continued disruption would create greater inventory financing needs. Meanwhile, 55% expected that easing supply chain troubles would boost demand as product availability concerns faded. Of those that expected weaker loan demand, interest rates were by-and-large the biggest factor, with an overwhelming 96% believing that rising rates would quell loan demand. This was followed by concerns that supply chain disruptions would keep prices high and product availability scarce (70%). On the whole, the responses capture a US economy that is at a tipping point, with market participants watching to see how it weathers an aggressive rate hiking cycle from the Fed. While underlying economic variables such as growth and employment remain strong, it still remains to be seen how much of a tightening in financial conditions the markets can bear. Euro Area In the euro area, banks on net reported a very slight tightening of standards to enterprises for the second consecutive quarter in Q4/2021 (Chart 5). Effectively, standards were unchanged as 96 of the 100 respondents to the survey reported no change from Q3. Slightly lower risk tolerance from banks contributed to tightening while lower risk perceptions related to the general economic outlook and the value of collateral had an easing effect. As in the US, standards in the euro area do show a correlation to overall financial conditions. Those have already tightened noticeably since the February 3rd meeting of the European Central Bank (ECB) Governing Council where President Lagarde set a more hawkish tone. While banks do expect a slight easing of standards over Q1/2022, that is unlikely given high inflation and geopolitical uncertainties which will negatively impact risk perceptions. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions ​​​​​​ Chart 6Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies ​​​​​​ Loan demand growth from enterprises was remarkably strong in Q4, with 18% of firms reporting increased demand for loans (middle panel). The main driver was increased demand for inventories, followed closely by fixed investment and merger & acquisition needs. Loan demand leads realized growth in inventories, which has been already been picking up. In Q1, banks expect continued growth in loan demand, albeit at a slower pace. On the consumer side, however, loan demand only increased slightly, with the pace of growth slowing from the previous quarter (bottom panel). This was in line with consumer confidence taking a hit from rising inflation and the Omicron variant in the fourth quarter. The generally low level of interest rates had a small positive impact, while durable goods spending had a slight negative impact on consumer credit demand. Lenders expect moderate growth in consumer credit demand in Q1. Moving to the four major euro area economies, demand for loans to enterprises picked up in Germany, France, and Italy, while remaining unchanged in Spain (Chart 6). Fixed investment needs made a positive contribution across the board. This is corroborated by data on total lending, which is still growing on a year-on-year basis, even though the pace of growth is slowing in all the major euro area economies except Spain. UK In the UK, overall corporate credit standards eased slightly in Q4/2021, marking the fourth straight quarter of easing (Chart 7). However, there was dispersion along firm size. Large private non-financials accounted for all the easing and standards for small and medium firms actually tightened slightly. Going forward, lenders expect a further easing in standards in Q1, about on par with the easing seen in Q4. Chart 7UK Credit Conditions UK Credit Conditions UK Credit Conditions ​​​​​ Chart 8UK Lenders Expect A Robust Growth To Ease Credit Availability Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? ​​​​​​ On the demand side, lenders reported slightly weaker corporate demand for lending in Q4. Again, the results were uneven across firm size – loan demand from large firms strengthened moderately, while demand from small and medium firms weakened. On average, lenders expect a slight pickup in corporate demand over Q1. Moving to the UK consumer, demand for unsecured lending continued to rise at a brisk pace, hovering around the highest levels since Q4/2014 (bottom panel). Going forward, lenders expect a continued increase in demand, but at a much slower pace. The strong developments in loan growth are seemingly at odds with the GfK consumer confidence index which has declined a total of 12 points since its July peak. Although the Bank of England does not survey respondents on the factors driving household unsecured lending demand, the divergence between confidence and loan demand suggests that precautionary demand for liquidity is playing a role. This lines up with the GfK survey, where expectations for the general economic situation over the next year are in freefall with consumers bracing for high inflation and further Bank Rate increases. Pivoting back to the drivers of corporate lending, the leading factor behind increased credit availability was an improvement in the overall economic outlook, followed by market share objectives (Chart 8). In contrast to the UK consumer, lenders are bullish on the economic outlook and believe it will continue to drive further easing over Q1/2022. On the demand side, investment in commercial real estate, which has seen steady improvement since Q3/2020, was the leading factor. This was followed by merger & acquisition and inventory financing needs. Capital investment needs, meanwhile, were a drag on demand. Moving forward, real estate investment and inventory restocking needs are expected to drive demand. Japan In Japan, credit standards to firms and households continued to ease in Q4/2021 (Chart 9). However, more than 90% of respondents in each case reported that standards were basically unchanged, and there were no reported instances of tightening among the sample of 50 lenders. Those that did report easier standards cited aggressive competition from other banks and strengthened efforts to grow the business. The vast majority of lenders expect standards to remain unchanged over Q1, but there is a slight easing expected on a net percentage basis. Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Business loan demand on the whole was unchanged in Q4 although small and medium firms did increase demand slightly (middle panel). In contrast to other regions, business loan demand tends to behave counter-cyclically in Japan, with businesses borrowing more on a precautionary basis when they are pessimistic and vice-versa. Those dynamics were at play in Q4, with lenders attributing increased demand to a fall in firms’ internally generated funds. Banks expect a slight net pickup in demand next quarter, in line with business confidence which has fallen from its September peak on the back of concerns about Covid-19 infections, supply chain disruptions, and rising input prices. On the consumer side, loan demand was basically unchanged, with a very small net percentage of banks reporting weaker demand (bottom panel). The key reason for decreased demand was a decrease in household consumption, which is in line with retail sales, where the pace of growth has been falling. Even though core inflation in Japan is low, consumers are still exposed to rising energy prices, which might cause them to tighten other parts of their budgets. Canada Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions In Canada, business lending standards continued to ease at a slightly slower pace in Q4/2021 (Chart 10). This marks the fourth consecutive quarter of easing conditions, coming amid booming economic activity, high capacity utilization, and buoyant sentiment. Both, price and non-price lending conditions eased at roughly the same pace. On the consumer side, non-mortgage lending conditions continued to ease, but at a slower pace (middle panel). 1-year ahead consumer spending growth expectations, sourced from the Bank of Canada’s (BoC) Survey Of Consumer Expectations, and non-mortgage lending conditions typically display an inverse correlation, with expected spending growth increasing when standards are getting easier on the margin and vice-versa. The divergence in Q4 is explained in part by excess savings accumulated during the pandemic that have yet to be spent down, and in part by expected price increases over the coming year. In either case, it demonstrates that nominal spending has room to grow even in an environment where consumer credit availability is worsening. We also saw mortgage standards ease at a slightly slower pace in Q4, with both price and non-price lending conditions easing (bottom panel). While the BoC has made a hawkish pivot, underlying conditions are still easy – the conventional 5-year mortgage rate is still flat at 4.79%, the same level as Q3/2020. However, house price growth has peaked, and rate hikes this year will help prices moderate further. New Zealand Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions In New Zealand, business credit standards eased in the six month period ended September 2021 (Chart 11). However, the real impact of the Reserve Bank of New Zealand’s (RBNZ) tightening is being felt in the housing market, where actual standards entered tightening territory. More importantly, a net 23.1% of respondents expect mortgage credit availability to erode by the end of March; if realized, this figure would be a series high. Banks reporting less credit availability cited regulatory changes and risk perceptions. On the mortgage loan demand side, banks continued to see increased demand even after the record spike in March 2021 (middle panel). Going forward, demand is expected to moderate and fall from current levels. These dynamics have already made their mark on house prices which have already peaked, indicating that the RBNZ’s push is working as intended. Business loan demand does not appear to have been much affected by higher rates, with demand picking up slightly and expected to increase going forward (bottom panel). However, confidence has been falling since September 2021, with businesses feeling the twin bite of supply chain disruptions and labor shortages.   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1      The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades