Disasters/Disease

Listen to a short summary of this report.       Executive Summary Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities in late February but see the current level of stock prices as offering enough upside to warrant an overweight. Global equities are now trading at 15.6-times forward earnings, and only 12.6-times outside the US. More importantly, the forces that pushed down stock prices are starting to abate: The war in Ukraine no longer seems likely to devolve into a broader conflict; the number of new Covid cases in China has fallen by half; and global inflation has peaked. The next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. The “Last Hurrah” for equities is coming. We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, countertrend rallies are likely. To express this view, we recommend taking partial profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020) and our short Bitcoin position (up 98% based on our exponential shorting technique). Bottom Line: Global equities are heading towards a “last Hurrah” starting in the second half of this year. Tactically upgrade stocks to overweight.   Feature Dear Client, We published a Special Alert early this afternoon tactically upgrading global equities to overweight. As promised, the enclosed report elaborates on our view change. Best regards, Peter Berezin Restore Tactical Overweight On Global Equities Chart 1Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities from overweight to neutral on February 28th. The war in Ukraine, the Covid outbreak in China, and most importantly, the rise in bond yields have kept us on the sidelines ever since. At this point, however, the outlook for stocks has brightened, and thus we are restoring our tactical (3-month) overweight to stocks so that it is consistent with our bullish 12-month cyclical view. First, valuations have discounted much of the bad news. After the recent sell-off, global equities are trading at 15.6-times forward earnings (Chart 1). Outside the US, they trade at only 12.6-times forward earnings. Second, the forces that pushed down stock prices are starting to abate. The war in Ukraine is approaching a stalemate, with Russian troops unable to take much of the country, let alone seriously threaten regional neighbours. A European embargo on Russian oil is likely but will be watered down significantly before it is implemented. European officials have shied away from banning Russian natural gas, an action that would have much more severe economic implications. While still very high in absolute terms, December-2022 European natural gas futures are down 36% from their peak on March 7 (Chart 2). The 7-day average of new Covid cases in China has fallen by more than half since late April (Chart 3). Considering that a significant fraction of China’s elderly population is unvaccinated, the authorities will continue to play whack-a-mole with the virus for the next few months (Chart 4). Fortunately, Chinese domestic production of Pfizer’s Paxlovid anti-Covid drug is starting to ramp up, which should allow for some easing in lockdown measures later this year. Chart 2European Natural Gas Futures Have Come Off The Boil European Natural Gas Futures Have Come Off The Boil European Natural Gas Futures Have Come Off The Boil Chart 3Covid Cases Are Falling In China… It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight The 20th Chinese National Party Congress is slated for this fall. In the lead-up to the Congress, it is likely that the government will move to diffuse social tensions over its handling of the pandemic by showering the economy with stimulus funds. Of note, the credit impulse has already turned higher, which bodes well for both Chinese growth and growth abroad (Chart 5). Chart 4… But Low Vaccination Rates Among The Elderly Remain A Risk It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Chart 5A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World   Inflation Is Peaking On the inflation front, the data flow has gone from unambiguously bad to neutral (and perhaps even slightly positive). In the US, core goods inflation fell by 0.4% month-over-month in April, the first outright decline in core goods prices since February 2021. The Manheim Used Vehicle Value Index has crested and is now 6.4% below its January peak (Chart 6). Global shipping rates have moved up a bit recently on the back of Chinese port shutdowns but remain well below their highs earlier this year (Chart 7). Chart 6Used Car Prices Appear To Have Peaked Used Car Prices Appear To Have Peaked Used Car Prices Appear To Have Peaked Chart 7Global Shipping Rates Are Well Off Their Highs Global Shipping Rates Are Well Off Their Highs Global Shipping Rates Are Well Off Their Highs It Is The Composition Of Spending That Is Distorted Despite the often-heard claim that US consumer spending is well above trend, the reality is that spending is more or less in line with its pre-pandemic trend (Chart 8). It is the composition of spending that is out of line: Goods spending is well above trend while services spending is well below. One might think that only the overall level of spending should matter for inflation, and that the composition of spending is irrelevant. However, this ignores the reality that services prices are generally stickier than goods prices. Companies that sold fitness equipment during the pandemic had no qualms about raising prices. In contrast, gyms barely cut prices, figuring that lower membership fees would do little to drive new business through the door (Chart 9). Chart 8Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 9Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices This asymmetry matters, and it suggests that goods inflation should continue to fall over the coming months as the composition of spending shifts back to services. A Lull In Wage Growth Wages are the most important determinant of services inflation. While it is too early to be certain, the latest data suggest that wage growth has peaked. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 10). Assuming productivity growth of around 1.5%, this is consistent with inflation of only slightly more than 2%. Nominal wage growth is a function of both labor market slack and expected inflation. Slack should increase modestly during the rest of the year as labor participation recovers. Chart 11 shows that the labor force participation rate is still about 0.9 percentage points below where one would expect it to be, even adjusting for an aging population and increased early retirements. Chart 10Wage Growth Seems To Be Topping Out Wage Growth Seems To Be Topping Out Wage Growth Seems To Be Topping Out Chart 11Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Employment has been particularly depressed among lower-wage workers (Chart 12). This should change as more low-wage workers exhaust their savings and are forced to seek employment. According to the Fed, the lowest-paid 20% of workers are the only group to have seen their bank deposits dwindle since mid-2021 (Chart 13). Chart 12More Low-Wage Employees Will Return To Work More Low-Wage Employees Will Return To Work More Low-Wage Employees Will Return To Work Chart 13The Savings Of Low-Wage Workers Are Dwindling The Savings Of Low-Wage Workers Are Dwindling The Savings Of Low-Wage Workers Are Dwindling Inflation expectations should come down as goods inflation recedes and oil prices come off their highs (Chart 14). Bob Ryan, BCA’s Chief Commodity Strategist, sees the price of Brent averaging $86/bbl in the second half of this year, down 16% from current levels.  Central Banks Will Dial Back The Hawkishness With inflation set to fall over the remainder of the year, and financial markets showing increasing signs of stress, the Fed and other central banks will adopt a softer tone. It is worth noting that the median terminal dot for the Fed funds rate actually declined from 2.5% to 2.4% in the March Summary of Economic Projections (Chart 15). Given that markets expect US interest rates to rise to 3.25% in 2023, the Fed may not want investors to further rachet up rate expectations. Chart 14US Inflation Expectations Should Recede If Oil Prices Drop US Inflation Expectations Should Recede If Oil Prices Drop US Inflation Expectations Should Recede If Oil Prices Drop Chart 15Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral   The Bank of England has already veered in a more dovish direction. Its latest forecast, released on May 5, showed real GDP contracting slightly in 2023. Based on market interest rate expectations, the BoE sees headline inflation falling to 1.5% by end-2024, below its target of 2%. Even assuming that interest rates remain at 1%, the BoE believes that inflation will only be slightly above 2% at the end of 2024, implying little need for incremental policy tightening. Not surprisingly, the pound has sold off. We have been tactically short GBP/USD but are using this opportunity to turn tactically neutral. Given favorable valuations, we like the pound over the long run. Chart 16Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend The euro area provides a good example of the dangers of focusing too much on short-term inflation dynamics. Supply-side disruptions stemming from the pandemic and the war in Ukraine have weighed on European growth this year. Yet, those very same factors have also pushed up inflation. Harmonized inflation across the euro area reached 7.5% in April, the highest since the launch of the common currency. The ECB is eager to put some distance between policy rates and the zero bound. However, there is little need for significant tightening. Unlike in the US, spending in the euro area is well below its pre-pandemic trend (Chart 16). If anything, more inflation would be welcome since that would give the ECB scope to bring real rates further into negative territory if economic conditions warrant it. To its credit, the Bank of Japan has stuck with its yield curve control system, even as bond yields have risen elsewhere in the world. Japan’s currency has weakened but given that inflation expectations are too low, and virtually all of its debt is denominated in yen, that is hardly a bad thing. Too Late? Has the surge in bond yields already done enough damage to the global economy to make a recession inevitable? We do not think so. As noted above, much of the recent harm has been caused by various dislocations, namely the war in Ukraine and the ongoing effects of the pandemic. As these dislocations dissipate, inflation will fall and global growth will recover. Despite the hoopla over how the US economy contracted in the first quarter, real private final sales to domestic purchasers (a measure of GDP growth that strips out the effects of changes in government spending, inventories, and net exports) rose by 3.7% at an annualized rate. As Table 1 shows, this measure of economic activity has the highest predictive power for GDP growth one-quarter ahead. Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.7% In Q1 It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Meanwhile, and completely overlooked at this point, S&P 500 earnings have come in 7.3% above expectations so far in Q1, with nearly 80% of S&P 500 companies surprising on the upside. Earnings are up 10.4% year-over-year in Q1. Sales are up 13.6%. Looking out to Q4 of 2022, S&P companies are expected to earn $60.93 in EPS, up 4.3% from what analysts expected at the start of the year. It is also worth noting that homebuilder stocks have basically been flat over the past 30 days, even as the S&P 500 has dropped by nearly 10% over this period. Housing is the most interest rate-sensitive sector of the economy. With the homeowner vacancy rate at record low levels, even today’s mortgage rates may not be enough to push the economy into recession (Chart 17). Economic vulnerabilities are greater outside the US. Nevertheless, there is enough pent-up demand on both the consumer and capital spending side to sustain growth. The Last Hurrah How long will the “Goldilocks” period of falling inflation and supply-side driven growth last? Our guess is about 18 months, starting this summer and lasting until the end of 2023. Unfortunately, as is often the case, the benign environment that will emerge in the second half of this year will sow the seeds of its own demise. Real wages are currently falling across the major economies (Chart 18). That has dampened consumer confidence and spending. However, as inflation comes down, real wage growth will turn positive. This will stoke demand, leading to a reacceleration in inflation, most likely in late 2023 or early 2024. Chart 17Tight Supply Makes Housing More Resilient Tight Supply Makes Housing More Resilient Tight Supply Makes Housing More Resilient Chart 18Real Wages Are Falling In Most Countries Real Wages Are Falling In Most Countries Real Wages Are Falling In Most Countries   In the end, central banks will discover that the neutral rate of interest is higher than they thought. That is good news for stocks in the short-to-medium run because it means that forthcoming rate hikes will not induce a recession. Down the road, however, a higher neutral rate means that investors will eventually need to value stocks using a higher discount rate. It also means that the disinflation we envision over the next 18 months will not last. All this puts us in the rather lonely “transitory transitory” camp: We think much of today’s high inflation will prove to be transitory, but the transitory nature of that inflation will itself be transitory. Be that as it may, the next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. For most investors, that is too long a period to sit on the sidelines. The “Last Hurrah” for equities is coming. Taking Partial Profits On Our Short Treasury, Long Value/Growth, And Short Bitcoin Trades We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, with the “Last Hurrah” approaching, countertrend rallies are likely. To express this view, we recommend taking half profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020), and our short Bitcoin position (up 98% based on our exponential shorting technique). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Special Trade Recommendations Current MacroQuant Model Scores It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight

Executive Summary More Chinese Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest The Politburo meeting last Friday signaled that China is determined to achieve the 5.5% annual growth target set earlier this year. Policymakers vowed to accelerate the implementation of existing pro-growth measures and hinted that they may scale up stimulus due to domestic challenges and external uncertainties. However, Chinese policymakers are facing an “impossible trinity” of eliminating domestic COVID cases and avoiding an overshoot as they stimulate the economy, while trying to achieve a high rate of economic expansion. The Politburo did not mention any plans to boost income and consumption via direct fiscal transfers to households, a sector that has been a weak link in China’s economy in the past two years. China’s consumption growth and demand for housing will not recover any time soon without meaningful aids to shore up household income.  Bottom Line: Policy stimulus measures announced so far fall short of what is required to lift the economy. Given constraints on household consumption and the property market, China’s economic growth is set to underwhelm and Chinese stock prices will underperform their global counterparts.     China’s top leaders have pledged to provide more support to the economy. The Politburo meeting last week indicated that the 5.5% growth target set for 2022 will be maintained and stimulus measures will be accelerated. Chinese stocks in both on- and offshore markets rebounded sharply following the positive rhetoric. Related Report  Emerging Markets StrategyA Whiff Of Stagflation? In our view, however, Chinese authorities are facing an “impossible trinity” as they simultaneously attempt to achieve three goals: (1) pursuing a dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. The pro-growth measures announced last week by the government lack the needed elements to generate a quick and strong rebound in the economy, particularly in the household and property sectors. Hence, the rebound in Chinese stock prices will unlikely progress into a cyclical rally (over a 6- to 12-month time span). We maintain our neutral allocation in Chinese onshore stocks and an underweight stance on the MSCI China Index, within a global portfolio. An “Impossible Trinity” The messages from the Politburo meeting highlight policymakers’ determination to shore up the economy. However, the authorities are not backing away from the zero-COVID policy, which is taking a heavy toll as cities are forced into lockdown to contain outbreaks. In addition, the Politburo reiterated the housing policy principle that “housing is for living, not for speculation” and did not mention concrete measures to boost household consumption. Thus, the biggest challenge for China to achieve its growth target this year is how to normalize economic activity without resorting to another round of “irrigation-style” stimulus while keeping domestic COVID cases at bay. In an environment of frequent lockdowns, monetary and fiscal easing have limited effect as the private and household sectors are averse to taking risks. China’s zero-COVID policy comes with hefty economic costs. April’s PMI showed sharp declines in a wide range of business activities due to the prolonged lockdown in Shanghai and several other cities (Chart 1). The new orders, new export orders, and imports subindexes in the manufacturing PMI and services PMI, all fell to their lowest levels since Q1 2020 when COVID first hit China (Chart 2). Chart 1April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities ​​​​​​ Chart 2PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 Going forward, even if China manages to avoid a Shanghai-style month-long lockdown, the dynamic zero-COVID policy will have devastating ramifications on the economy. Notably, March economic data from the city of Shenzhen, China’s technology center, suggests that even a week-long lockdown has had large impact on the local economic activity. Chart 3Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown In contrast with the extensive outbreak in Shanghai, Shenzhen was able to contain its COVID cases at an early stage and endured a citywide lockdown for only one week in mid-March. However, Shenzhen’s export growth contracted by 12.8% year-on-year (YoY) in March, a stark contrast from the 14.7%YoY increase in exports on a national level. The city’s imports fell by 11.9%YoY, also significantly lower than China’s total import growth, which was flat (Chart 3). Retail sales of consumer goods in Shenzhen shrank by 1.6%YoY in March and home sales plummeted by a stunning 90%YoY during the week of March 13-20. On the national level, the Politburo has called for an acceleration in infrastructure investment through frontloading local government special purpose bonds (SPB) and fast-tracking infrastructure project approvals. However, the lack of details has created questions regarding the magnitude of incremental stimulus, or whether the stepped-up policy effort will involve an increase in SPB or a general bond quota for local governments. Chart 4Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown The stringent COVID containment methods will also undermine the effectiveness of China’s pro-growth measures. As expected, China’s construction activity PMI tumbled in April amid the lockdowns, but the new orders and business expectations components in the construction PMI had already started to slide in March (Chart 4, top and middle panels). Moreover, employment in the labor-intensive construction sector also declined substantially in March and April (Chart 4, bottom panel). The deterioration in these indicators is consistent with our view that even short and less draconian lockdowns spark considerable disruptions in business activities. Bottom Line: There is a low likelihood that China will deviate from its existing zero-COVID policy for the rest of this year. As such, boosting the economy via stimulus will be challenging due to frequent interruptions to economic activities. No Bazooka For Consumers China’s household consumption, which accounts for about 40% of the country’s aggregate demand, has been a weak link in the economy during the past two years. Last week’s Politburo meeting pledged to stabilize employment, create new jobs and encourage hiring from small and medium enterprises (SMEs). However, there was no mention of any large-scale fiscal transfer to households via cash or subsidy payments, which suggests that pro-consumer measures are not in the stimulus package. Chart 5Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle China’s retail sales growth has been muted in the current business cycle, a deviation from past economic recoveries when a revival in the general economy and moderate pro-consumption stimulus helped to lift household spending growth substantially above the rate of nominal GDP expansion (Chart 5). Since the pandemic, however, government stimulus to the household sector has been insufficient to revive consumption, due to the negative impact lockdowns have on both labor market demand and the service sector activities. Compared with the US and Europe, China’s fiscal transfer to the household sector has been very limited since the first wave of COVID in early 2020 (Chart 6). Local governments handed out vouchers in Q2 2020 aimed at boosting consumption, but the amounts were dismal and have had a minimal effect on the sector. Chart 6IMF Fiscal Monitor Database: Fiscal Response To The COVID-19 Pandemic China’s Trilemma China’s Trilemma Presently the RMB value in direct payments to the household sector is even smaller: some cities including Shenzhen distributed consumption vouchers ahead of the May holiday week. Nonetheless, the total value of consumption vouchers this year is estimated at around RMB 2billion. The amount, even with a multiplier effect of 3 on consumption, will be less than 0.1% of China’s monthly retail sales in nominal value. Hence, the coupons are unlikely to make any significant difference to the aggregate household spending. Bottom Line: Household consumption will be severely curtailed as lockdowns wreak havoc on the economy and household income, and the government so far has not provided meaningful direct transfers to the public. Rebound In Housing Demand Doubtful The Politburo encouraged local governments to further relax local housing policies, such as lowering mortgage rates and down payment ratios, and easing restrictions on home sales and purchases. However, we do not expect that these policies alone will restore homebuyers’ confidence amid short-term factors such as COVID outbreaks/lockdowns, and longer-term factors like slowing household income growth, high household debt and poor demographics (Chart 7A and 7B). Chart 7AProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Chart 7BProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics China’s household sector was struggling prior to recent lockdowns. The growth rate of national disposable income per capita slowed by more than two percentage points (in nominal terms) in Q1 this year compared with Q4 2019 (Chart 7A, top panel). In addition, the PBoC’s quarterly urban depositor survey (released before the Shanghai lockdown) in Q1 showed subdued confidence in future household income (Chart 8). Households’ willingness to save hit a record high and is even more elevated than in early 2020; on the other hand, the propensity to invest has dropped to a multi-year low (Chart 9).  Chart 8Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chart 9More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest Chart 10Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Despite lower interest rates and easier monetary conditions, Chinese consumers’ medium- to long-term loans continued to trend down in Q1, which indicates a declining appetite for purchasing real estate assets and durable goods (Chart 10). COVID-related restrictions have exacerbated matters and weighed heavily on the demand for housing. Home sales from 30 Chinese cities were down by 56% in April from a year ago (Chart 11). House prices have started to deflate in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. ​​​Furthermore, the unemployment rate has picked up, especially among younger workers (Chart 12). Job and income dynamics normally improve after the overall economic cycle bottoms. Therefore, without any measures to boost household income, the demand for housing will remain a drag on the economy in the near term.   Chart 11Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Chart 12Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Bottom Line: The real estate market has been vital to business cycle recoveries in China since 2009. However, the property market will not recover anytime soon without a substantial boost to household income and a normalization in social and economic activities. Investment Conclusions The policy rhetoric from the Politburo meeting helped to shore up market confidence last Friday. Nevertheless, we do not think that the stimulus measures will be sufficient to produce a rapid business cycle recovery or a sustainable stock market rally (Chart 13A and 13B). Chart 13AIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Chart 13BIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Given the negative forces from rolling lockdowns and shrinking demand, China’s economy requires a massive government stimulus via direct transfers to households and SMEs. Yet, Beijing is neither ready to abandon its dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. The policy stimulus measures announced so far still fall short of what is required to lift the economy. In light of the constraints on household consumption and the property market, economic growth in China is set to underwhelm and stock prices will likely underperform their global counterparts. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Real Wages Are Declining Real Wages Are Declining Chart 2Consumer Confidence Has Soured Consumer Confidence Has Soured Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories Here Comes Goldilocks Here Comes Goldilocks The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Here Comes Goldilocks Here Comes Goldilocks Chart 6The Clogged-Up Port Of Shanghai Here Comes Goldilocks Here Comes Goldilocks Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Here Comes Goldilocks Here Comes Goldilocks Special Trade Recommendations Current MacroQuant Model Scores Here Comes Goldilocks Here Comes Goldilocks

Executive Summary Brent Stable As Demand + Supply Fall Brent Stable As Demand + Supply Fall Brent Stable As Demand + Supply Fall Oil demand growth will slow this year and next by 1.6mm b/d and 1mm b/d, respectively. These expectations are in line with sharp downgrades in World Bank and IMF economic forecasts, which cite pressures from the Ukraine War, COVID-19-induced lockdowns in China, and central-bank policy efforts to contain rising inflation. Lower oil demand will be offset by lower supply from Russia and OPEC 2.0, which now are ~ 1.5mm b/d behind on pledges to restore production taken from the market during the pandemic. In 2022, US production will increase ~750k b/d year-on-year. The strategic relationship between the US and core OPEC 2.0 producers Saudi Arabia and the UAE is fraying. The Core's unwillingness to increase production despite pleas from the Biden administration likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian storage to fill, and lead to production shut-ins. Oil prices would surge to destroy enough demand to cover this loss. Our base-case Brent forecast is at $94/bbl this year and $88/bbl in 2023, leaving our forecast over the period mostly unchanged. Bottom Line: Despite major shifts in global oil supply and demand over the past month, oil markets have remained mostly balanced. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs. Feature Related Report  Commodity & Energy StrategyDesperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma Oil demand and supply growth are weakening on the back of the Ukraine War, COVID-19-induced lockdowns in China, and central-bank efforts to contain rising inflation. We expect global demand growth to slow this year and next by 1.6mm b/d and 1mm b/d, respectively, in line with downgrades in IMF and World Bank global growth forecasts.1 Demand will fall to 100mm b/d on average this year, down from our earlier expectation of 101.5mm b/d published in March. For next year, we expect global oil consumption to come in at 102.2mm b/d, down from our March estimate of 103.2mm b/d (Chart 1). EM consumption, the engine of oil-demand growth, falls to 54.2mm b/d vs. 55.8mm b/d in last month's forecast for 2022 demand. We have been steadily lowering our estimate for 2022 Chinese demand this year due to its zero-tolerance COVID policy and its associated lockdowns, and again take it down 250k b/d in this month's balances to 15.7mm b/d on average. In our estimates, Chinese oil demand grows 2.6% from its 2021 level of 15.3mm b/d. We have been expecting DM oil consumption to flatten out this year, following massive fiscal and monetary stimulus fueling oil demand during and after the pandemic, and continue to expect it to come in at ~ 45.7mm b/d this year. Chart 1Sharply Lower Oil Demand Expected Sharply Lower Oil Demand Expected Sharply Lower Oil Demand Expected Oil Supply Gets Complicated Oil supply will continue to weaken along with demand this year, primarily due to sanctions imposed on Russia by Western buyers following its invasion of Ukraine. Russia's production reportedly was just above 10mm b/d. Estimates of Russian production losses over 2022-23 range from 1mm b/d to as much as 1.7mm b/d over at the US EIA. The outlier here is the IEA, which warns Russian production will fall 1.5mm b/d this month, then accelerate to 3mm b/d beginning in May. In our base-case modeling, we expect Russian output to average 9.8mm b/d in 2022 and 9.9mm b/d next year (Chart 2). Tracking Russia's production became more complicated, as the government this week announced it no longer would be reporting these data. Prices and satellite services will be needed to impute Russia's output in the future. Russia and the Kingdom of Saudi Arabia (KSA) are the putative leaders of OPEC 2.0 (otherwise known as OPEC+). In the wake of Russia's invasion of Ukraine, OPEC, the original cartel led by KSA, continues to maintain solidarity with Russia, referring in its Monthly Oil Market Report (MOMR), for example, to the "conflict between Russian and Ukraine," or the "conflict in Eastern Europe" – not the war in Ukraine. This would suggest KSA and its allies continue to place a high value in maintaining the OPEC 2.0 structure, which has shown itself to be an extremely useful organization for managing production and production declines among non-Core states – i.e., those states outside the Gulf that cannot increase output, or are managing declining production due to lack of capital, labor or both (Chart 3). Chart 2Brent Stable As Demand + Supply Fall Brent Stable As Demand + Supply Fall Brent Stable As Demand + Supply Fall Chart 3OPEC 2.0 Remains Useful To KSA And Russia War, Lockdowns, Rate Hikes Depress Oil Demand War, Lockdowns, Rate Hikes Depress Oil Demand The strategic relationship between core OPEC 2.0 producers capable of maintaining higher production – KSA and the UAE – and the US is fraying. Both states showed no interest in increasing production despite pleas from the Biden administration following Russia's invasion of Ukraine, and have shown a propensity to expand their diplomatic and financial relationships, e.g., exploring oil sales denominated in Chinese RMB, beyond their US relationships.2 This likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. Outside the OPEC 2.0 coalition, we continue to expect higher output from the US, led by shale oil production. According to Rystad Energy, horizontal drilling permits in the Permian basin hit an all-time high in March.3 If these permits are converted into new projects, oil supply growth will be boosted starting 2023. The US government’s recent announcement to lease around 144,000 acres of land to oil and gas companies – in a bid to bring down high US oil prices – also will spur supply growth towards the beginning of next year.4 These bullish factors are balanced out by nearer-term headwinds. Bottlenecks resulting from pent-up demand released following global lockdowns, the Russia-Ukraine crisis, and investor-induced capital austerity means US oil producers will not be able to turn on the taps as quickly this year as they've been able to do in days gone by. Given the near-term bearish factors and longer-term bullish factors, we expect total US crude production to grow slower this year and ramp up at a faster pace the next. US shale output (i.e., Lower 48 states (L48) ex Gulf of Mexico) is expected to average 9.73mm b/d in 2022 and 10.53mm b/d in 2023 (Chart 4). Total US crude supply is expected to average 11.92mm b/d and 12.74mm b/d, respectively, over this period. Additional production increases are expected from Canada, Brazil and Norway. Chart 4Shales Continue To Pace US Onshore Output Increases Shales Continue To Pace US Onshore Output Increases Shales Continue To Pace US Onshore Output Increases Upside Risk Remains KSA's and the UAE's strategy to hold off on production increases despite US entreaties upends one of our expectations – i.e., that these state would increase production as the deficit in OPEC 2.0 output being returned to the market widened. We are coming around to the idea this could represent a desire to diversify their exposure to USD payments and assets, which, as Russia's invasion of Ukraine demonstrated, can become liabilities in an economic war. This also would begin to reduce the heavy reliance KSA and the UAE place on the US vis-à-vis defending its interests.5 Lastly, we would observe KSA's and the UAE's spare capacity is being husbanded closely, given it constitutes most, if not all, of OPEC 2.0's 3.4mm b/d of spare capacity (Chart 5). There are multiple scenarios in which this spare capacity would be needed by global markets to address production outages. One of the most imposing is an EU embargo on Russian oil imports floated by France this week, which triggers a cut-off of natural gas supplies by Russia to the EU.6 An embargo of Russian oil imports by the EU is a very low-probability event, but it is not vanishingly small. The EU imports about 2.5mm b/d of Russia's crude oil exports. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian pipelines and storage to fill, and would lead to production shut-ins. Oil prices would have to surge to destroy enough demand to cover this loss of supply, even after OPEC's spare capacity was released into the market. If realized, such an event also would throw the world into recession, in our view. The prospect of a cut-off of Russian oil imports by the EU was addressed last month by Energy Minister Alexander Novak, who said such an act would prompt Russia to shut down natural gas exports to the EU.7 If Russia follows through on such a threat, it would shut down much of the EU's industrial and manufacturing activity. The experience of this past winter – when aluminum and zinc smelters were forced to shut as natural gas prices surged and made electricity from gas-fired generation too expensive for their operations – remains fresh in the mind of the market. An oil-import ban by the EU followed by a cut-off of natgas exports by Russia almost surely would spike volatility in these markets (Chart 6). In addition, a global recession would be a foregone conclusion, in our view. Chart 5OPEC Spare Capacity Concentrated In KSA, UAE War, Lockdowns, Rate Hikes Depress Oil Demand War, Lockdowns, Rate Hikes Depress Oil Demand Chart 6Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Markets Remain Roughly Balanced … For Now Our supply-demand modeling indicates production losses are roughly balanced by consumption losses at present (Chart 7). If anything, the lost demand slightly outweighs the loss of production, when we run our econometric models. However, we are maintaining a $10/bbl risk premium in our estimates for 2022-23 Brent prices, which keeps our current forecast close to last month's levels. Persistent strength in the USD, particularly in the USD real effective exchange rate, acts as a headwind on prices by making oil more expensive ex-US (Chart 8). We expect this to continue, given the Fed's avowed commitment to raise policy rates to choke off inflation, which, all else equal, will make USD-denominated returns attractive. Chart 7Markets Remain Mostly Balanced Markets Remain Mostly Balanced Markets Remain Mostly Balanced Chart 8Strong USD Restrains Oil Prices War, Lockdowns, Rate Hikes Depress Oil Demand War, Lockdowns, Rate Hikes Depress Oil Demand Investment Implications Despite the major shifts in oil supply and demand over the past month, markets have remained mostly balanced (Table 1). Falling Russian output and weak OPEC 2.0 production – where most states are managing production declines – is being exacerbated by falling Chinese demand and SPR releases from the US and IEA. The market does not yet need the 1.3mm b/d of Iranian output that is being held at bay due to a diplomatic impasse between the US and Iran, which we believe will persist. With overall economic output growth slowing – per the forecasts of the major supranational agencies (WTO, IMF, World Bank) – weaker demand can be expected to persist. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 War, Lockdowns, Rate Hikes Depress Oil Demand War, Lockdowns, Rate Hikes Depress Oil Demand This is not to say upside risk is non-existent. A move by the EU to ban Russian oil imports could set in motion sharply higher oil and gas prices and a deep EU recession, as discussed above. This could trigger an immediate need for OPEC spare capacity and those Iranian barrels waiting to return to export markets. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish Russia's concentration of exposure to OECD Europe – as customers for its energy exports – exceeds the latter's concentration of imports from Russia by a wide margin. Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this Russia exported last year, OECD Europe was its largest customer, accounting for 50% of total oil exports, according to the US EIA (Chart 9). On the natgas side, more than one-third of the ~ 25 Tcf of natgas produced by Russia last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 84% – was exported via pipeline to the OECD Europe, with the biggest customers being Germany, Turkey, Italy and France. As is the case with crude oil and liquids, OECD Europe is Russia's biggest natgas customer, accounting for ~ 75% of exports in either gaseous or liquid form. There is an argument to be made Russia needs OECD Europe as much or more than the latter needs Russia. Ags/Softs: Neutral Grains and vegetable oils are at multi-year or all-time highs, as a result of the war in Ukraine. This week, corn futures hit the highest since 2012, while wheat futures surged amid the ongoing war and unfavorable weather in U.S. growing areas. The U.N. Food and Agriculture Organization's Food Price Index rose 12.6% from February, its highest level since 1990. According to the FAO, the war in Ukraine was largely responsible for the 17.1% rise in the price of grains, including wheat and corn. Together, Russia and Ukraine account for around 30% and 20% of global wheat and corn exports. The cost of fertilizers has increased by almost 30% in many places due to the supply disruptions caused by the war and the tightening of natural gas markets, which is being driven by EU efforts to diversify away from Russian imports of the commodity.8 Planting is expected to be very irregular in the upcoming grain-sowing months, navigate through much higher prices for fuel and fertilizers (Chart 10). Chart 9 War, Lockdowns, Rate Hikes Depress Oil Demand War, Lockdowns, Rate Hikes Depress Oil Demand Chart 10 Wheat Price Level Going Down Wheat Price Level Going Down     Footnotes 1     Please see the IMF's April 2022 World Economic Outlook report entitled War Sets Back the Global Recovery, and the World Bank's Spring Meetings 2022 Media Roundtable Opening Remarks by World Bank Group President David Malpass, posted on April 18, 2022. 2     Please see, e.g., Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales published by wsj.com on March 15, 2022.   3    Please see Permian drilling permits hit all-time high in March, signaling production surge on the horizon, published by Rystad Energy on April 13, 2022. 4    Please see Joe Biden resumes oil and gas leases on federal land, published by the Financial Times on April 15, 2022. 5    Please see Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma, which we published on January 14, 2014. In that report, we noted, "… the U.S. has decided to stop micromanaging the Middle East. The latter policy sucked in too much of Washington's material resources, blood and treasure, at a time when regional powers like China and Russia were looking to establish their own spheres of influence in East Asia and Eurasia respectively." Building deeper commercial relationships with China also would bind both states together in terms of addressing KSA's security concerns, given China's existing relationships with Iran. This is a longer-term strategy, in our view. 6    Please see An EU embargo on Russian oil in the works - French minister, published by reuters.com on April 19, 2022. 7     Please see War in Ukraine: Russia says it may cut gas supplies if oil ban goes ahead, published by bbc.co.uk on March 8, 2022. 8    Please refer to Food prices soar to record levels on Ukraine war disruptions, published by abcNEWS on April 8, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022 Image

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

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

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

Executive Summary Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases The economic impact of China’s struggle with another wave of COVID outbreaks is showing up in March’s PMI and high-frequency data. The highly contagious nature of the Omicron variant suggests that Shanghai’s battle against the virus spread may last longer than the market has priced in. Chinese authorities will continue playing whack-a-mole in efforts to eliminate the country’s COVID cases. The zero-COVID approach and the virus’ mutating to more contagious variants mean that the country may have to impose more frequent mobility restrictions going forward than in the past two years. Although Chinese policymakers are determined to stabilize the economy, the ongoing combat with COVID will weigh down the effectiveness of the stimulus. In relative terms, we maintain a neutral position on Chinese onshore stocks. However, downshifting corporate profits and the economic shock from lockdowns remain significant risks to the absolute performance of Chinese stocks. Bottom Line: China’s combat against the current COVID-19 outbreaks may last longer than the market has priced in. In the near term, the lockdowns will weigh down the effectiveness of the stimulus. In the second half of the year, the more contagious virus mutations and China’s sticking to zero-COVID strategy may lead to more frequent disruptions to business activity.     Chart 1China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China’s efforts to stabilize economic growth are facing new challenges, dampening an already fragile recovery. The current wave of COVID-19 outbreaks — the worst since early 2020 — has infected more than 100,000 (TK) people across the country, and the number of new cases is still rising at an exponential rate (Chart 1). Measures to contain the spread of the virus have led to city lockdowns, halted factory production and have dragged down the tourism and catering industries. In previous reports, we noted that it is challenging for China to reach this year’s 5.5% growth target due to downbeat private-sector sentiment and subdued demand for housing. The outlook for China’s economy is grimmer now. The highly contagious COVID virus mutations, including the emerging Omicron BA.2 variant, will make it more difficult for China to control its domestic outbreaks going forward. We do not expect that China will fundamentally change its zero-COVID policy throughout the rest of this year. Therefore, the country will probably see more frequent regional and city lockdowns this year than in the past two years.  The leadership will calibrate its handling of these lockdowns to minimize damage to the economy, and Beijing will continue stepping up its growth support policies. However, the whack-a-mole strategy to eliminate domestic COVID cases will be disruptive to business activity and dampen the effectiveness of policy easing. A One-Two Punch… Related Report  China Investment StrategyA Choppy Bottom The downside risks to China’s economy stemming from the ongoing domestic COVID outbreaks are adding to the difficulties the country is already facing due to subdued domestic demand. As we have been highlighting in our previous reports, weak private sector sentiment has been weighing down the effectiveness of authorities’ efforts to stimulate the Chinese economy. The sluggish PMI data released last week in part reflects the impact of restrictions imposed to control the latest wave of COVID-19 infections, but also highlights the bleak domestic demand conditions. Notably, the March PMI survey does not capture the full impact of the Shanghai lockdown as the data collection period ended before the restrictions went into effect on March 28. The official composite PMI fell from 51.2 to 48.8 – below the 50 boom-bust threshold and the lowest reading since February 2020. The drop reflects a slump in the manufacturing and – to a greater extent – the non-manufacturing sectors, which both fell into a contractionary territory. The manufacturing PMI slid 0.7 points to 49.5, while the non-manufacturing PMI dropped 3.2 points to 48.4 (Chart 2). The new orders sub-index of the manufacturing PMI lost nearly two percentage points and deteriorated more sharply than the production index (Chart 3). Moreover, the spread between the new orders component and new export orders – a proxy for domestic demand – ticked down in March (Chart 3, bottom panel). This indicates that weak production does not just stem from COVID-related supply-side issues, but also from poor domestic demand conditions. Chart 2Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chart 3Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Chart 4Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 In addition, high-frequency data from the China Automobile Dealers Association shows that the Vehicle Inventory Alert Index (VIAI) – a survey that measures destocking pressures in the automobile industry – jumped to the highest level since the first wave of COVID-19 hit China in early 2020 (Chart 4). A rising VIAI above the 50-percent threshold indicates that auto inventories are cumulating at a faster pace than demand.  Importantly, the cities and regions that have been worst hit by this round of COVID outbreaks are mostly coastal metropolises and business hubs such as Shanghai, Shenzhen and cities in Jiangsu and Zhejiang provinces. These cities and provinces represent more than 20% of China’s aggregate GDP and almost 30% of the country’s total import and export volume. As such, the negative impact on China’s overall economy from the lockdowns will be more substantive than during the previous waves. Measures to contain Shanghai’s worst-ever COVID outbreak are also disrupting operations at the world’s busiest container port, adding strains to the already overstretched global shipping industry (Chart 5). The supplier delivery times subindex of the manufacturing PMI dropped to 46.5 in March, the lowest reading since March 2020 (Chart 6). This suggests that suppliers’ delivery times have lengthened with near-term supply chain pressure, since lower readings reflect longer delivery times. Chart 5Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Chart 6Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Bottom Line: The economic shock from the current COVID outbreaks is compounding an already weak domestic demand in China. Since the cities and regions that are affected by this round of lockdowns are some of China’s most developed metropolitan areas, the negative impact will likely be larger than during the past two years. How Long Will The Battle Last? China’s struggle to contain the current round of domestic COVID outbreaks will likely last longer than the market has priced in. There is also a non-trivial risk that during the rest of the year, the country will need to shutter large parts of its economy more frequently to combat the spread of COVID variants, which appear to become more contagious as the mutation continues. The lockdowns in Shanghai have already been extended beyond the originally announced two-phased, eight-day restriction plan (Chart 7). The first phase of the lockdown, for which restrictions were due to be lifted on the morning of April 1, has now been extended to anywhere between 3 to 10 days. It may take Shanghai, a city of 25 million residents, between four to six weeks to bring the number of new cases down to a level that is acceptable to the authorities. Chart 7Shanghai Is Extending Its Two-Phased, Eight-Day Lockdowns Bracing For More Turbulence Bracing For More Turbulence Shenzhen, a dynamic metropolitan city bordering Hong Kong, seems to have successfully contained its COVID outbreaks after only one week of a city-wide lockdown. However, Shenzhen imposed lockdowns at an early stage of the outbreak, when both confirmed and asymptomatic case numbers in the city were in the low double digits. Shanghai, on the other hand, took more stringent measures when the number of asymptomatic cases had already reached nearly a thousand. The Omicron variant is four times more transmissible than the earlier Delta mutation, which means it will generate an explosive rise in cases and make containing the virus spread much more difficult than with Delta. In a fully susceptible (unvaccinated and uninfected) population, one person with Delta would on average infect five other people, while one person with Omicron could transmit the virus to about 20 others. As a result, despite a relatively low number of newly confirmed cases, the surging asymptomatic cases in Shanghai imply that a larger population in the city might have already been infected (Chart 8). China’s struggle with the current wave of COVID outbreaks may be an example of what lies ahead, as continuously mutating variants become more contagious and will pose fresh new challenges to China’s zero-COVID approach. The latest strain of Omicron BA.2 appears to be 40% more contagious than the original Omicron strain and is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 9). It took only two months from when China reported its first local Omicron BA.1 case in early January to the outbreaks of Omicron BA.2 in March. Chart 8Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Chart 9Covid Cases Are On The Rise Again Globally Bracing For More Turbulence Bracing For More Turbulence This presents the Chinese authorities with a difficult dilemma: impose severe mobility restrictions when domestic cases pop up, or let the virus run rampant and develop a herd immunity among much of its population. China’s leadership has recently reiterated that the country will stick to its zero-COVID strategy. The success that China has had in suppressing the virus in the past two years has left its population with little natural immunity. Moreover, while China’s overall vaccination rate is high at 85%, less than 50% of people over the age of 80 in the country are fully vaccinated. The authorities have been fine tuning their measures to control the virus spread while sticking to a zero-COVID approach. The recently calibrated measures include allowing residents to take rapid antigen tests at home, quarantining people with asymptomatic COVID cases at dedicated isolation centers rather than hospitals, and monitoring patients for shorter periods than previously required. China has also fast-tracked the approval for the importing and domestic manufacturing of Paxlovid, which is highly effective at preventing hospitalization if taken within five days of the onset of symptoms. In addition, the global production of antiviral drugs is starting to ramp up (Chart 10). Nonetheless, China will probably wait until the antiviral drugs are in sufficient supply before fundamentally relaxing its zero-COVID policy. In the meantime, while the country’s economic growth will rebound when the current wave of COVID cases subsides, disruptive outbreaks and lockdowns may become more frequent as the authorities continue to play whack-a-mole with COVID (Chart 11). As a result, business activity in China will suffer. Chart 10Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Chart 11China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies Bottom Line: Shanghai’s current battle with COVID outbreaks will likely continue in the coming weeks. Before China can relax its zero-COVID policy, the more contagious COVID virus mutations in the future will see Chinese authorities adopt even harsher quarantine and control measures, which will disrupt economic activity further. Investment Conclusion  Chinese stocks in both onshore and offshore markets have recovered some ground from their deeply oversold conditions in mid-March (Chart 12A). While the risk-reward profile for the A-share market warrants a neutral position in a global portfolio, in absolute terms both on- and offshore Chinese stock prices have probably not reached their bottom (Chart 12B). Chart 12AChinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chart 12BIn Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks The private sector’s downbeat sentiment, households’ subdued demand for housing, and the ongoing COVID-19 lockdowns pose significant near-term downside risks to China’s economy and corporate profits. February’s credit impulse shows that corporate and household demand for credit has been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Moreover, the March PMI readings suggest that the lockdowns in China’s business and manufacturing hubs will have substantial negative impacts on the economy. As such, we maintain our neutral stance on Chinese onshore stocks and continue to recommend underweight Chinese offshore stocks in a global portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Strategic Themes Cyclical Recommendations

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Executive Summary China’s Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed Recent data showed a substantial improvement in the economy in the first two months of the year. However, the optimism is not well supported by other industry and high-frequency data. China’s exports were resilient, while infrastructure investment also rebounded sharply on the back of front-loaded fiscal stimulus. Nonetheless, domestic demand in China remains in the doldrums. Housing market indicators show a further deterioration in home sales and prices in January and February. Consumption in tourism during the Chinese New Year and service sector activities were also weaker compared with the same period last year. While we expect policymakers to roll out more measures to shore up domestic demand, China’s economy will likely have a choppy bottom in the first half of 2022. We maintain our neutral position on Chinese onshore stocks in a global portfolio. In absolute terms, we are cautious and are looking for a better price entry point in Q2. Bottom Line: Economic data in the first two months of the year sent mixed signals, which suggests that China’s economy has not reached a solid bottom. Feature Newly released economic data from January and February (i.e. industrial production, fixed-asset investment, retail sales and property investment) all generated sizable positive surprises. However, other industry and high-frequency data sent conflicting messages. The improvement in China’s total social financing (TSF) in the past few months has been due to local government (LG) bond issuance (Chart 1). Corporate credit showed little advancement, while household loans were extremely weak (Chart 2). In addition, further contracting home sales paint a bleak picture of housing demand. Soft readings in the service sector Purchasing Managers' Index (PMI) and core consumer price index (CPI) suggest that consumption remains sluggish. Chart 1The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) Chart 2No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit Beijing is stepping up its pro-growth stimulus, particularly on the fiscal front. However, the country will unlikely undergo a strong recovery in its business cycle without a major reversal in the housing market and an improvement in demand from the private sector. Moreover, recent lockdowns to tame surging domestic COVID-19 cases amid China’s zero-tolerance pose major downside risks to the near-term economic outlook. Chinese equities sold off in response to lockdown news despite the release of better economic data earlier this month, highlighting investors’ weak sentiment. Chart 3China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed We maintain our neutral view on China’s onshore stocks relative to their global peers, but we are cautious on Chinese equities in absolute terms.  On a cyclical time horizon (6 to 12 months), there are increasing odds that Chinese policymakers will stimulate the economy more aggressively, particularly in the 2nd half of the year. However, it is too early to turn bullish on Chinese equities (Chart 3). The ongoing war in Ukraine and elevated oil prices, coupled with risks of further lockdowns in China and a prolonged downturn in domestic demand, present significant near-term risks to the performance of Chinese equities. Investors should closely watch for more reflationary efforts from Beijing and we believe a better entry point to upgrade Chinese stocks may emerge in Q2.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Near-Term Outlook For The Housing Market Remains Bleak Real estate investment growth in January-February was surprisingly strong, according to data from China’s National Bureau of Statistics. However, headline growth in real estate investment deviates from the continued weaknesses in other housing market indicators (Chart 4). In addition, data on the production of some key construction materials showed little improvement (Chart 5). Chart 4Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Chart 5Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Demand for housing remains lackluster. February’s medium- to long-term household loan growth, which is mainly mortgage loans and is highly correlated with home sales, plunged to an all-time low (Chart 6). Meanwhile, the deep contraction in home sales growth continued in February, and sentiment among home buyers remains downbeat (Chart 6, bottom panel) Chart 6Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Chart 7Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Although authorities have reiterated that they want to stabilize the property market, the policy measures have been only fine-tuned. Regional governments have been allowed to initiate their own housing policies and some cities have eased processes for home purchases.1 However, given that maintaining stable home prices is an overarching goal and China’s leadership is trying to avoid further inflating the home price bubble, it is doubtful that the government will allow significant re-leveraging in the property market (Chart 7). Chart 8 shows that funds to real estate developers have slowed to the lowest level since 2010, which will further dampen housing construction. Chart 8Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Chart 9The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales Moreover, high-frequency floor space sold data shows a broad-based decline in housing sales in tier-one, two and three cities through mid-March (Chart 9). The latest spike in China’s domestic COVID-19 cases and regional lockdowns will likely weigh on home sales in the short term. Property investment and construction will remain at risk without a decisive rebound in home sales. A Disrupted Recovery In Household Consumption Both retail and online sales of consumer goods held up better than expected in January and February (Chart 10). However, the subdued underlying data highlight that the strong reading in retail sales in the first two months of the year may be less than meets the eye. Chart 10Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Chart 11...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels Service sector and passenger activities are still well below their pre-pandemic levels, two years after the first COVID lockdowns in early 2020 (Chart 11). Consumption in tourism during the Chinese New Year holiday was weaker than last year. Households’ propensity to spend also showed few signs of rebounding (Chart 12 & 13). Chart 12Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Chart 13Households’ Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Furthermore, both core and service CPI weakened in February, reflecting lackluster demand from consumers (Chart 14). Labor market dynamics have also worsened and the unemployment rate, particularly among young workers, has risen rapidly since the beginning of the year (Chart 15).  Chart 14Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Chart 15Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening The ongoing fight against mounting new COVID cases in China will likely drag down service sector activities in the coming months (Chart 16A & 16B). Importantly, the new round of lockdowns and mobility restrictions are primarily in busier and more developed coastal metropolitans, such as Shenzhen and Shanghai. Therefore, the negative impact from social activity restrictions will be more substantive compared with previous lockdowns. Chart 16AEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Chart 16BEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Strong Rebound In Manufacturing Investment Growth In January-February Probably Not Sustainable A strong rebound in the growth of manufacturing investment helped to support overall fixed-asset investment in the first two months of the year (Chart 17). Robust external demand for China’s manufacturing goods has likely contributed to the pickup in manufacturing output and helped to sustain Chinese manufacturers’ near-maximum capacity (Chart 18). Chart 17Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Chart 18Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization While the volume of manufacturing output increased, prices that producers charge consumers have rolled over (Chart 19). Historically, prices have been more important in driving corporate profits than the volume of output. In addition, a strong RMB and sharply climbing shipping costs will also weigh on Chinese exporters’ profitability (Chart 20). Chart 19Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Chart 20Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Chart 21Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed The elevated prices of oil and global industrial metals will continue to disproportionally benefit upstream industries, which are mainly composed of commodity producers. Meanwhile, the manufacturing sector’s profit margins will be squeezed by rising input costs and sluggish final demand (Chart 21). Chinese manufacturers’ profit growth will likely weaken through 1H22 and the downtrend may be exacerbated by the ongoing struggle to contain COVID cases.  The impact from recent lockdowns in the northern city of Jilin (an auto production center), Shenzhen (a high-tech manufacturing production and export hub), and Shanghai (a city with major ports and a key logistics provider) will disrupt China’s manufacturing production and curb investment in the near term. Infrastructure Sector Will Remain A Bright Spot Through 1H22 Related Report  China Investment StrategyAiming High, Lying Low Infrastructure investment staged a strong recovery in January-February on the back of front-loaded fiscal stimulus (Chart 22). LG bond issuance started to accelerate last November and will boost both traditional and new-economy infrastructure spending at least through 1H22. Our calculations suggest that fiscal thrust will rise to more than 2% of GDP this year, a sharp reversal from last year’s negative impulse of 2% (Chart 23). Chart 22Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Chart 23Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 24Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment However, shadow bank activity, which historically had a tight correlation with infrastructure investment, remains downbeat (Chart 24). February’s reading of shadow bank credit was extremely weak, highlighting that local governments still face constraints in off-balance sheet leveraging through local government financing vehicles (LGFVs). The trend in shadow bank loans bears close attention in the coming months because it will signal whether the central government will allow more backdoor financing to help local governments fund their infrastructure projects. A continued soft reading in shadow bank activities will likely limit the upside in infrastructure investment growth. Table 1China Macro Data Summary A Choppy Bottom A Choppy Bottom Table 2China Financial Market Performance Summary A Choppy Bottom A Choppy Bottom     Footnotes 1     Guangzhou lowered its down-payment ratio from 30% to 20%, along with a 20bp cut in mortgage rates. Zhengzhou marginally relaxed home purchase restrictions by allowing families who bring elderly relatives to live in the city to buy one extra home and also lifted the “definition of second home ownership by physical unit & mortgage history”. ​​​​​​​ Strategic Themes Cyclical Recommendations