Disasters/Disease

The conditions for a sustainable rally in Chinese stocks have not been met. In this report we discuss the four signposts which we will closely monitor to gauge when it will be warranted to upgrade our stance on Chinese equities both in absolute terms and relative to the global stock benchmark.

A client concerned about the slump in asset prices, the stubbornness of inflation, and rising bond yields asks what went wrong, and what happens next? This report is the full transcript of our conversation.

Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.

This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.

Dear Client, This month’s Special Report has been written by my colleagues Mathieu Savary and Jeremie Peloso, of BCA’s European Investment Strategy service. The report was published in that service on September 26, and addressed the outlook for European assets. The EUR/USD stop buy mentioned in the report has since been triggered, meaning that our European Investment Strategy service is now long the euro with a stop loss position at 0.94. Although this is a tactical position for that service, it is consistent with the view expressed in Section 1 of our report that the dollar has significantly overshot versus the euro what currency fundamentals would imply. I trust you will find their report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights The outlook for European assets is uniquely muddled. European energy prices will remain elevated, but the worst of the adjustment is already behind us. The global economy is teetering on the edge of a recession and weak global growth is historically very negative for European assets. However, European valuations and earnings forecasts already discount an extremely severe outcome for global growth. A hawkish Fed should support the dollar, but investors increasingly realize foreign central banks are fighting inflation equally aggressively. The dollar already anticipates a global recession. Meantime, European credit offers a large spread pickup over sovereigns and even appears as a decent alternative to equities. Within a credit portfolio, we adopt a more cautious approach towards European investment grade bonds (IG) relative to their US counterpart. Instead, we recommend favoring UK IG over Euro Area IG as well as Swedish IG relative to US IG. Feature Following the hawkishness that transpired from the Fed press conference and revised forecasts last week, EUR/USD plunged below 0.99 and hit a 20-year low. Moreover, President Vladimir Putin’s announcement of a broader mobilization of the Russian army is stoking fears that the Ukrainian conflict will only be prolonged. The prospects of a lengthier war and greater energy market shock are raising further worries for Europe’s growth outlook, which weighs on European asset prices, notably the euro and the pound. The odds of a global financial accident are on the rise. Global central banks have joined the Fed and are relentlessly tightening global monetary and financial conditions. Moreover, the surging dollar is adding to global risks by raising the cost of capital around the world. This is a very fragile situation and the odds of a global recession have jumped significantly. Against this backdrop, investors should continue to overweight defensive equities at the expense of cyclical stocks. The euro also has more downside, but we are issuing a tentative stop-buy at EUR/USD 0.9650 with a stop at 0.9400. Credit remains a safer alternative to European stocks. The Evolving European Energy Backdrop Chart II-1All About The Gas All About The Gas All About The Gas The surge of natural gas and electricity prices since the fall of 2021 has been one of the main drivers of the underperformance of European assets and the fall in the euro (Chart II-1). While the medium-term outlook for European energy prices remains fraught with risk, the near-term prospects have improved. Following a surge from €77.4/MWh in June to €340/MWh on August 26, one-month forward natural gas prices at the Dutch Title Transfer Facility (TTF) have declined 45% to €187/MWh. These wild gyrations reflect the evolution of both the natural gas flows from Russia, which have fallen from 3,060Mcm to 599 Mcm today, and the rapid buildup of natural gas inventories across the European Union. The good news is that the costly efforts to rebuild European gas inventories have been successful. EU-wide inventories are at 85.6% capacity, achieving its 80% storage objective well before November. Germany has gone even further, with storage use now standing at 90% of capacity. This large stockpile, along with the re-opening of coal power plants and consumption curtailment efforts, should allow Europe to survive the winter without Russian energy imports, as long as the temperatures are not abnormally cold. The absence of a summer dip in Norwegian gas exports and the surge in LNG flows to Europe have partially replaced the missing Russian inflows, thus helping Europe rapidly rebuild its natural gas inventories (Chart II-2). This success was a consequence of elevated European natural gas prices, which have allowed Europe to absorb LNG flows from the rest of the world (Chart II-3). Chart II-2No Restocking Without LNG No Restocking Without LNG No Restocking Without LNG Chart II-3LNG Flowed Toward High Prices LNG Flowed Toward High Prices LNG Flowed Toward High Prices     So far, the European industrial sector has managed to adjust better than expected to the jump in the price of natural gas, a crucial energy input. Take Germany as an example. For the month of August, Germany’s consumption of natural gas by the industrial sector fell 22% below the 2018-2021 average (Chart II-4, top panel), while PPI moved up vertically. Yet, industrial output is only down 5% year-on-year and industrial capacity utilization stands at 85%, which is still a level that beats two thirds of the readings recorded between 1990 and this the most recent quarter (Chart II-4, bottom panel). The adjustment will be uneven across various industries, with those most voracious of natural gas likely to experience a declining share of Europe’s gross value added. Using the German example once again, we can see that the chemicals, basic metal manufacturing, and paper products sectors are the most at risk from higher natural gas prices and most likely therefore to suffer the most from gas rationing this winter (Chart II-5). Chart II-4A Surprisingly Successful Transition A Surprisingly Successful Transition A Surprisingly Successful Transition Chart II-5The Three Sectors Most At Risk October 2022 October 2022   Going forward, important changes are likely to take place that will allow the European economy to continue to survive on diminished Russian gas flows: European natural gas prices will remain elevated compared to the rest of the world to attract LNG flows to the region. Importantly, Europe’s capacity to absorb these flows keeps increasing, as more re-gasification ships are docked around the continent. Moreover, North America is building more facilities to export LNG to Europe. Chart II-6Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear electricity production will rebound. Currently, the EU’s nuclear production is around 43.2TWh, well below the normal 60TWh to 70TWh winter levels, driven mostly by the collapse in French production from 35TWh to 18TWh (Chart II-6). This decline in nuclear electricity generation has accentuated the upward pressure on European natural gas and electricity prices. One of the key objectives of the nationalization of EDF by the French government is to accelerate the maintenance of France’s ageing nuclear power plants and allow a return to more normal production levels by the winter. The role of natural gas in European household’s energy mix will decline. Currently, EU households are the largest natural gas consumers and account for 41% of the bloc’s gas consumption (Chart II-7). It will be easier to replace their natural gas consumption over time with other sources of energy than it will be to cut the industrial sector’s consumption extensively. As a result, even if European natural gas imports are permanently below 2021 levels, the industrial sector will not bear the brunt of the adjustment. Chart II-7Households To Be Displaced October 2022 October 2022 These developments imply that natural gas prices have limited downside. However, we believe that the worst of the spike in prices is behind us, at least over the near term. The reason is that the inelastic buying created by the inventory re-stocking exercise since May 2022 is ending. In fact, the German Federal Minister for Economic Affairs and Climate Action, Robert Habeck, declared last week that his country would no longer purchase gas at any price. Chart II-8The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over If prices stabilize around €200/MWh, European industrial activity will continue to face a headwind, but the worst of the adjustment process will be in the rearview mirror as natural gas inflation recedes (Chart II-8). Ultimately, capitalist systems are dynamic, and it is this rapid change in price that causes the most pain. In other words, the impoverishment of the European private sector has already happened. Steady states are easier to manage. Moreover, if natural gas prices eventually follow the future’s curve (this is a big “if”), the picture for Europe will improve considerably. One additional mitigating factor should ease the pain being experienced by the European private sector. Fiscal policy is responding very aggressively to the current energy crisis. So far, EU countries and the UK have allocated more than €500 billion to protect their private sectors against higher energy costs (Chart II-9) and the UK just announced tax cuts of £45 billion. This is in addition to the disbursement of €150 billion from the NGEU funds in 2023. Moreover, the European commission is planning to modify the EU fiscal rules to abandon annual structural deficit targets and for debt sustainability to be evaluated over a ten-year period. Bottom Line: The worst of Europe’s adjustment to higher energy prices is now behind us. However, European energy prices will remain elevated, which will continue to put Europe at a handicap compared to the rest of the world. Chart II-9Massive Fiscal Support October 2022 October 2022 Bad News From The Rest Of The World Chart II-10A Global Recession This Way Comes A Global Recession This Way Comes A Global Recession This Way Comes The worst of Europe’s energy crisis is behind us, but the world is teetering toward a recession, which will hurt the trade- and manufacturing-sensitive European economy. The tightening in global financial conditions created by the surge in the dollar and by the jump in global yields is pushing the US Manufacturing ISM and the Euro Area PMIs toward the low-40s, which is consistent with a recession (Chart II-10). The problem does not stop there. Global central banks have become solely focused on fighting inflation. For 2023, the FOMC’s dot plot forecasts both an interest rate rise to 4.6% and a 0.7% increase in the unemployment rate. This is tantamount to the Fed telling the market that it will increase interest rates as a recession emerges to repress inflation. Not to be undone, European central banks are also rapidly increasing their policy rates, even as they also forecast an imminent deterioration in domestic growth conditions. Quickly tightening policy in a slowing growth environment, especially as the dollar hits a 20-year high, is a recipe for a financial accident and a global recession. Chart II-11No Help From China No Help From China No Help From China Moreover, China’s economy is still unable to create a positive offset to the deterioration in global monetary and financial conditions. The marginal propensity of China’s private sector to consume remains in a downtrend, hampered by the country’s zero-COVID policy and the continuing meltdown in real estate activity (Chart II-11). Furthermore, the most rapid decline in the yuan exchange rate in 5 years is imparting an additional downside risk to the global economy. European stocks are uniquely exposed to these threats. Europe overweights deep cyclicals, which are currently squeezed by the deteriorating global growth outlook. The message from the collapse in FedEx’s stocks on very poor guidance is particularly ominous: this company has a much closer correlation with the Dow Jones Euro STOXX 50 than with the S&P 500 (Chart II-12). European share prices are already factoring in much of the bad news. Valuations are significantly less expensive than they once were. The Shiller P/E ratio of European equities and their equity risk premium stand at the same levels as those in the 1980s. This is in sharp contrast to the US (Chart II-13). Chart II-12FedEx's Gloomy Delivery FedEx's Gloomy Delivery FedEx's Gloomy Delivery Chart II-13Low CAPE In Europe Low CAPE In Europe Low CAPE In Europe   European forward earnings have also already done considerable work adjusting downward. Excluding energy, 2022 and 2023 forward EPS are down 11.7% and 13.3% since their peak, respectively (Table II-1). But inflation flatters earnings growth and European large-cap indices are dominated by multinational firms, which implies that looking at earnings in USD terms makes more sense. In both real and USD terms, 2022 and 2023 forward EPS, excluding energy, are already down 28.7% and 30.1%, respectively. These adjustments are in line with previous recessions. Table II-1A Deep Downgrade To European Earnings October 2022 October 2022 The counterargument is that analysts still expect positive earnings growth in 2023 relative to 2022. However, at 4%, this increase in expected earnings is still well below inflation and 6% below the average expected growth in forward earnings recorded over the past 35 years (Chart II-14). Additionally, a global recession could put further downward pressure on energy prices in Europe, which would create an additional cushion under European earnings in 2023. The implication here is that it still makes sense to be modestly long European equities in absolute terms, especially for investors with an investment horizon of twelve months or more. However, we cannot be complacent, as the risk of an additional selloff is still too large for comfort. As a result, for now investors should only garner a small exposure to European equities and do so while favoring defensive names over cyclical ones (Chart II-15). Chart II-14Weak Forward Earnings Growth Weak Forward Earnings Growth Weak Forward Earnings Growth Chart II-15Continue To Favor Defensive Names Continue To Favor Defensive Names Continue To Favor Defensive Names   Bottom Line: European stocks must still contend with the growing threat of a global recession catalyzed by tighter financial conditions and aggressive global central banks. The good news is that they already discount considerable pessimism, as illustrated by their low valuations and downgraded forward earnings. Consequently, investors can continue to nibble at European equities, but do so to a limited degree and by favoring defensive stocks over cyclical ones, at least for now. The Euro Dilemma On the back of the very hawkish Fed meeting and the announcement of Russia’s broadened military mobilization, the EUR/USD broke below the 0.99 support level and fell under 0.98, a level we judged in the past as very attractive on a six-to-nine months basis. Obviously, Fed Chair Jerome Powell’s reaffirmation of the FOMC’s war on inflation is a major boost to the dollar. The momentum property of the greenback implies that it has room to rally further in the near term. This narrative, however, overlooks the fact that the Fed is not the only central bank intent on fighting inflation, no matter the cost. The Norges Bank, the Riksbank, the ECB, and even the SNB have all showed their willingness to move aggressively against inflation. While the BoE only increased rates by 50bps last week, its communication suggested that an at least 75bps increase would be due at the November meeting, when the MPC publishes its Monetary Policy report that will incorporate the impact of the budget measures announced by new British Prime Minister, Liz Truss. As a result, market interest rate expectations are climbing in the US, but they are rising even faster in Europe, albeit from a lower base. However, the decline in the expected rate of interest in the US relative to Europe and in the number of expected hikes in the US relative to Europe are consistent with a sharp decline in the DXY in the coming months (Chart II-16). Due to its 80% weight in European currencies, a weaker DXY implies a rebound in the EUR, GBP, CHF, NOK, and SEK against the USD. Moreover, there could be room for expected interest rate differentials to narrow further against the dollar. The analysis we published two weeks ago shows that, even when the different nonfinancial private debt loads are accounted for, the gap in the US and Eurozone r-star stands at 1%. However, the spread between the Fed funds rate’s upper bound and the ECB Deposit Rate is 2%. The gap between the July 2023 US and Eurozone OIS is 1.7%. Since European inflation may prove more stubborn than that of the US in the near term, there is scope for the expected interest rate gap to narrow further, especially as the Euro Area final domestic demand is surprisingly more robust than that of the US (Chart II-17). Chart II-16The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed Chart II-17Surprising European Resilience Surprising European Resilience Surprising European Resilience   What about global growth? The view that the global economy is about to experience a recession is consistent with a stronger dollar, since the greenback is an extremely countercyclical currency. However, the DXY’s 25% rally since January 2021 already prices in such an outcome (Chart II-18). Similarly, the euro is trading again at 2002 levels, which is also in line with a global recession with deep negative repercussions for the Eurozone. Additionally, the Euro has fallen 21% since May 2021, which compares to the 21.4% fall in 2008, the 20% decline in 2010, the 18% plunge in 2011/12 and the 24% collapse in 2014/15; yet EUR/USD is much cheaper now than in any of those instances. Moreover, the wide difference between the competitiveness of Germany and that of the rest of the Euro Area has now faded, which means that a major handicap against the euro has disappeared (Chart II-19). Chart II-18The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession Chart II-19Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness     This does not mean that the euro is not without risk. First, since the major euro collapse began in June 2021, EUR/USD breakdowns have been followed by average declines of 3.6%, ranging from 2.7% to 4.2%. Since the dollar is a momentum currency, it is unlikely that this time will be different. Second, if the tightening in global policy does cause a financial accident, the dollar will catch one last major bid that could push EUR/USD toward 0.9. As a result, to mitigate the danger, we recommend setting a stop-buy in the euro at EUR/USD 0.965 or 2.6% below the breakdown level of 0.9904. This position comes with a stop-loss at 0.94. For now, we would view this bet as a tactical position if it were triggered. Bottom Line: While a hawkish FOMC is very positive for the dollar, markets now expect foreign central banks to catch up to some extent with the Fed. This process is dollar bearish. Additionally, while a global recession would be supportive of the greenback, the USD already discounts this scenario. Instead, Europe is proving surprisingly resilient, which could soon create a tailwind for EUR/USD. Set a stop-buy at EUR/USD 0.965, with a stop-loss at 0.94. Market Update: European Credit After Central Bank Week For investors concerned with the left-tail risk in European equities, European credit offers a credible alternative in the near term. This asset class is also attractive relative to European government bonds. Chart II-20Central Bank Week October 2022 October 2022 Taken together, the Fed, the ECB, the BoE, the Riksbank, the Norges Bank, the SNB, and the BoC have tightened policy by 475bps over the past month (Chart II-20). Moreover, the SNB’s hike closed the chapter of negative rates in Europe. But make no mistake – there will be a second chapter. Until then, European corporate bond yields have risen enough to offer attractive spreads over duration-matched government bonds and to challenge the earnings yield provided by equities (Chart II-21). Besides, the volatility observed in equity markets over the past few months makes the European corporate bond more appealing. In the Euro Area, BB-rated bonds, which are the highest credit quality and largest tranche within the high-yield space, are particularly attractive. They sport a 6.6% YTM, at a spread of 480bps over 3-year German government bond yields. This compares to an equity earnings yield of 7.4% (Chart II-21, top panel). In other European corporate bond markets, there is no need to go down in credit quality. Yields-to-maturity for investment grade corporate bonds in the UK, Sweden, and Switzerland provide appealing alternatives to equities, with shorter duration still. This is especially true in Sweden, where the equity earnings yield has collapsed and is now only 60bps above Swedish IG yield, with substantially greater risk. Meanwhile, the spread pickup offered by Swiss IG over Swiss government bonds of similar duration is at its widest in more than ten years (Chart II-21, bottom panel). This week, we turn neutral on European credit versus US credit. Back in March, we made the case that European credit would outperform its US counterpart in response to a more hawkish Fed than the ECB. Since then, European IG outperformed US IG by 1% on a total return basis. However, with the Fed funds rate at 3.25%, traders now expect more monetary policy tightening from the ECB, which often corresponds to an underperformance of Euro Area credit relative to that of the US (Chart II-22, top panel). On the other hand, Swedish IG is expected to outperform US IG over the next six months (Chart II-22, bottom panel). Chart II-21Push Back Against TINA Argument Push Back Against TINA Argument Push Back Against TINA Argument Chart II-22Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials         Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Footnotes

Executive Summary A Structural Downshift In China’s Real Estate Investment Growth Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower The Politburo has set a date for the much-anticipated 20th Communist Party Congress at which President Xi will most likely secure his third term as general secretary. Although we expect China’s leaders to focus on supporting the economy following the Party Congress, there are high odds that the authorities will underdeliver on policy easing. Beijing may recalibrate its stringent zero-Covid policy next year, but the conditions are presently not yet met for a turnaround in the current strategy. China’s structural issues remain, and policymakers will likely continue to tackle them while downplaying the importance of GDP growth. The housing market remains the epicenter of risk to both China’s financial system and social stability. China’s leaders have incrementally introduced accommodative initiatives, but they still continue to seek reduced leverage among property developers. Investors should be prepared for a scenario that China will avoid “irrigation-type” stimulus in the next six months. Therefore, the economy will continue to expand at below potential growth. Bottom Line: There is a nontrivial risk that China’s stimulus will fall short of market expectations following the upcoming Party Congress. This poses risks to Chinese share prices.   Market participants believe that the 20th Communist Party Congress beginning October 16 will be a jumping off point for Chinese leaders to stimulate the economy more aggressively. This would signal a shift in the leadership’s focus, from securing political stability ahead of the Party Congress to ensuring an economic recovery next year. However, to achieve a meaningful and sustainable rebound in economic activity and equity market performance, policymakers will need to overcome two major hurdles: the zero-Covid policy and the "three red lines" regulation for property developers. At the risk of being wrong, we identify some of the factors that will preclude using irrigation type of stimulus after the conclusion of the Party Congress. Given the prevailing headwinds to China’s economy and the lack of “all-in” type of stimulus, we recommend that global equity portfolios stay neutral for now on Chinese onshore stocks and underweight offshore stocks. The Date Is Set! The Politburo’s announcement that the 20th Party Congress would take place earlier than November, in our view, is a sign of political stability and marginally positive for the economy. On the opening day, President Xi will deliver the Party’s work report, which will chart China’s policy trajectory for the next five years and beyond. It is generally believed that President’s Xi’s vision to turn China into an advanced global power will be endorsed by the Party. The earlier date for the Congress is significant for the following reasons: It shows that preparations for the Party Congress are progressing on schedule. President Xi will most likely cement his third term as general secretary, leaving little room for surprises from a political standpoint. The Party Congress will provide some indication whether the leadership will revise policies, including the zero-Covid strategy and industry regulations. Lower-level officials have been waiting to see which way the political winds are blowing. The Party Congress will clarify the situation and allow officials to focus on their economic work. Bottom Line: The Party Congress, along with the Central Economic Work Conference in December, will set the tone for China’s key economic, social, and industry policies for 2023 and beyond. Endgame To The Zero-Covid Strategy? Chart 1The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The primary risk to China’s economic recovery is its stringent zero-Covid policy, which has significantly impacted the service sector, household income and consumption (Chart 1). In recent months policymakers have incrementally adjusted their Covid-containment measures, such as shortening the quarantine period for international travelers and streamlining mass testing procedures. However, the fundamental goal of eradicating domestic Covid cases remains intact. The best scenario in the coming year, in our view, is that China will adopt hybrid measures to combat Covid. Countries like Japan, South Korea, New Zealand, and Australia have all adopted a mixed series of Covid-control policies. These include a gradual reduction in testing and quarantine protocols, an increase in targeted vaccination among the elderly, an introduction of antiviral drugs and strengthening the quality of primary care. However, China may not tolerate the level of Covid experienced in these countries, especially since their number of new cases and related deaths have risen of late (Chart 2A and 2B). Chart 2ACovid Case Counts In Other Countries Have Risen Or Remain Elevated... Covid Case Counts In Other Countries Have Risen Or Remain Elevated... Covid Case Counts In Other Countries Have Risen Or Remain Elevated... Chart 2B...Along With Number Of Deaths ...Along With Number Of Deaths ...Along With Number Of Deaths   China sees its extremely low case count as proof that the dynamic zero-Covid policy has succeeded (Chart 3). It argues that if it shifts course and re-opens before proper protective measures have been introduced, then the losses might exceed a million deaths. China’s authorities believe that Hong Kong SAR’s high death rate in the spring is stark proof of that possible scenario (Chart 4). Chart 3China Has Managed To Keep Its Covid Case And Death Counts Extremely Low China Has Managed To Keep Its Covid Case And Death Counts Extremely Low China Has Managed To Keep Its Covid Case And Death Counts Extremely Low Chart 4Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Thus, a sudden pivot from zero-Covid to living with the virus next year seems farfetched. China’s National Health Commission experts recently stated that victory over the virus would require effective vaccines, treatments and mild variants. We examine these three premises as follows: Covid vaccination rate: China’s overall Covid vaccination rate is high at 90% as of August this year. However, more than 35% of Chinese over age 60 have not received a booster dose and only 61% above age 80 have had a primary vaccination. Given that the majority of China’s population has not been exposed to the virus and is immunologically naïve, unlike their Western counterparts, the population relies completely on immunity acquired through Covid vaccines.  Chart 5China's Vaccination Progress Has Stalled China's Vaccination Progress Has Stalled China's Vaccination Progress Has Stalled China’s daily vaccination rate has fallen to below 200,000 per day, sharply down from the peak of 3-5 million per day in March and April (Chart 5). Even if we assume that three doses of China’s domestically produced vaccines are as effective as the West’s mRNA vaccines, at the current pace it would take several years to provide three doses of Covid vaccines to China’s 1.4 billion people. Hence, to significantly loosen zero-Covid policy, we would need to see a huge acceleration in the country’s vaccination rate. Treatment drugs: China okayed the imports and use of Pfizer’s antiviral drug Paxlovid in February and approved its first homegrown Covid antiviral medication “Azvudine” in July. Azvudine’s efficacy in reducing Covid-related hospitalization and deaths remains to be seen. The manufacturer, Genuine Biotech, says that the facility's annual production capacity is 1 billion tablets (each tablet is 1 mg), but is expected to reach 3 billion tablets in the future. Assuming each patient will need 50 mgs of Azvudine to complete a full course of treatment (as instructed by the drug manufacturer), the company can provide enough tablets for approximately 20 million Chinese within one year. To put the number into respective, China has more than 26 million people over age 80, of which more than 10 million have not had their first Covid vaccine. Chart 6The Level Of Beijing's Covid Policy Stringency Remains Elevated The Level Of Beijing's Covid Policy Stringency Remains Elevated The Level Of Beijing's Covid Policy Stringency Remains Elevated ​​​​​​​ Milder variants: Another possibility is if new mild variants emerge next year and they cause no harm or panic among the population. However, there is no guarantee that Beijing will be willing to relent on its Covid policy based on evidence and statistics from other countries where the populations may have received mRNA vaccines. Even statistics provided within China may not warrant a decisive reopening of the economy. A recent study conducted by leading Chinese public health experts found that only 22 of the nearly 34,000 Covid patients hospitalized in Shanghai from March 22 to May 3 developed severe illness. Nonetheless, the study has not prompted policymakers to step back from the tight Covid control protocols (Chart 6). Bottom Line: The conditions do not seem to be met for a drastic change in Beijing’s dynamic zero-Covid strategy. China’s transition from zero tolerance to an orderly, managed approach to life with an evolving Covid virus will likely be long and difficult. The Housing Market Policy Dilemma The other key to achieving a meaningful recovery in China’s economy is through stimulating the country’s housing market. We expect that more accommodative real estate policy initiatives will be introduced later this year and early next year. However, structural headwinds in the property market will limit the government's willingness to stimulate the sector as aggressively as in previous cycles. China’s shrinking working population since 2015 likely led to a peak in the demand for housing in 2017/18. Moreover, it is estimated that China's total population growth will turn negative this year, further suppressing demand (Chart 7). The combination of demographic headwinds and a slowdown in urbanization, means that if policymakers overstimulate the sector as in the past, then they will have a bigger bubble to pop in the future.  There is no indication that the authorities will stop focusing on deleveraging and reducing financial risks in the real estate sector. The magnitude of mortgage rate cuts so far this year is much smaller than in the 2008/09 and 2015/16 cycles. Moreover, mortgage rates remain higher than growth in household income and home prices (Chart 8). The positive gaps between mortgage rates and both household income growth and house price appreciation discourage house purchases. Chart 7Demand For Housing In China Is On A Structural Downtrend Demand For Housing In China Is On A Structural Downtrend Demand For Housing In China Is On A Structural Downtrend Chart 8Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Importantly, while policymakers have intervened and provided liquidity to cash-strapped real estate developers, the “three red lines” policies restraining developers’ leverage remain intact. The message is clear: Beijing will use all necessary tools to prevent systemic risks and social unrest by ensuring the completion of existing housing projects. However, the authorities will continue to force developers to structurally shift their business models and reduce their leverage. Chinese authorities would be more incentivized to bail out the sector if there were risks of widespread mortgage loan defaults among households. In our view, this risk remains low in the next 6 to 12 months. The mortgage down payment ratio is relatively high in China and mortgages are full recourse loans as borrowers are personally liable beyond the collateral (i.e., the property asset). This combination reduces the incentive for homebuyers to stop paying mortgages even in a situation of negative equity (i.e., when the value of the property asset falls below the outstanding mortgage). Indeed, ongoing mortgage boycotts have been isolated to unfinished apartments in stalled projects. The boycotts are driven by homebuyers to pressure developers to finish these projects and are not due to household financial difficulties. There will likely be more defaults by overleveraged developers next year. The sector will consolidate further, with opportunistic, well-funded developers taking advantage of the situation to acquire distressed assets at a discount. Many of these may be state-owned or state-backed companies and investment funds. Chart 9Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower Bottom Line: Policymakers will continue to feed the housing sector with stimulus measures, but the leadership might be reluctant to overstimulate the sector. China’s real estate market dynamics, particularly the completion of existing projects, will likely improve on the margin in the next 6 to 12 months. Structurally, however, China’s home sales and real estate investment growth will continue shifting to a lower gear (Chart 9).    Investment Conclusions At the start of the year, China was expected to aggressively stimulate its economy. This was based on the premise that policymakers would not tolerate slower economic growth ahead of the Party Congress. Nonetheless, Chinese leaders downplayed the annual GDP growth target this year, a major deviation from the past. Post October’s Party Congress, we think that the authorities will continue to roll out measures to support the economy, but we recommend that investors remain realistic about the magnitude of policy easing. There are nontrivial risks that policymakers will continue to tackle structural issues, while allowing the economy to muddle through. With piecemeal stimulus, China may still be able to manage a soft landing in its property market and prevent the risks from spilling over to other sectors of the economy. In this case, we will monitor macro and financial market dynamics and change our stance on Chinese equities if warranted (Chart 10A and 10B). Chart 10AWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Chart 10BWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Lastly, investors should be prepared for greater emphasis of common prosperity policies at the Party Congress. Reducing income inequality and improving social welfare will remain core principles of President Xi’s political agenda. Common property policies mean that there will be a continued shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 11). The pandemic in the past 2.5 years has likely exacerbated the country’s income inequality and discontent among middle-class households. Chart 11Implications Of China’s Common Prosperity Policy Implications Of China's Common Prosperity Policy Implications Of China's Common Prosperity Policy Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com ​​​​​​​Jing Sima Consulting China Strategist Strategic Themes Cyclical Recommendations

Highlights The odds of a Goldilocks outcome for the US economy increased somewhat in August, but the risks of a US recession over the coming year remain quite elevated. We continue to recommend that investors stay neutrally positioned towards equities within a global multi-asset portfolio. The disinflationary impulse from the July US CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices. It is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. The OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, but it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023. This suggests that a further upward adjustment in the OIS curve is likely warranted, and that a modestly short duration stance is appropriate. Investors believe that the rate hike path priced into the OIS curve would not be recessionary, because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation. From the perspective of market participants, this would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. We agree that the odds of a recession will decline if headline inflation does fall below 4% over the coming year, but it is not yet clear that this will occur. And if it does, the resulting improvement in real wages would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put heavy pressure on equity multiples. This underscores that stock prices face risks in both a recessionary and non-recessionary environment. There are arguments pointing to a decline in the dollar beyond the near term, even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. Stay neutral for now, but look for opportunities to short the dollar beyond the coming few months. Jumping The Gun On Goldilocks The odds of a Goldilocks outcome for the US economy over the coming six to nine months increased somewhat in August. The July CPI report presented some evidence of supply-side and pandemic-related disinflation (Chart I-1), and we saw more resilient manufacturing production in the US – even after excluding the automotive sector – than many manufacturing indicators have been indicating (Chart I-2). In addition, the regional Fed manufacturing index in the especially manufacturing-sensitive state of Pennsylvania surprised significantly to the upside in July, although this was at least somewhat offset by a collapse in the New York and Dallas Fed’s general business conditions indexes (Chart I-3). Chart I-1There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US Chart I-2US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested Against the backdrop of significant recessionary risks, and a debate about whether negative growth in the first half of the year already constitutes a recession in the US, these developments have been positive. The Atlanta Fed’s GDPNow model is pointing to positive (albeit below-trend) growth of 1.4% in Q3, which is consistent with consensus forecasts. The Atlanta Fed’s model is also forecasting the strongest real consumption growth since Q4 2021 (Chart I-4). Equity investors responded to incrementally lower recession odds and a slower pace of inflation by bidding up the S&P 500 from roughly 3800 at the beginning of July to over 4200 in August. Chart I-3Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Mixed Messages From The Regional Fed Indicators Chart I-4The Atlanta Fed GDPNow Model Is Pointing To Positive Growth And Resilient Consumption In Q3 September 2022 September 2022   However, several other developments over the past month continue to highlight that the risks of a US recession over the coming year are quite elevated, which supports our recommendation that investors stay neutrally positioned towards equities within a global multi-asset portfolio: The August flash PMIs were fairly negative, especially for the services sector. The August flash S&P Global manufacturing PMI rose in Germany, but it fell in the US, France, and the UK. Services PMIs declined significantly in all four countries, especially in the US where survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed.” Survey respondents also noted that “new orders contracted at the steepest pace for over two years, as companies highlighted greater client hesitancy in placing new work.” Chart I-5The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board's LEI Is Very Weak The Conference Board’s leading economic indicator dropped for a fifth month in a row in July, which has always been associated with a US recession (based on the indicator’s current construction). Chart I-5 highlights that the indicator’s market-based and real economy components are both very weak, and that the Conference Board’s coincident indicator has now fallen below its 12-month moving average. While the Philly Fed manufacturing index picked up in July, the new orders component of the regional Fed manufacturing PMIs broadly sank further into contractionary territory (Chart I-6). Chart I-6The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Regional Fed New Orders Components Are Very Weak The Atlanta Fed model shown in Chart I-4 is pointing to a second quarter of negative growth from real residential investment, a component of GDP that reliably peaks in advance of economic contractions.1 Job openings are now pointing to a potential rise in unemployment. The relationship between job openings and unemployment is currently subject to heavy debate, as discussed in a recent report by my colleague Ryan Swift.2 However, abstracting from a theoretical discussion about movements along or shifts in the Beveridge curve, investors should note that the empirical record is fairly clear – Chart I-7 highlights that falling job vacancies occurred alongside a significant rise in the level of unemployment during the last two recessions. We acknowledge that the relationship has seen some deviations since 2018/2019, so this may highlight that a larger decline in job openings will be required for unemployment to trend higher. A 10% rise in the level of unemployment relative to its 12-month moving average has always been associated with a recession, implying that a sustained decline in job openings to 10M or lower would represent a likely recessionary signal – even if that recession proves to be a mild one (see Section 2 of this month’s report). Chart I-7Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Declining Job Openings Are Pointing To Potentially Higher Unemployment Table I-1 highlights that the disinflationary impulse from the July CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices (particularly gasoline and fuel oil). Outside of the clear impact that falling fuel prices had on airline fares, there is not yet compelling evidence that core inflation is decelerating due to easing supply-side and pandemic-related effects, or due to slowing demand. As we will discuss below, it is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. Table I-1The Disinflationary Impulse From The July CPI Report Is Less Compelling Than It Seems September 2022 September 2022 Inflation And The Fed As we discuss in Section 2 of our report, recessions occur because monetary policy becomes tight, a significant non-policy shock to aggregate demand or supply occurs, or some combination of both develops. We do not believe that monetary policy is currently restrictive on its own (Chart I-8), and we have not yet concluded that a US recession is inevitable. But when combined with the speed of adjustment in interest rates, the fact that real wages have fallen sharply (Chart I-9), and the fact that the Fed is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. Chart I-8Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Chart I-9But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid Many investors do not appear to fully appreciate the fact that the Fed will continue to tighten policy until it sees clear and unequivocal signs that inflation is easing. Importantly, the minutes of the July FOMC meeting highlighted that this is likely to be true even if unambiguous signs of easing supply-side and pandemic-related inflation present themselves. During the July meeting, FOMC participants noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. They also emphasized that “a slowing in aggregate demand would play an important role in reducing inflation pressures”. The upshot is that the Fed was aware before the July CPI report that energy-related inflation might fall, but also understood that they would still have to tighten enough to slow aggregate demand to reduce underlying inflationary pressures. It is true that investors are pricing in additional rate hikes from the Fed, but there are two caveats for investors to consider. The first is that while the OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023 (Chart I-10). This suggests that a further upward adjustment in the OIS curve is likely warranted. Second, and more importantly, investors appear to be making the assumption that the rate hikes already built into the OIS curve will not be recessionary. Investors are making this assumption because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation (Chart I-11), which would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. Chart I-10A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted A Further Upward Adjustment In The OIS Curve Is Likely Warranted Chart I-11Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation We agree with investors that the odds of a recession will decline significantly, ceteris paribus, if headline inflation does drop below 4% over the coming year. But we noted above that it is not yet clear that this will occur. In addition, we disagree with investors that this would result in a reduction in short-term interest rates, because this belief is based on the view that monetary policy is currently in restrictive territory even without the negative impact of sharply lower real wages. Absent the negative real wage effect, our view is that monetary policy would still be stimulative at current interest rates, which is why we believe that the 2023 portion of the OIS curve is too dovish in a non-recessionary scenario. The Outlook for Stocks The equity market rally that began in early July has been based on the assumption that significant supply-side and pandemic-related disinflation is now a fait accompli. If it is, then the odds of a recession over the coming year are indeed meaningfully lower, and the risk to corporate profits is less than feared. We noted above that investors may have jumped the gun in pricing in substantial disinflation and sharply lower odds of a US recession. But even in a scenario in which the odds of recession do come in significantly, stocks still face risks from a significant rise in real bond yields. Chart I-12Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Investors have been focused on very elevated inflation as the driver of both rising inflation expectations and rising real bond yields, and have assumed that a meaningful slowdown in inflation (as forecast by short-term measures of inflation expectations) implies that the Fed funds rate will return to the Fed’s estimate of neutral. This belief, along with a lower projected Fed funds rate in 2024 than 2023 in the FOMC’s participant forecasts, is the basis for the 2023 “pivot” currently priced into the OIS curve. Given that the Fed funds rate has already reached the Fed’s neutral rate estimate, there is a meaningful chance that this estimate will be revised upwards by the Fed or challenged by investors if economic activity improves in response to a decline in inflation and a corresponding rise in real wages. Such a scenario would highlight to investors that the Fed’s estimate of neutral is likely too low, which would imply a significant increase in real 10-year TIPS yields (which are currently 160 basis points below their pre-2008 average). Chart I-12 highlights the impact that a rise in real long-maturity bond yields could have on equities, even in a non-recessionary scenario where 12-month forward earnings per share grows 8% over the coming year. A rise in 10-year TIPS yields to 1.5% by the middle of 2023 would cause a 16% contraction in the 12-month forward P/E ratio and a 10% decline in stock prices, assuming an unchanged 12-month forward equity risk premium (ERP). It is possible that the ERP could decline in a rising bond yield scenario. Chart I-13 highlights that the ERP is indeed negatively correlated with real bond yields (in part due to the methods that we use to calculate it). The counterpoint is that there are a number of risks that equity investors should be compensated for today that did not exist in the late 1990s or early 2000s, especially the risks of populist policies in many advanced economies and major geopolitical events (as Russia’s invasion of Ukraine recently highlighted). Chart I-14 illustrates that, since 1960, a long-term version of the equity risk premium, calculated using trailing earnings and our adaptive expectations proxy to deflate long-maturity bond yields, has been fairly well explained by the Misery Index (the sum of the unemployment and headline inflation rates). However, the chart also shows that the ERP has been structurally higher over the past decade than the Misery Index would have predicted. It is unclear if this is due to a riskier environment or the negative ERP/real yield correlation that we noted. Chart I-13The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed Chart I-14A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks The conclusion is that investors do not yet appear to have a basis to bet on a declining ERP in a rising bond yield environment, underscoring that even a non-recessionary scenario poses a risk to stock prices. It is worth noting that this second risk facing stocks has essentially been caused by the Fed because of its maintenance of a very low neutral rate estimate that we feel is no longer economically justified. Bond Market Prospects Chart I-15Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Investors Should Stay Modestly Short Duration, For Now Over the past few months, the Bank Credit Analyst service has continued to recommend that investors maintain a modestly short duration stance even as we recommended reducing equity exposure. The recent rise in the 10-year Treasury yield back to 3% has validated that view (Chart I-15), and reinforces our view that there is significant upside risk to long-maturity bond yields in a non-recessionary scenario. Our expectation that the Fed will raise interest rates to a higher level over the next year than the OIS curve is currently discounting also argues for a modestly short stance, based on BCA’s “Golden Rule” framework. The “Golden Rule” states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. As we detail in Section 2 of our report, the Fed has always cut interest rates in response to a recession in the post-WWII environment, so we would certainly recommend a long duration stance if a recession emerges. But given our view that a recession is still a risk rather than a likely event, we feel that a modestly short duration stance is currently appropriate. Chart I-16US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle As noted above in our discussion of the risks facing stock prices in a non-recessionary scenario, falling inflation that is not associated with a recession will ironically be a bearish signal for long-maturity bonds, because it means that the Fed will have greater capacity to raise interest rates without ending the recovery. The short end of the yield curve could be flat or move modestly lower in response to a significant easing in inflation, but the long end of the curve would be at serious risk of moving higher. We are thus very likely to recommend a short duration stance in response to solid evidence of true supply-side and pandemic-related disinflation, assuming it emerges outside of the context of a recession. Within the credit space, the rise in US corporate bond spreads since the start of the year has meaningfully improved the value of investment- and speculative-grade corporate bonds (Chart I-16), but not so much that it justifies a positive stance towards these assets relative to government bonds given the risks facing the US economy. We continue to recommend an underweight stance towards investment-grade and a neutral stance towards speculative-grade within a fixed-income portfolio. The Outlook For Energy Prices Chart I-17The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The EU's Oil Embargo Will Cause Russian Oil Production To Tank The likely path of commodity prices, particularly that of oil, is an extremely important determinant of whether the US is likely to experience a recession over the coming year. We are among those who have downplayed the significance of oil price shocks in driving contractions in economic output over the past two decades,3 but the current situation is unique given the role that very elevated inflation has played in driving real wages lower. In a recent Strategy Report from our Commodity & Energy Strategy service, my colleague Robert P. Ryan underscored the impact that the European Union’s embargo of Russian oil will likely have on the energy market. If fully implemented, ~ 2.3mm barrels/day of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. EU, UK and US shipping insurance and reinsurance sanctions are also scheduled to be implemented in December, which means that “surplus” Russian oil production cannot be fully reoriented to other countries. Chart I-17 presents the likely impact on Russia’s crude oil output, namely a ~ 2mm barrels/day decline in oil output by the end of next year – nearly equal to the amount of oil set to be embargoed. Our base case view remains that supply and demand in the oil market will remain relatively balanced going into the winter, but the removal from the market of Russian oil production because of the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will ultimately push crude oil prices higher and inventories lower (Chart I-18). The price impact of this event could happen earlier than the immediate supply/demand balance would suggest, if investors have not fully priced in the extent of the decline in Russian oil production that our commodity team is forecasting. Our commodity team’s forecast serves as an important reminder that the economic consequences of Russia’s invasion of Ukraine may not be fully behind us. It also highlights that the recent disinflation observed in the US, which was mostly driven by lower energy prices in July, may not be sustained. Chart I-19 highlights what could happen to US gasoline prices based on the path for oil shown in Chart I-18, and how that forecast is sharply at odds with the current gasoline futures curve. Chart I-20 highlights that US gasoline stocks are currently below their 5-year average; the last time this occurred was in Q1 2021, which was an environment of rising gasoline prices to levels that were higher than what would usually be implied by crude oil prices. Chart I-18Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Oil Prices Are More Likely To Rise Than Fall Chart I-19Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Chart I-20Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices The upshot is that our commodity team expects oil prices to move higher over the coming 6-12 months, under the assumption that the EU’s embargo against Russian oil moves forward as announced. This poses a clear threat to imminent supply-side and pandemic-related disinflation, and underscores the risks to a Goldilocks economic outcome over the coming few months. The Dollar: Value, Technical Conditions, And The Cycle Chart I-21The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The US dollar moved higher over the past month, after first retreating from its mid-July high for the year. We tempered our view about the likelihood of a falling dollar over the near term in last month’s report, but from a bigger picture perspective we have been surprised by the degree of dollar strength this year. The US dollar is a reliably countercyclical currency, so clearly some of the dollar’s strength has been the result of weakness in risky asset prices (Chart I-21). But the bottom panel of Chart I-21 highlights that the broad trade-weighted dollar has performed even better over the past year than returns to the S&P 500 would have implied, underscoring that the magnitude of the dollar’s strength has been atypical. The last two times that the US dollar performed substantially better than the trend in risky assets would have implied were in 2012 and 2015, years in which euro area breakup risk was a driving force in markets. Alongside the fact that EURUSD has fallen below parity and USDEUR has outperformed even more than the broad trade-weighted dollar has, “excess” dollar returns point strongly to Europe’s energy woes in the aftermath of Russia’s invasion of Ukraine as the key driver of outsized broad dollar strength. Chart I-22 highlights that European natural gas prices have exceeded the level that we had forecasted would occur in a complete cutoff scenario, meaning that Europe’s energy crunch is likely happening now, rather than in the winter. However, even considering the negative economic outlook facing the euro area, there are arguments pointing to a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. First, Chart I-23 highlights that EURUSD has undershot what the trend in relative real interest rates would suggest, which has historically led changes in the euro. This implies that the euro has declined partly because of the introduction of a sizeable risk premium, which may dissipate after the winter. Chart I-22The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch The Euro Has Been Heavily Impacted By Europe's Energy Crunch Chart I-23EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest Second, Chart I-24 highlights that the US dollar is extremely overbought and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. Finally, Chart I-25 highlights that the US dollar is extraordinarily expensive based on our valuation models, underscoring that an eventual decline in the dollar may be quite severe. We agree that valuation is not usually an effective market timing tool, but investors should place a greater weight on valuation measures as they are stretched further. Based either on our models or a more traditional PPP approach, the degree of US dollar overvaluation is extreme – arguing for a bearish bias on a 6-12 month timeline barring an unambiguous move towards recession in the US. Chart I-24US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought US Dollar And Indicator The US Dollar Is Heavily Overbought Chart I-25The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive The US Dollar Is Extremely Expensive         Investment Conclusions Considering the economic developments over the past month and the reaction of financial markets, the takeaway for investors seems clear. Market participants have eagerly shifted towards the Goldilocks economic and financial market outcome, based on (so far) incomplete evidence of supply-side and pandemic-related disinflation that has predominantly been driven by declining energy prices. Given significant potential upside risks to oil and US gasoline prices over the coming few months, investors should wait for more durable signs of significant disinflation before downgrading the odds of a US recession over the coming year. We would certainly recommend cutting global equity exposure to underweight were we to determine that the US is likely to experience an imminent recession, but the avoidance of a recession does not necessarily suggest that an overweight stance is warranted. Sharply lower inflation would reduce the odds of a recession, but it would also raise real wages and would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put meaningful pressure on equity multiples. Barring a decline in the equity risk premium, US stocks could face a loss on the order of 10% over the coming year in such a scenario (even under the assumption of positive earnings growth), reinforcing our view that a neutral stance towards global equities is currently appropriate. In addition to a neutral global asset allocation stance, we recommend that investors maintain a neutral regional equity position and a neutral stance towards cyclicals versus defensives, although we do recommend a modest overweight towards value stocks given our view that a modestly short duration stance is appropriate. Although we recommend a neutral stance towards USD over the next few months, we also see ample scope for a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. We believe that there are upside risks to energy prices, which our Commodity & Energy Strategy service recommends playing via the iShares GSCI Commodity Dynamic Roll Strategy (COMT) ETF. As a final point, we remain cognizant of the fact that financial markets rarely trend sideways over 6-to-12 month periods. We continue to regard a neutral global asset allocation stance as a temporary stepping stone either to a further downgrade of risky assets to underweight, or to an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see unequivocal signs of a substantial and broad-based slowdown in the US headline inflation rate, and if long-maturity real bond yields are well-behaved in response or if we see clear signs of a declining equity risk premium. Thus, investors should note that additional changes to our recommended cyclical allocation may occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 25, 2022 Next Report: September 29, 2022 II. The Fed Funds Rate, Bond Yields, And The Next US Recession The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession September 2022 September 2022 Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory September 2022 September 2022 Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today September 2022 September 2022 How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.4 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions September 2022 September 2022 Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,5 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward 5-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts In contrast to the recent rally in equities, BCA’s equity indicators continue to paint a bearish outlook for stock prices. Our Monetary, Technical, and Speculative indicators have stopped falling, but they remain very weak. Meanwhile, the recent rally has pushed our valuation indicator back towards a level indicating stocks are considerably overvalued. While it is still a risk and not yet a likely event, the odds of a US recession over the next 12 months remain elevated. We maintain a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being revised up, but bottom-up analysts’ expectations for earnings are likely still too optimistic. Although earnings growth will be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits given ongoing pressure on profit margins. Within a global equity portfolio, we maintain a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. We recommend a modest overweight towards value versus growth stocks, given our recommendation of a modestly short duration stance within a global fixed-income portfolio. Commodity prices have stopped falling, and our composite technical indicator now highlights that commodities are oversold. Our base-case view is that oil prices are likely to rise over the coming 12-months, barring a US recession. Global food prices have come down in the wake of deal between Russia and Ukraine to allow the latter to resume its agricultural exports. But the recent surge in European natural gas prices suggests that global food inflation may remain elevated, given that natural gas is used in the production of fertilizer. Ongoing weakness in the Chinese property market argues for a neutral stance towards industrial metals, until compelling signs of a more aggressive policy response emerge. US and global LEIs have now fallen into negative territory, underscoring that the risk of a global recession is elevated. Some indicators are easing back towards positive territory, such as our global LEI Diffusion Index and our US Financial Conditions Index, but it is not yet clear if they are heralding a reacceleration in economic activity or merely a less intense pace of decline. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate 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 Footnotes 1     Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 2     Please see US Bond Strategy "The Great Soft Landing Debate," dated August 2, 2022, available at usbs.bcaresearch.com 3    Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust China's Baby Bust China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong Wage Growth Remains Strong Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook The Early-1980s Playbook The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued The Dollar Is Very Overvalued The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Special Trade Recommendations Current MacroQuant Model Scores Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis      

US services spending collapsed during the COVID-19 pandemic, and remains significantly below the level that would have prevailed had the pandemic not occurred. This raises the question of whether services consumption will ever return to “normal.” In this report, we address this question by examining the weakest components of services spending, with an eye towards any evidence indicating that this weakness is permanent. A category analysis of services spending highlights that the spending gap currently exists due to a combination of work-from-home trends and evidence of lasting aversion to COVID-19. The latter is unlikely to be permanent, and the former will be partially or fully offset by a permanent increase in substitutable goods spending. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. The COVID-19 pandemic has been enormously disruptive, socially as well as economically. In the US, a massive shift from services to goods spending represents one of the most significant economic disruptions caused by the pandemic, which persists even today. Chart II-1The Pandemic Caused An Extreme Shift In Spending From Services To Goods The Pandemic Caused An Extreme Shift In Spending From Services To Goods The Pandemic Caused An Extreme Shift In Spending From Services To Goods Chart II-1 presents our best estimate of the real goods and services spending gaps relative to potential GDP, which illustrates how extreme the shift from services to goods has been. The real goods spending gap exploded during the pandemic to a level that had not been seen since the early-1950s, and services spending collapsed in an unprecedented fashion and remains at a level that is lower than at any other point over the past seven decades (aside from the worst of the pandemic itself). Chart II-2 highlights that the overall output and household consumption gaps have not yet turned positive, despite an extremely strong labor market. This underscores that weak services spending is playing a role in depressing consumption, and thus overall economic activity. Chart II-2Weak Services Spending Is Playing A Role In Depressing Consumption Weak Services Spending Is Playing A Role In Depressing Consumption Weak Services Spending Is Playing A Role In Depressing Consumption This persistent weakness in services spending raises the question of whether services consumption will ever return to “normal,” defined as the level of spending that would have likely prevailed had the pandemic never occurred. In this report we address this question by examining the weakest components of services spending, with an eye towards any evidence indicating that this weakness is permanent. We conclude that the services spending gap currently exists due to a combination of WFH trends and evidence of lasting aversion to COVID-19. While the effect of the former may be permanent, we do not believe that the effect of the latter will be. And, in cases where certain categories of services spending are likely to be permanently lower, at least some of this decline in spending is likely to be partially or fully offset by a permanent increase in substitutable goods spending. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. The Pandemic, Remote Work, And Services Spending During the very early phase of the pandemic, COVID-19 was spreading rapidly in industrialized economies. Following recommended or mandatory stay at home orders from governments in many countries, most office-based businesses rapidly shifted to work-from-home (WFH) arrangements as an emergency response. This, in conjunction with forced closures of “close contact” businesses such as restaurants, entertainment, and travel caused US services spending to collapse. However, by the summer of 2021, many of these pandemic control measures had been significantly eased or lifted in the US. In addition, several national US surveys found many office workers preferred the flexibility afforded by WFH arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved. These findings led many in the business community to conclude that WFH policies are not, in fact, emergency measures that will ultimately be reversed and instead reflect the “new normal” for work. While this “new normal” is still in the process of being defined, it seems fairly clear that some form of hybrid work arrangements will be permanent for many businesses. Chart II-3 presents the Kastle Systems Back to Work Barometer, which reflects keycard swipes in office buildings in the top 10 US cities. The chart highlights that urban office building activity has recovered to less than half of its pre-pandemic level, and that there has been no evidence of a continued uptrend over the past 3 months. Chart II-4 reinforces this point by highlighting that public transit use in major US cities has lagged the recovery in air travel, and also has not substantially changed over the past few months. Chart II-3Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Urban Office Building Activity Has Recovered To Less Than Half Of Its Pre-Pandemic Level Chart II-4Urban Public Transit Use Has Lagged The Recovery In Air Travel Urban Public Transit Use Has Lagged The Recovery In Air Travel Urban Public Transit Use Has Lagged The Recovery In Air Travel This underscores that investors have a basis to question whether at least some US services spending may be permanently impaired by the pandemic, as was the case for overall output for several years following the 2008/2009 global financial crisis. To answer this question, we present a detailed review of the most lagging categories of US services spending on pages 8-15, focused on whether WFH trends and/or activity in central business districts can plausibly explain the gap in spending in each category. The US Services Spending Gap: Key Observations And Conclusions As discussed in greater detail below, we make the following observations about the US services spending gap: Among the seven major categories of US services spending, health care accounts for the largest portion of the services spending gap. Reduced health care spending has little to do with work from home trends, and more to do with an aversion to contracting the disease in a healthcare environment and the reluctance to place elderly relatives in nursing homes given the higher risk that COVID presents to those who are older. Some recreation services spending has been impacted by WFH trends and thus may be permanent, but a lingering fear of crowded indoor spaces and still-recovering international tourism appear to be more important drivers of the recreation services spending gap. Some portion of reduced transportation services spending may be permanent (either in whole or in part), as the spending gap in road transportation seems strongly connected to WFH trends. But the sizeable and impactful decline in real spending on motor vehicle leasing is likely to recover as motor vehicle production improves over the coming year, suggesting that transportation services spending will continue to improve over the coming year relative to its pre-pandemic trend even if a spending gap in this category of services spending is permanent or long-lasting. Personal care and clothing services is mostly responsible for the spending gap in other services, and clear WFH effects do suggest that a reduction in spending in this category may be permanent. However, these categories are relatively small, and in some cases have been partially offset by what is likely to be a permanently positive spending gap on equivalent goods. The takeaway for investors is that the services spending gap currently exists due to a combination of WFH trends and evidence of lasting aversion to COVID-19. While some investors may interpret these observations as suggesting that the gap will act as a permanent or long-lasting drag on consumer spending, we disagree for two important reasons. First, we agree that some form of hybrid work arrangements will be permanent for many businesses, and that a spending gap may be permanent or long-lasting for spending categories most closely tied to WFH effects. But this also suggests that the goods-equivalent spending that has occurred as a result of this decline in services spending will also be permanent. In other words, some of the drag that permanent WFH effects will have on overall consumer spending will be offset by a permanent increase in certain categories of goods spending. Chart II-5Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Some Of The Permanent Drag On Services Spending Will Be Offset By Permanently Higher Goods Spending Chart II-5 highlights the sum of spending for two pairs of clearly substitutable services/goods categories: miscellaneous personal care services plus personal care products, and sporting equipment, supplies, guns, and ammunition plus membership clubs and participant sports centers. The chart highlights that the sum of these four categories is currently above its pre-pandemic trend, highlighting that permanently lower spending in some services categories affected by WFH trends will likely be offset by permanently higher spending in some goods categories. Second, we doubt that a strong aversion to a COVID-19 infection will be permanent, as the endemicity of the disease has yet to be recognized by the public and normalized by political leaders and health professionals. This is especially true given that the availability and awareness of Pfizer’s Paxlovid antiviral therapy is still in its early stages in the US, and remains severely restricted in other developed economies and (for now) essentially unavailable in the emerging world. As an additional point concerning the lingering societal fear of COVID-19, estimates for the likely annual disease burden from “endemic COVID” are now coming into focus. In a recent New York Times opinion piece, the author cited forecasts from a number of medical professionals that endemic COVID-19 will likely infect roughly half of the US population per year, and will kill on the order of 100,000-250,000 Americans annually.1 That compares with roughly 50,000 fatalities over the course of a year from the worst flu season experienced over the past decade, implying that COVID-19 will end up being between 2-5 times as bad over the longer term as worst-case flu. If the disease burden of endemic COVID-19 ends up being on the higher end of that estimate, then it is likely that an aversion to crowded spaces and shared human settings will be permanent. But we suspect that the eventually-widespread availability of Paxlovid – and other treatment options that have yet to be developed – makes it more likely that annual fatalities will be on the lower end of that range. Chart II-6“Endemic COVID” Will Still Be A Significant Killer, But It Will Not Likely Cause A Permanent Fear Of Crowded Spaces August 2022 August 2022 While tragic, a disease with a fatality rate of 30 per 100,000 people (equivalent to 100,000 US deaths per year) will rank behind accidents, chronic lower respiratory diseases (such as bronchitis, emphysema, and asthma), stroke, and just in line with Alzheimer’s disease as a leading cause of death (Chart II-6). It is certainly unwelcome that a new leading cause of death has emerged. But given that COVID-19 will never go away, we doubt that this will be enough to cause a permanent change in public behavior, suggesting that US services spending will return to normal over time. To the extent that some services spending declines are permanent, we expect that to be partially or fully offset by a permanent increase in substitutable goods spending. Investment Conclusions As we discussed in Section 1 of our report, the risk of a US recession is quite elevated. In a non-recessionary scenario, our analysis suggests that the US services spending gap will continue to close, which will provide support for overall consumption as goods spending slows in response to weak real wage growth and higher interest rates. Chart II-7In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending In A Nonrecessionary Scenario, Excess Savings Will Support Services Spending Chart II-7 highlights that the excess savings that have accumulated since the onset of the pandemic – which can be deployed to support spending – have accrued heavily to upper income earners, who are typically responsible for a significant amount of services spending. While it is true that upper income earners have also suffered a significant wealth shock from the combined effect of falling stock and bond prices, we strongly suspect that excess savings and the transition to endemic COVID-19 will support services spending and cause it to move toward the level that would have prevailed had the pandemic not occurred. In a recessionary scenario, we doubt that services spending would fall significantly, given that it is still extraordinarily depressed relative to history. However, some cyclical categories of services spending would decline, and Chart II-1 highlighted that services spending does tend to decline during recessions. The key point for investors is that changes in services spending would not be large enough to cushion a meaningful decline in goods spending were a recession to emerge. While the emergence of a US recession is not yet a foregone conclusion, the risk that it will occur is an important reason supporting our a neutral asset allocation stance. As noted in Section 1 of our report, further signs of an impending recession would cause us to recommend that investors underweight risky assets over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Overall Household Consumption Expenditures for Services Household consumption expenditures for services is composed of seven categories of services spending: Housing and Utilities, Health Care, Transportation Services, Recreation Services, Food Services and Accommodations, Financial Services and Insurance, and Other Services. In order to gauge to what degree services spending is likely to be permanently impaired by the COVID-19 pandemic, we estimate the “services spending gap” for each of these seven categories based on the pre-pandemic trend of overall services spending and the pre-pandemic weight of each category (Chart II-8). Chart II-8The Services Spending Gap Is Fairly Broad-Based August 2022 August 2022 Spending fell in all seven services categories during the early phase of the COVID-19 pandemic, but the pace of their respective recoveries has been varied. Spending in many of these sectors has not yet fully recovered relative to its pre-pandemic trend (Charts II-9 and 10), contributing to a spending gap of more than $350 billion real dollars.2 Chart II-8 presents a breakdown of this spending gap by category, and we analyze the drivers of each of these gaps by examining subcategories of services spending on pages 8-15. Our subcategory analysis focuses on areas of services spending that are well below their pre-pandemic level, rather than relative to the hypothetical level of spending that would have prevailed had the pandemic not occurred. This is due to BEA data limitations that prevent us from accurately attributing category spending gaps to subcategories in real terms. Charts II-8-10 underscore that the services spending gap is very broad-based. However, four categories stand out as being particularly impactful: health care, recreation services, transportation services and other services. We discuss the causes of the spending gap in these four categories below, with the goal of determining whether they will likely abate as the pandemic continues to recede, or whether they are likely to be permanent. Chart II-9Four Categories Of Services Spending Stand Out… Four categories Of Services Spending Stand Out... Four categories Of Services Spending Stand Out... Chart II-10…As Being Particularly Impactful Drivers Of The Services Spending Gap ...As Being Particularly Impactful Drivers Of The Services Spending Gap ...As Being Particularly Impactful Drivers Of The Services Spending Gap Health Care Real US personal consumption on health care services is currently $126 billion below our estimate of its pre-pandemic trend, and is currently just below its pre-pandemic level (Chart II-11). “Missing” health care spending accounts for the largest share of the overall spending gap for household consumption expenditures for services. Chart II-11“Missing” Health Care Spending Accounts For A Large Part Of The Overall Services Spending Gap August 2022 August 2022 Health care spending initially experienced a V-shaped recovery following the onset of the pandemic, but the pace of recovery has since slowed. The sectors displaying the most significant deviations from their pre-pandemic levels are physician services, dental services, and nursing home spending (Chart II-12). The gap in spending on hospital, physician, and dental services is clearly related to the COVID-19 pandemic, in the sense that some households likely fear contracting the disease in a healthcare setting (especially given the invasive nature of dental treatments). It is also possible that households have been visiting doctor and dentist offices less frequently due to work-from-home policies, in cases where these offices were located in or adjacent to central business districts. Nursing home spending is very much the outlier in the health care sub-sectors, in the sense that its recovery has been more U-shaped than V-shaped. As the pandemic placed the elderly at great risk, we suspect that many family members decided to remove them from nursing homes (or postpone moving them into a nursing home), due to the concern that a communal living environment significantly increased the risk of COVID exposure. Bottom Line: We strongly doubt that the gap in healthcare services spending is permanent. The increasing availability of Paxlovid should help physician services, dental services, and nursing home spending recover, although it is possible that nursing home spending will be the most lagging of the three. Still, we expect that the health care services spending gap will close meaningfully over the coming year if a US recession is avoided (and possibly even if a recession does occur). Chart II-12Some Households Likely Fear Contracting COVID In A Healthcare Setting Some Households Likely Fear Contracting COVID In A Healthcare Setting Some Households Likely Fear Contracting COVID In A Healthcare Setting Chart II-13Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Lingering Fears Of Crowded Indoor Spaces And Still Weak Tourism Explain Weak Recreation Services Spending Recreation Services Real spending on recreation services is currently $75 billion below its pre-pandemic trend, and remains well below its pre-pandemic level (Chart II-14). Despite only accounting for 6% of household consumption expenditure for services, the sharp decline in spending in certain sub-sectors of recreation services has been large enough to significantly contribute to the overall services spending gap. Chart II-14The Recreation Services Spending Gap: Concerts, Amusement Parks, Movies, And Gyms August 2022 August 2022 Chart II-13 highlights that the sectors most responsible for the gap in recreation services spending are 1) live entertainment excluding sports, 2) amusement parks, campgrounds and related recreational services, 3) motion picture theatres, and 4) membership clubs and participant sports centers. A fairly clear narrative explains large spending gaps in three of these categories. In contrast to real spending on spectator sports, which is currently $9 billion above its pre-pandemic level, movies and concerts tend to be held indoors, underscoring that large spending gaps in these categories likely reflect lingering fears of contracting COVID in crowded indoor spaces. Membership clubs and participant sports centers spending is also explained by the COVID-fear effect, although some of the spending gap in this subcategory may be long-lasting as it is also seemingly related to work-from-home effects (for example, substituting home exercise equipment for gym memberships). Real spending on amusement parks, campgrounds and related recreational services is somewhat more difficult to explain, given that spending on these types of services tend to occur outdoors. In addition, some high-profile examples of amusement parks, such as those maintained by the Walt Disney Company in California and Florida, have seemingly experienced strong attendance compared with pre-pandemic levels. We suspect that weakness in this spending category reflects the fact that international tourism has yet to return to its pre-pandemic level. Over the past 12 months, visitor arrivals to the US, while rising, have been less than 40% of what prevailed prior to the pandemic. Bottom Line: We strongly doubt that a sizeable majority of the recreation services spending gap is permanent. As noted for healthcare spending, the increased availability of Paxlovid should progressively reduce the fear associated with crowded indoor spaces, which we believe will cause the recreation services spending gap to close meaningfully over the coming year if a US recession is avoided. Transportation Services Real spending on transportation services is currently $64 billion below our estimate of its pre-pandemic trend, and remains well below its pre-pandemic level (Chart II-15). Chart II-15Road Transportation And Motor Vehicle Leasing Are The Largest Contributors To The Transportation Services Spending Gap August 2022 August 2022 Similar to recreation services spending, transportation services spending accounts for only 5% of household consumption expenditure for services, but the extent of the decline in certain categories of transportation services spending has significantly contributed to the overall gap in services spending. The sectors responsible for the transportation services spending gap are: road transportation, motor vehicle leasing, motor vehicle maintenance and repair, and parking fees and tolls (Chart II-16). Some of the gap in transportation services spending is related to work-from-home trends, and as such may be permanent (either in whole or in part). The decline in road transportation spending has been heavily driven by a collapse in spending on intercity buses and mass transit, which is strongly connected to reduced office building occupancy in major US cities and also appears to explain reduced spending on parking fees and tolls. In addition, weak motor vehicle maintenance and repair seems strongly correlated with retail and recreation mobility, which remains below its pre-pandemic level. However, reduced spending on motor vehicle leasing accounts for an important portion of the transportation services spending gap, and does not appear to be caused by work-from-home trends. Instead, the decline in leasing seems strongly linked to the decline in motor vehicle inventory that has caused an enormous rise in new and used car prices. As we have discussed at length in previous reports, this decline in vehicle production and sales has been caused by a semiconductor shortage that will eventually abate, underscoring that this subcomponent of transportation services spending will eventually recover. Bottom Line: We expect the transportation services spending gap to close further over the coming year, even if it does not close fully. Some portion of reduced transportation services spending may be permanent (either in whole or in part), but spending on motor vehicle leasing will not be, suggesting that transportation services spending will continue to improve over the coming year relative to its pre-pandemic trend if a contraction in the US economy is avoided. Chart II-16Some Of The Gap In Transportation Services Spending May Be Permanent Some Of The Gap In Transportation Services Spending May Be Permanent Some Of The Gap In Transportation Services Spending May Be Permanent Chart II-17Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Personal Care And Clothing Services Spending Has Definitely Been Impacted By Work-From-Home Trends Other Services Other services spending represents a 14% share of household consumption expenditure for services. Real spending on other services is currently $51 billion below our estimate of its pre-pandemic trend, and still below its pre-pandemic level (Chart II-18). In percentage terms, the other services spending gap is smaller than for health care, recreation services, and transportation services, but it is closer in dollar terms because other services spending is a larger expenditure category. Chart II-18Some Other Services Spending Is Higher Than Before The Pandemic, But Personal Care And Clothing Services Is The Laggard August 2022 August 2022 Real spending on other services is below its pre-pandemic level in four subcategories: personal care and clothing services, education services, household maintenance, and social services and religious activities. However, the majority of the spending gap in other services is accounted for by personal care and clothing services (Chart II-17). Some components of personal care and clothing services spending are likely permanently impaired (in whole or in part). Almost all of clothing and footwear services spending is made up by spending on laundry and dry-cleaning services, which remains 12% below its pre-pandemic level and is not exhibiting any meaningful uptrend. In addition, within personal care services, spending on hairdressing salons and personal grooming establishments remains well below its pre-pandemic level, and is only slowly recovering in line with central business district office occupancy. However, one interesting aspect of personal care services spending is that spending on personal care products has increased significantly during the pandemic as spending on miscellaneous personal care services decreased. This suggests that any permanently negative spending gap on personal care and clothing services will be at least partially offset by a permanently positive spending gap on personal care products. Bottom Line: Some of the negative spending gap on other services is likely to be permanent or long-lasting due to persistent work-from-home effects, but at least some of this negative gap will be offset by a permanently positive spending gap on the goods equivalent of these services.   Footnotes 1    New York Times Opinion, Endemic Covid-19 Looks Pretty Brutal, July 20, 2022 2    Please note that all real dollar references in this report refer to chained (2012) dollars.

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing