Developed Countries

Executive Summary Equities Are Closer To Capitulation The market appears to be moving away from concerns about inflation toward worries about slowing growth. The initial stage of the sell-off in risky assets, pricing in tighter monetary policy, may now be complete. The next and final stage of the bear market will be pricing in a global growth slump. Slowing growth is not yet built into consensus expectations, neither for earnings nor GDP – downgrades and negative surprises are in store. The US consumers are under duress and are unlikely to lend a “spending hand” to support economic growth. Inflation is easing. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “put” is no longer at play – falling equities will help the Fed tame inflation via the “wealth effect”. The next chapter for the market is down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by short-lived rallies on hopes that the Fed may change its course. Our updated Equities Capitulation Scorecard is marginally more positive on equities but is still signaling that not all conditions for a sustainable rebound are yet met.​​​​​​ Bottom Line: Repricing of tighter monetary policy is likely complete. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-lived rallies. Monetary Tightening Is Probably Priced In Until now, the sell-off in equity markets was a repricing of tighter monetary conditions. One may argue that most of the damage has been done: Since the beginning of the year, the NASDAQ is down 30% while the S&P is down 20%. Nearly 34% of stocks in the S&P 500, and 14% of stocks in the NASDAQ are trading below their 200-day moving average. Does this mean that the sell-off is over and that hawkish Fed fears are overdone? After all, over the past few days, Fed rate expectations appear to have topped out (Chart 1), and Treasury yields have come down 37 bps from their recent peak to 2.75% (Chart 2). Monetary conditions have tightened substantially year to date, although more tightening is still on the way (Chart 3). The Citi Inflation Surprise Index has turned decisively down (Chart 4) and some of the series most affected by supply chain bottlenecks, such as shipping costs, have been deflating. Chart 1Fed Rate Expectations Have Stabilized Chart 2Treasury Yield Has Come Down Chart 3Financial Conditions Are Getting Tighter Chart 4Inflation Is Starting To Surprise To The Downside Is it clear sailing for longer-duration assets like growth equities? Not so fast: While much adversity has been priced in, a sustainable rebound in equities is probably still elusive. Worries About Economic Growth Are Starting To Dominate The Market Narrative We posit that long-term rates have come down because the markets have moved on from worries about raging inflation and the hawkish Fed to concerns about a downshift in growth both in the US and globally. As such, both earnings and economic growth disappointments are on the cards, potentially leading the markets down further. Overall, the next phase of the sell-off in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. Thunder Clouds On The Horizon During the J.P. Morgan Investor Day, Jamie Dimon, in his otherwise upbeat speech, said that there are “thunder clouds on the horizon.” Indeed, the list of investor concerns is long: A global growth slowdown, build-up of inventories, inflation damaging consumer purchasing power, the soaring costs of raw materials, declining corporate profitability, tightening monetary conditions and, to top it all, a stronger dollar. However, from Dimon’s standpoint, these are just that: Clouds that could dissipate at any time. Of course, there is always a chance that things will turn out better than expected, and a “softish landing” is on the cards. We hope Dimon is right… Economic Growth Surprises To The Downside For now, our working assumption is that the economy is still strong, but growth is decelerating. To us, this is a story about the second derivative. The troubling part is that slowing growth is not yet built into consensus expectations: It is confounding that GDP growth forecasts have still barely budged from the beginning of the year and do not yet reflect all the headwinds listed above (Chart 5). Moreover, the Q1-2022 GDP revision has shown that growth was weaker than initially reported, with the latest reading of -1.5%, growth reduced by investments weaker than initially anticipated.  The Atlanta Fed Nowcast GDP tracker points to only 1.8% annualized growth in Q2-2022. Elevated expectations are setting investors up for disappointment, which will lead to the next leg of the sell-off. The Citigroup Economic Surprise Index has recently shifted into negative territory (Chart 6). Chart 5GDP Forecasts Need To Be Revised Down Further Chart 6Economic Data Disappoints What is the evidence of slowing growth? Walking down the main street of any major city and seeing restaurants overflowing with customers and people buzzing in and out of shops, one may think that the economy is booming. Yet, there is plenty of evidence to the contrary. The ISM PMI is on a downward trajectory, hitting 55 in May, which was also 2.4 points below consensus. The S&P Global (former Markit) May flash PMI readings have also declined from 59.2 in April to 57.5 in May. This is hardly surprising: As night follows day, monetary tightening leads to slowing growth (Chart 7). Inventory overhang: It is noteworthy that the ISM PMI new orders-to-inventories ratio (NOI) is in a free-fall: It is foreshadowing further weakness in manufacturing activity as demand for durable goods is fading (Chart 8). May durable goods orders were also soft. Chart 7Monetary Tightening Leads To Slower Growth Chart 8Inventories Are Building Up   Freight volumes are also contracting, pointing to weakening growth, and are consistent with the NOI ratio (Chart 9). Global growth is also slowing as evidenced by the contraction in global trade volumes (Chart 10): US and European demand for goods ex-autos is shrinking following the pandemic binge, while China’s recovery has been delayed. Chart 9Freight Volumes Also Point To Weaker Growth Chart 10Global Export Volumes Are Set To Shrink Economic growth is slowing, and more negative surprises are in store. Earnings Growth Expectation Have Gotta Come Down While the stock market is not the economy, they are closely intertwined. One of the key differences between the two, however, is that the US economy is dominated by services, while the S&P 500 has higher exposure to goods. With the current demand for services outstripping demand for goods, the economy should fare better than the market (Chart 11). Therefore, it does not bode well for S&P 500 earnings expectations that the Q1-2022 GDP revision flagged earnings contracting 2.3% on a quarter-on-quarter basis, under the weight of slowing sales and rising costs. And while the S&P 500 Q1-22 results were just fine, the ratio of negative/positive guidance for Q2-22 was roughly two to one. Slowing growth at home and abroad, rising costs of raw materials and wages, as well as fading demand for goods will weigh on earnings over the balance of the year (Chart 12). Chart 11Slowing Growth Will Weigh On Earnings Chart 12US EPS Expectations Have Not Yet Been Downgraded Also, there is the not-so-small issue of a strong dollar, which has gained nearly 13% since January 2021. This makes US goods more expensive and also reduces companies’ bottom lines via the currency translation effect. According to our rough estimates, every percentage change in the USD reduces earnings growth by roughly 33 bps, i.e., 4.3% off earnings caused by the entire dollar move. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Importantly, US economic growth does not need to contract for a profit recession to take hold. However, S&P 500 EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10%; despite the recent market rout, US stocks have not yet priced in negative profit growth. However, either downgrades or earnings disappointments are coming, neither of which bodes well for US equity performance. Earnings growth expectations need to come down to reflect reality on the ground.   Valuations Are Only Optically Cheap And one more salient point: If earnings expectations are set to unrealistically high levels, then the recent forward multiple of the S&P 500 is not 17x, but 2 to 3 points higher, and, voilà, US equities no longer look cheap. Will US Consumers Save The Day? Perhaps things are not as dire as we describe. After all, US consumers are healthy, their balance sheets are pristine, and retail sales look good. There is also the not-so-small issue of $2.2 trillion in excess savings. This argument rings true. Chart 13Negative Real Wage Growth Is Sapping Consumer Confidence However, inflation continues to put pressure on US consumers. Negative real wage growth is sapping their confidence (Chart 13) and is cutting into their purchasing power. Soaring inflation also makes people concerned about the future as they watch their life savings melt away. Underwhelming reports from Walmart and Target are cases in point: Lower-income consumers are shifting spending away from discretionary items and towards necessities. Strong reports from Dollar General and Family Dollar indicate that many Americans are price sensitive and are shopping around. Home Depot commented that fewer customers walked through its doors (but the ones that did, tended to spend more in nominal terms). And retail sales are reported in nominal terms: Rising prices inflate growth rates. Indeed, excess savings may help achieve the “soft landing.” However, there are early signs that either many lower-income Americans have spent the money, or their savings accounts are earmarked for a rainy day, and many people aim to spend only what they earn. However, higher-income Americans are still willing to spend, but this group is shifting spending away from goods and towards services, which is consistent with strong results from the US airline carriers, which report a significant gain in pricing power. A similar message came from both Nordstrom and Macy’s. Clearly, American consumers are highly heterogeneous, and there is a significant bifurcation between “haves” and “have nots.” It is, however, concerning that many of the wealthier Americans have lost a significant percentage of their nest eggs in the stock market. The theory goes that the wealth effect is one of the main mechanisms through which monetary tightening affects consumer demand (Chart 14). It stands to reason that it is only a matter of time (unless the stock market rebounds) before even the wealthier cohorts start tightening their belts, dampening demand for consumer services. Chart 14Nest Eggs Are Dwindling Another obvious implication is the effect of dwindling investments on the housing market: Americans are watching their down payments disappear, with cash buyers subject to the same negative forces. The US consumer is under duress, and the more embedded the inflation and the deeper the market rout, the greater proportion of the US population is affected, making them less and less likely to lend a “spending hand” to support economic growth.  Inflation Will Turn: Too Little, Too Late One may also argue that inflation will turn, which would help both the economy and the markets, and will reset the Fed trajectory. Inflation will come down assisted by the arithmetic of the base effect. Supply chain bottlenecks are clearing, shipping costs are coming down, and demand is weakening – all of these developments point to inflation coming down over the next few months. However, this process may be rather slow: Inflation permeates the entire economy (Chart 15), and there are also signs that a vicious wage-price spiral is taking hold (Chart 16). Therefore, inflation is unlikely to revert to levels that the Fed and the US consumer will consider acceptable any time soon. Chart 15Inflation Is Broad-based And It Will Take Time For It To Revert To Acceptable Levels Chart 16Wage-Price Spiral Is Taking Hold Just recently, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation… We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 6.2%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. While we believe that the Fed will be steadfast in its objective to combat inflation, any positive news on inflation will be perceived by a hopeful market as a sign that the Fed may alter its course, which would lead to a rally, only to be punctured by the negative news from either growth or the Fed. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “Put” Is No More The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with the wealthier Americans paying the toll.   When Bad News Is Good News We make a case that disappointing growth will be the next chapter of this market saga. One might wonder if poor growth readings would actually be perceived by the market as a positive: Not only does disappointing growth put downward pressure on Treasury yields but also creates an expectation that the Fed will pause and monetary policy will end up looser than initially projected. Our take is that stable or lower rates will offer support for equities, and that is the reason why we conclude that the first stage of the repricing is complete. Will slower growth invite a more gentle and considerate Fed? We don’t think so as the Fed has already telegraphed that it now aims for a “softish landing” and that fighting inflation will incur some “pain”. Investment Implications Chart 17In 1980-82, The Market Was "Fat And Flat" We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-term rallies. Rallies are frequent during bear markets and other severe corrections and are generally significant in magnitude. Markets showed a similar pattern in 1980-1982 as Chairman Volker was battling inflation (Chart 17). The bull market took hold only in 1982. Rallies will follow pullbacks because the market is not yet ready for a sustainable rebound. This first leg of the correction was pricing in tighter monetary policy. The next leg down will be the market pricing in slowing growth both at home and abroad, corporate earnings disappointments, and weakening consumer demand. Over the next few months, the market is likely to trend down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by fast and furious rallies on hopes that inflation is abating, and that a gentler, data-driven Fed would be more supportive of the economy and the markets. Thus, with markets looking oversold, a short-lived rally is now likely. It will be accompanied by a change in leadership: Energy and Materials will give back gains, while Big Tech and other cyclicals will bounce. And US equities may still plumb new lows on the back of economic growth or earnings growth disappointments. The market will also not take it kindly if inflation turns out to be stickier than expected and is accompanied by slowing growth: Stagflation is one of the most challenging regimes for US equities (Chart 18). Sticky inflation would call for an even more aggressive rate hiking cycle. Chart 18Stagflation Would Be The Worst Possible Outcome For The Markets Table 1Equities Are Closer To Capitulation We believe that a sustainable rebound will take place once most of the negative “news” is priced in. Compared to two months ago, we conclude that the first part of the adjustment process, i.e., pricing in tighter monetary policy, has run its course. Now it is a matter of adjusting growth expectations. Our “Equities Capitulation” scorecard (“Have We Hit Rock Bottom” report), adds up to -1, a slightly less negative reading than the -2 just a few weeks ago — but a reading which still signals negative equity returns (Table 1). We conclude that staying close to the benchmark, with a small tilt towards defensive growth, remains the most sensible strategy.   Bottom Line The first stage of the market correction is probably complete and tighter monetary policy is getting priced in. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next several months as rallies ignited by soothing inflation readings are punctured by growth disappointments and a resolute Fed.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum

Listen to a short summary of this report.         Executive Summary US Financial Conditions Have Tightened Significantly This Year US financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations. If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the US and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. Stay overweight stocks, favoring non-US equities over their US peers. We are closing our short 10-year Gilts trade, initiated at a yield of 0.85%, for a gain of 7.5%. We are also opening a new trade going long Canadian short-term interest rate futures versus their US counterparts. Investors expect Canadian rates to exceed US rates in 2024, which seems unlikely to us given that the Canadian housing market is much more sensitive to higher rates than the US market. Bottom Line: After having tightened significantly over the past seven months, financial conditions should loosen modestly during the remainder of the year. This should benefit risk assets. Fed Focused on Financial Conditions Chart 1Tighter Financial Conditions Will Hurt Growth Like many central banks, the Fed sees financial conditions as a key driver of the real economy. While there are many financial conditions indices (FCIs), most include bond yields, credit spreads, equity prices, and the exchange rate as inputs. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa. Goldman’s US FCI is especially popular among market participants. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the historic relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below-trend pace by the second quarter of 2023. In fact, the tightening in the Goldman FCI over the past 12 months already suggests that the manufacturing ISM will fall below 50 (Chart 1).  Along the same lines, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved slightly into restrictive territory. Aside from a brief period at the outset of the pandemic, the index has been consistently in expansionary territory since early 2013 (Chart 2). Chart 2The Chicago Fed Financial Conditions Index Has Moved Into Slightly Restrictive Territory Other data are consistent with the message from the FCIs. Most notably, growth estimates for the US and for other major economies have come down over the past few months (Chart 3). Economic surprise indices have also fallen, especially in the US.   Chart 3AGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Chart 3BGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Mission Accomplished? Chart 4The Fed Expects To Lift Rates Above Its Estimate Of Neutral Given the recent tightening in financial conditions and weaker growth expectations, the Fed is likely to soften its tone. Already this week, Atlanta Fed President Raphael Bostic suggested that the Fed could pause raising rates in September in order to assess the impact of the Fed’s tightening campaign. The Fed minutes also conveyed a sense of flexibility and data-dependence about the timing and magnitude of future hikes once rates reach 2%. It’s worth stressing that the Fed expects rates to rise in 2023 to about 40 bps above its estimate of the terminal rate (Chart 4). Jawboning rate expectations higher would potentially undermine the Fed’s goal of achieving a soft landing for the economy. Inflation Will Dictate How Much Easing Lies Ahead There is a big difference between not wanting financial conditions to tighten further and wanting them to loosen. The Fed would only want to see an easing in financial conditions if inflation were to fall faster than expected. Chart 5 shows how the year-over-year change in the core PCE deflator would evolve over the remainder of the year depending on different assumptions about the month-over-month change in the deflator. The Fed would be able to reach its expectation of year-over-year core PCE inflation of 4.1% for end-2022 if the month-over-month change averages 0.33%. Monthly core PCE inflation averaged 0.3% in February and March and is expected to clock in at around the same level for April once the data is released tomorrow. Chart 5AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) Chart 5BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) Regardless of tomorrow’s data print, as we discussed last week, we expect the monthly inflation rate to average less than 0.3 in the back half of the year. If that happens, inflation will surprise to the downside relative to the Fed’s expectations. Consistent with the observation above, market-based inflation expectations have already declined. The 5-year TIPS inflation breakeven has fallen from 3.64% in March to 2.98% at present. The widely watched 5-year/5-year forward breakeven rate is back down to 2.29%, at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 6).1 The Citi US Inflation Surprise Index has also rolled over (Chart 7). Chart 6Market-Based Inflation Expectations Have Come Down Of Late Chart 7The US Inflation Surprise Index Has Rolled Over Financial Conditions  Abroad Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar (Chart 8). Nevertheless, with growth momentum having already deteriorated sharply, central banks are signaling a more balanced approach towards policy normalization. Chart 8Financial Conditions Have Tightened More In The US Than Elsewhere This Year ECB: Wait and See? In a blog post published on Monday, Christine Lagarde observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than they were two years ago. In her mind, this warrants ending net purchases under the Asset Purchase Programme early in the third quarter. It also warrants raising the deposit rate by 25 bps at both the July and September meetings, bringing it back to zero from -0.5% at present. Beyond then, Lagarde was circumspect about what should be done, stressing the need for “gradualism, optionality and flexibility.” She noted that “The euro area is clearly not facing a typical situation of excess aggregate demand or economic overheating … Both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends.” She then added: “The outlook is now being clouded by the negative supply shocks hitting the economy … households’ expectations of their future financial situation dropped to their second-lowest level on record in March and remained close to that level in April.” The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023 (Chart 9). BCA’s Global Fixed Income team, led by Rob Robis, foresees only 50 bps of tightening over the next 12 months. Chart 9Markets Expect Rates To Rise The Most In The Anglo-Saxon World The UK, Canada, and Australia: Frothy Housing Markets Will Limit Rate Hikes The Bank of England (BoE) hiked rates by 90 bps over the past 12 months. The UK OIS curve is priced for another 140 bps of rate hikes over the next year. According to the BoE’s forecasting models, this would raise the unemployment rate by two percentage points while lowering inflation to below 2% within the next two-to-three years. In our opinion, that is more tightening than the BoE would like to see. BCA’s strategists expect the BoE to deliver only another 75 bps of hikes over the next year. Chart 10Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries The Canadian economy has been quite strong, with the unemployment rate falling to 5.2% in April, the lowest since 1974. The Canadian OIS curve is discounting 195 bps of interest rate hikes over the next 12 months, substantially more than the 150 bps of tightening our fixed income team foresees. By mid-2024, investors expect Canadian policy rates to be about 25 bps above US rates. This seems unreasonable to us, and as of this week, we are expressing this view by going long the June 2024 3-month Canadian Bankers’ Acceptance (BAX) futures contract (BAM4) versus the corresponding 3-month US SOFR futures contract (SFRM4). A more liquid option is to simply go long the 10-year Canadian government bond versus the 10-year US Treasury note. At present, Canadian 10-year government bonds are yielding  5 bps more than their US counterparts. Unlike in the US, where household debt has fallen over the past 14 years, debt in Canada has risen, fueled by a massive housing boom (Chart 10). High indebtedness and the prevalence of variable rate/short-term fixed-rate mortgages will limit the ability of the BoC to raise rates. The Australian OIS curve is currently discounting 262 bps of rate hikes over the next year which, if realized, would take the cash rate to 3.3% – a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. BCA’s fixed income strategists expect only 150 bps of tightening over the next 12 months. Japan: Yield Curve Control Will Continue Chart 11Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World The Bank of Japan expects inflation excluding fresh food prices to remain at about 2% in the second half of 2022, but then to slow to 1.1% in the fiscal year starting April 2023. The Japan OIS curve is discounting almost no tightening over the next 12 months. Long-term inflation expectations are far lower in Japan than in any other major economy, which makes ultra-low rates a necessity for the foreseeable future (Chart 11). China: Outright Easing Chart 12Covid Restrictions Have Eased Only Modestly In China China faces a trifecta of problems: A weakening housing market; slowing external demand for manufactured goods; and the ongoing threat of Covid-related lockdowns. Despite a steep drop in the number of new Covid cases over the past month, China’s lockdown index has only eased modestly, as the authorities continue to fret about the next outbreak (Chart 12). The leadership in Beijing has responded with policy easing. The PBoC lowered the 5-year loan prime rate by 15 bps last week, the largest such cut since 2019. This followed a cut in the floor rate for first-home mortgages that was announced on May 15. BCA’s China strategists believe these measures will arrest the deep contraction in the property market but will not spark a full-blown recovery due to the ongoing commitment of the government to the “three red lines” policy.2  In normal times, a Chinese real estate slump would be a cause of grave concern for global investors. These are not normal times, however. Public enemy number one these days is inflation. A weaker Chinese property market would curb commodity demand, thus helping to cool inflation. That would be a welcome development for global investors. Investment Conclusions Global financial conditions have tightened to the point that betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric.  We took partial profits on our short 10-year Treasury trade earlier this month (initiated at a yield of 1.45%). As of this week, consistent with the earlier decision of BCA’s fixed income strategists to upgrade UK Gilts, we are closing our short 10-year Gilt position (initiated at a yield of 0.85%) for a gain of 7.5%. The coming Goldilocks environment of falling inflation and supply-side led growth will buttress equities. We expect global stocks to rise 15%-to-20% over the next 12 months, with non-US markets outperforming the US. Looking further out, the fate of Goldilocks will rest on where the neutral rate of interest resides. If the neutral rate in the US turns out to be substantially lower than 2.5%, then any growth recovery will falter as the lagged effects of restrictive monetary policy work their way through the economy. Conversely, if the neutral rate turns out to be substantially higher than 2.5%, then inflation will reaccelerate as the economy overheats. Given the choice, we would wager on the latter outcome. Thus, while we expect global bond yields to decline over a 12-month horizon, we foresee them rising over a 2-to-5-year time frame. Similarly, while stocks will strengthen over the next 12 months, they are likely to encounter another bout of turbulence starting late next year or in 2024 as central banks initiate a second round of rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter     Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate​​​​​ Chart 5The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment​​​​​​ Chart 9Headwinds For The Australian Consumer​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade​​​​​ Chart 14The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming​​​​​ Chart 16Australia Is Resource Superstar​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com