Economic Growth

BCA’s Emerging Markets Strategy team’s view remains that US inflation will prove to be sticky. That said, in this report, we examine under what conditions a considerable drop in US core inflation, whenever it transpires, would be bullish for stocks. Potentially significant US disinflation would be bullish for stocks if it is due to an improvement in supply-side dynamics, but bearish if it is demand driven.

In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.

In this report, we elaborate on why the Chinese central government has been reluctant to open stimulus taps as much as in the past, especially when it comes to the ailing property market. In recent years, there has been a major shift in Beijing’s assessment of the trade-offs between short-term economic growth, sociopolitical stability and the nation's long-term goals. We explain this difficult balancing act, little-known in the global investment community.

This week, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for Q3/2022. We also discuss the model portfolio’s expected performance over next 3-6 months after our recent moves to reduce overall duration exposure and increase the underweight to US Treasuries.

Investors should go long US treasuries and stay overweight defensive versus cyclical sectors, large caps versus small caps, and aerospace/defense stocks. Regionally we favor the US, India, Southeast Asia, and Latin America, while disfavoring China, Taiwan, Hong Kong, eastern Europe, and the Middle East.

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

In Section I, we note that the Fed’s new interest rate projections show that US monetary policy is set to rise soon into restrictive territory even relative to what we consider to be the neutral rate of interest, and to a level that has been consistent with the onset of recession since the 1960s. Imminent supply-side and pandemic-related disinflation is crucial for the US to avoid a recession over the coming year. Stay neutral stocks versus bonds for now, but the next shift in our recommended asset allocation stance is more likely to be a downgrade to underweight rather than an upgrade to overweight. In Section II, a guest piece from our European Investment Strategy service discusses the outlook for European assets.

Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted China's Semi Imports Plummeted China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Global Auto Production Will Rise Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang Semiconductor Inventory Overhang Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

Executive Summary Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues In this report, we discuss our move last week to shift to a below-benchmark overall global duration stance in more detail. Our strongest conviction view on developed market government bonds is underweighting US Treasuries. The outcome of last week’s FOMC meeting, where the Fed committed to a rapid shift to restrictive US monetary policy, supports that position. Our strongest conviction overweight is on Japan, with the Bank of Japan both willing and able to maintain its cap on longer-term JGB yields. We are also overweight countries where it will be difficult for central banks to lift rates as much as markets expect – core Europe, Australia and Canada. The explosion in UK bond yields, and collapse of the British pound, seen after last week’s UK “mini-budget” shows that investors have not lost the power to punish fiscal and monetary policies that are non-credible - like a massive debt-financed tax cut at a time of high inflation. As a result, the Bank of England will now be forced to raise rates much more than we had been expecting, and Gilts will remain extremely volatile in the near-term. Bottom Line: Maintain a below-benchmark overall duration stance in global bond portfolios. Stay underweight US Treasuries. Upgrade exposure to government bonds in Japan and Canada to overweight, but tactically downgrade UK Gilts to underweight until a more market-friendly policy mix leads to greater stability of the British pound. Feature We shifted our recommended stance on overall global portfolio duration to below-benchmark in a Special Alert published last week. In this report, we go into the rationale for that move in more detail, and present specific details of that shift in terms of allocations by country across the various yield curves. Related Report  Global Fixed Income StrategyReduce Global Portfolio Duration To Below-Benchmark The global inflation and monetary policy backdrops remain toxic for bond markets. Last week saw interest rate increases from multiple developed economy central banks, including the Fed and Bank of England (BoE). The magnitudes of the rate hikes unnerved bond investors, with even the likes of perennial low yielders like the Swiss National Bank and Riksbank lifting rates by 75bps and 100bps, respectively. The Fed followed up its own 75bp hike by digging in its heels on the need for additional policy tightening after the 300bps of hikes already delivered this year (Chart 1). Fed Chair Jerome Powell strongly hinted that a policy-induced US recession is likely the only way to return overshooting US inflation back to the Fed’s 2% target. This triggered a breakout of the benchmark US 10-year Treasury yield above 3.5%. But the real fireworks in global bond markets occurred after the UK government announced its “mini-budget” last Friday that included massive tax cuts to be funded by debt issuance, triggering a sharp decline in the British Pound and spike in UK Gilt yields – a move that spilled over into other bond markets, pushing government bond yields to cyclical highs in the US and euro area. Chart 1Central Banks Keep Trying To “Out-Hawk” Each Other The Global Bond Bear Market Continues The Global Bond Bear Market Continues Chart 2Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation We had been anticipating another move upward in global bond yields for this cycle, and we shifted to a below-benchmark overall global duration stance in advance of the Fed and BoE meetings last week. We see this next move higher in yields as being driven not by rising inflation expectations but by an upward repricing of interest rate expectations, leading to additional increases in real bond yields (Chart 2). Trying to pick a top in bond yields has now become a game of forecasting the level to which policy rates must rise in the current global monetary tightening cycle. On that front, there is still scope for rate expectations, and bond yields, to move higher in most developed market countries, justifying our downgrade of our recommended overall duration exposure to below-benchmark. Shifting rate expectations also lead to the changes in country bond allocations we announced last week. Rate Expectations And Country Bond Allocations Our proxy for medium-term nominal terminal rate expectations in developed market countries, the 5-year/5-year forward overnight index swap (OIS) rate, has been tracking 10-year bond yields very closely in the US and UK and, to a lesser extent, Europe (Chart 3). In those regions, the OIS curves are pricing in an increasing medium-term level of policy rates, leading to markets repricing government bond yields higher. In the US, the OIS curve is pricing in a 2023 peak for the fed funds rate of 4.67%, but with only a modest path of rate cuts in 2024 and 2025, leading to a 5-year/5-year OIS projection of 3.36% as of Monday’s market close. After the Gilt market rout, the UK OIS curve is now pricing in a 2023 peak Bank Rate over 6%, with our medium-term nominal rate proxy settling at 3.69%. In the euro area, the OIS curve is discounting a 2023 peak in the ECB policy rate of 3.22%, with a 5-year/5-year forward OIS rate of 2.7%. For all three of those regions, the market is now pricing in the highest peak in rates for the current tightening cycle. That is not the case in Canada or Australia, where rate expectations and longer-term bond yields are still below cyclical peaks (Chart 4). Japan remains the outlier, with the Bank of Japan’s yield curve control keeping 10-year JGB yields capped at 0.25%, even with the Japan OIS curve pricing in a medium-term terminal rate of 0.75%. Chart 3Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Chart 4Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights After looking at all the repricing of interest rate expectations and bond yields, we can determine our preferred government bond allocations within our strategic model bond portfolio framework. The US Remains Our Favorite Government Bond Underweight The new set of interest rate forecasts (“the dots”) presented at last week’s Fed meeting showed that the median FOMC member was forecasting the fed funds rate to rise to 4.4% by the end of 2022 and 4.6% by the end of 2023, before falling to 3.9% and 2.9% and the end of 2024 and 2025, respectively. Those are all significant increases from the June dots, where the expectations called for the funds rate to hit 3.4% by end-2022 and 3.8% by end-2023. The median Fed forecasts are now broadly in line with the pricing in the US OIS curve for 2022-2024, although the market expects higher rates than the FOMC in 2025 (Chart 5). Chart 5USTs Still Vulnerable To Additional Fed Hawkish Surprises The Global Bond Bear Market Continues The Global Bond Bear Market Continues There has been a lot of back and forth between the Fed and the markets this year, but the market has generally lagged the Fed interest rate projections for 2023 and 2024 before last week. Market pricing is now in line with the Fed dots, as investors have adjusted to the increasingly hawkish message from Fed officials that are focused solely on slowing growth, and tightening financial conditions, in an effort to bring US inflation down. We see the US Treasury curve as still vulnerable to additional hawkish messaging from the Fed, and a potentially higher-than-anticipated peak in the funds rate versus the FOMC dots. The US consumer is facing a lot of headwinds from higher interest rates and rising food and gasoline prices. However, the latter has fallen 26% from the June 13/2022 peak and is acting as a “tax cut” that also helps reduce US inflation expectations (Chart 6). Consumer confidence measures like the University of Michigan expectations survey have already shown improvement alongside the fall in gas prices, which has boosted real income expectations according to the New York Fed’s Consumer Survey (bottom panel). Even a subtle improvement in consumer confidence due to some easing of inflation expectations can help support a somewhat faster pace of consumer spending at a time of robust labor demand and accelerating wage growth. The Atlanta Fed Wage Tracker is now growing at a year-over-year pace of 5.7%, while the ratio of US job openings to unemployed workers remains near a record high (Chart 7). Fed Chair Powell has noted that the Fed must see significant weakening of the US jobs market for the Fed to consider pausing on its current rate hike path. So far, there is little evidence pointing to a loosening of US labor market conditions that would ease domestically-generated inflation pressures. Chart 6Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Chart 7A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish Chart 8Stay Underweight US Treasuries Stay Underweight US Treasuries Stay Underweight US Treasuries We expect overall US inflation to decelerate next year on the back of additional slowing of goods inflation, but will likely settle in the 3-4% range in 2023 given stubbornly sticky services inflation and wage growth. The Fed should follow through on its current interest rate projections, with a good chance that rates will need to be pushed up even higher in response to resilient labor market conditions in the first half of 2023. The risk/reward still favors higher US Treasury yields over at least the next 3-6 months, particularly with an improving flow of US data surprises and with bond investor duration positioning now much closer to neutral according to the JPMorgan client survey (Chart 8). Bottom Line: The US remains our highest conviction strategic government bond underweight in the developed markets. Recommended Allocations In Other Countries The path for monetary policy rates outside the US shows a similar profile as in the US, with a “front loading” of rate hikes to mid-2023 followed by modest rate cuts over the subsequent two years (Chart 9). The OIS-implied path for the level of rates is nearly identical in the US, Australia and Canada. On the other hand, markets are discounting much lower of levels of policy rates in Europe and Japan compared to the US, and a considerably higher path for rates in the UK (more on that in the next section). Chart 9Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes We would lean against the US-like pricing of interest rates in Australia and Canada. Based on work we published in a recent Special Report along with our colleagues at BCA Research European Investment Strategy, the neutral real interest rate (“r-star”) is estimated to be deeply negative in Australia and Canada after adjusting for the high level of non-financial debt in those countries (Table 1). That financial fragility makes it much less likely that the Bank of Canada and Reserve Bank of Australia can raise rates as much as the Fed. Table 1Some Big Swings In Our R* Estimates When Including Debt The Global Bond Bear Market Continues The Global Bond Bear Market Continues US-like interest rates would almost certainly trigger a major downturn in house prices and household wealth given the inflated housing values in those two countries – the growth of which is already slowing rapidly in response to rate hikes delivered in 2022. We are maintaining our overweight recommendation on Australian government bonds, while we upgraded Canada to overweight from neutral after last week’s duration downgrade. Chart 10Move To Overweight Japan Move To Overweight Japan Move To Overweight Japan We are also staying overweight on German and French government bonds, as the ECB is unlikely to deliver the full extent of rate increases discounted in the European OIS curve. Our estimated debt-adjusted r-star is also quite negative in the euro area, suggesting that financial fragility issues (due to high government debt in Italy and high corporate debt in France) will likely limit the ECB’s ability to continue with recent chunky rate increases for much longer. In Japan, we continue to view JGBs as an “anti-duration” instrument, given the Bank of Japan’s persistence in maintaining negative interest rates and yield curve control. That makes JGBs a good overweight when global bond yields are rising and a good underweight when global bond yields are falling (Chart 10). Given our decision to reduce our recommended duration exposure to below-benchmark, the logical follow through decision is to upgrade JGBs to overweight. The only remaining country to consider is our view on UK Gilts, which has now become more complicated. Anarchy In The UK The selloff in the UK Gilt market has been stunning in its ferocity. Dating back to last Thursday’s 50bp rate hike by the BoE, the 10-year UK Gilt yield has jumped 120bps and now sits at 4.52%. The increase in yields was identical at the front-end of the Gilt curve, with the 2-year yield jumping 120bps to 4.68%.  The surge in longer-term Gilt yields stands out to the rise in bond yields seen outside the UK, as it also incorporates an increase in our estimate of the UK term premium – a move that was not matched in other countries (Chart 11). The rise in Gilt yields was also much more concentrated in real yields compared to inflation expectations (Chart 12), as markets aggressively repriced the path for UK policy rates after the UK government’s announced debt-financed fiscal package, including £45bn of tax cuts. Chart 11Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Chart 12The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The UK’s National Institute for Economic And Social Research (NIESR) estimates that the combined impact of the tax cuts and additional spending measures would increase the UK government deficit by a whopping £150bn, or 5% of GDP. The NIESR also estimated that the fiscal measures, including the previously-announced plan for the UK government to cap energy price increases, would result in positive UK GDP growth in the 4th quarter and also lift annual real GDP growth to 2% over 2023-24. The UK government now faces a major credibility issue with markets on its announced fiscal plans. The sheer size of the package, coming at a time when the US economy was already operating at full employment with high inflation, invites a greater than expected monetary policy tightening response from the BoE. The UK OIS curve now forecasts a peak in rates of 6.3% in October 2023, up from the current 2.25%. That would be a massive move in rates in just one year from a central bank that has been relatively gun shy in lifting rates since the 2008 financial crisis, even during the current inflation overshoot. New UK Prime Minister Liz Truss, and her new Chancellor of the Exchequer Kwasi Kwarteng, have both noted they would prefer a mix of looser fiscal policy (aimed at boosting the supply side of the economy to lift potential growth) with tighter monetary policy that would prevent asset bubbles and inflation overshoots. While there is certainly merit in any plan designed to boost medium-term growth by lifting anemic UK productivity through supply-side reforms, the timing of the announcement could not have been worse. Just one day earlier, the BoE announced a plan to go forward with the sale of Gilts from its balance sheet accumulated during quantitative easing. The Truss government needs to find buyers for all the Gilts that must be issued to pay for the tax cuts and stimulus, but the BoE will not be one of them. In the end, however, the BoE’s expected path for interest rates matters more than the increase in Gilt supply in determining the level of Gilt yields and the slope of the Gilt curve. The NIESR estimates that the UK public debt/GDP ratio will rise to 92% by 2024-25, versus its pre-budget forecast of 88%. While that is a meaningful increase, the correlation between the debt/GDP ratio and the slope of the Gilt curve has been negative for the past few years (Chart 13, top panel). The stronger relationship is between the slope of the curve and the level of the BoE base rate (bottom panel), which is pointing to an inversion of the 2-year/30-year curve if the BoE follows market pricing and lifts rates to 6%. Our view dating back to the early summer was that a low neutral interest rate would prevent the BoE from lifting rates as much as markets were discounting without causing a deep recession, lower inflation and, eventually, a quick reversal of rate hikes. The huge UK fiscal stimulus package changes that calculus, as the nominal neutral rate that will be needed to bring UK inflation back to target is likely now much higher. We have always believed that when a thesis underlying an investment recommendation is challenged by new information, it is best to adjust the recommendation to reflect the new facts. Thus, this week, we are tactically downgrading UK Gilts to underweight in our model bond portfolio framework. We still see a significant medium-term opportunity to go overweight Gilts, as UK policy rates pushing into the 4-6% range are not sustainable. However, the BoE will likely have no choice to begin lifting rates at a much more aggressive pace to restore UK policy credibility, especially with the British pound under immense selling pressure (Chart 14). Despite rumors of an inter-meeting rate hike by the BoE this week to try and support the pound, that is likely too risky a step for the BoE to take as it would invite a battle with investors and currency speculators. Such a battle would be difficult to win without a more credible and market-friendly medium-term fiscal policy from the Truss government. Chart 13The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts Chart 14Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts   Bottom Line: We will review our UK Gilt stance once there are more clear signals of stability in the pound, but for now, we will step aside and limit our recommended exposure to Gilts – even after the huge selloff seen to date, which likely has more to go. Summarizing All The Changes In Our Model Bond Portfolio All the changes to our recommended duration exposure and country allocations after the past week, including the new weightings in our model bond portfolio, are shown in the tables on pages 14-16. To summarize: We moved the overall recommended global duration exposure to below-benchmark, and shifted the model bond portfolio duration to 0.9 years below that of the custom benchmark index. We increased the size of the US Treasury underweight, and moved Canada and Japan to overweight. We moved the UK to underweight, on top of the reduction in UK duration exposure that was part of last week’s move to reduce overall portfolio duration. We are also cutting exposure to UK investment grade corporates to underweight, as part of an overall move to reduce UK risk in the portfolio. We slightly increased the overweight in Germany. In next week’s report, we will present the quarterly performance review of our model bond portfolio and, more importantly, we will present out scenario-based return expectations after all the changes made this week. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com     GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The Global Bond Bear Market Continues The Global Bond Bear Market Continues The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) The Global Bond Bear Market Continues The Global Bond Bear Market Continues

Executive Summary We hold to our view that households are in better shape than widely perceived, nourished by a robust labor market and a formidable supply of pandemic savings. We do not believe that the equity bear market will derail our base-case scenario that consumption will keep the economy afloat over the next several quarters. Empirically, changes in equity wealth have exerted little to no impact on consumption. Housing does have a discernible wealth effect, and consumption may be more sensitive to falling home prices than rising ones. The sharp decline in home prices feared by many investors could prompt homeowners to retrench, realizing the number-one risk to our constructive view. Although home price appreciation is in the process of decelerating, housing remains undersupplied and home prices will not fall precipitously. Housing bubble chatter is unfounded. Consumption Declines Are Few And Far Between Consumption Declines Are Few And Far Between Consumption Declines Are Few And Far Between Bottom Line: Neither the equity bear market nor a softening housing market will stifle consumption. The Fed’s anti-inflation campaign will eventually induce a recession, but wealth effect concerns are overblown. Feature Flush consumers drawing down the mountain of excess savings they accumulated across 2020 and 2021 provide the foundation for our constructive near-term view on risk assets and the economy. Consumer retrenchment is one of the two principal risks to our stance1 and we would abandon it if a meaningful share of households began to cut back. We do not know that households will dip into their savings to keep consuming at something close to their trend pace – the scale of the fiscal transfers that fattened their bank accounts was unprecedented – but we view the low and declining savings rate as providing ongoing validation for our thesis. Households can sustainably dis-save relative to their post-crisis trend (Chart 1), as a 5% savings rate whittles down their remaining $2.1 trillion stash by just $150 billion per quarter. Chart 1An Extended Period Of Dis-saving Is Sustainable An Extended Period Of Dis-saving Is Sustainable An Extended Period Of Dis-saving Is Sustainable The wealth effect is real – household spending fluctuates with wealth – and one may question whether consumers will continue to spend amidst an equity bear market while the 3-percentage-point surge in mortgage rates pressures home values. As counterintuitive as it may seem, however, changes in equity wealth have had a modest and inconsistent effect on consumption. Changes in housing wealth have exerted greater influence, and one study by prominent researchers suggests that the effect is stronger when home prices decline. We consider the empirical evidence regarding equity and housing wealth effects, along with the prospects for a sharp decline in home prices, in this report. What Drives Spending? For all the talk of the wealth effect, consumer spending is predominantly a function of income. Every multi-factor regression we performed (Box 1) indicated that changes in nominal income account for the lion’s share of changes in nominal consumption, with estimates ranging up to 75%. When we regressed real consumption with real income and real measures of equity and housing wealth, the estimates of income’s effect were sharply lower – typically between 10 and 25% – but the modeled results were dramatically less robust. We accordingly focus on the nominal relationships in the rest of this report, though we note that the real regressions reinforced the nominal regressions’ pointed implication that changes in equity wealth are largely irrelevant for explaining changes in consumption. Box 1: A Regression Refresher Multi-factor linear regression is a statistical method for determining which independent variables influence the movements of a dependent variable. Regression analysis reveals the statistical significance of independent variables based on their empirical relationship with the dependent variable. If the relationship is robust enough that it is unlikely to have occurred randomly, the independent variable is deemed to be significant. The regression equation describes a best-fit line that minimizes the individual observations’ aggregate deviation from the line. It includes a constant term, b, marking the point where the best-fit line intersects the y-axis, and an x term that denotes each of the independent variables, paired with a coefficient, a. Each coefficient describes the sensitivity of the dependent variable to changes in the value of each independent variable. For dependent variable y, and independent variables x1, x2, …, xn, the equation is written as: y = a1x1 + a2x2 + … + anxn + b. The robustness of the regression is indicated by its r-squared value, ranging from 0 to 1, which quantifies the share of the dependent variable's movement that is explained by movement in the independent variables. In our research, we used Personal Consumption Expenditures and Personal Income from the National Income Accounts as our measures of consumption and income, respectively. We used the measure of corporate equities held by households and nonprofit organizations from the Fed’s quarterly Financial Accounts of the United States (report Z.1) to measure equity wealth and followed the methodology of Case, Quigley and Shiller (2005 and 2013)2 to calculate housing wealth.3 We also followed Case, Quigley and Shiller’s methodology in regressing the year-over-year percentage change in the natural log of the variables’ values. Homes Trump Stocks Simple regressions, measuring the empirical impact of a single independent variable upon a dependent variable, indicate that changes in equity wealth exert considerably less influence over changes in consumption than changes in housing wealth. With a two-quarter lag, year-over-year consumption has changed by nearly three cents for every dollar move in equity wealth (Chart 2). Three cents are in line with rule-of-thumb estimates, but we note that the regression’s r-squared is less than 3%. An unlagged year-over-year regression posits a 0.6-cent consumption change for every dollar move in equity wealth with a microscopic r-squared of 0.1%. Chart 2Equities' Relationship With Consumption Is Weak And Unreliable, ... The Wealth Of Households The Wealth Of Households The housing wealth regression indicates that every dollar of changes in housing wealth leads to a 38-cent change in consumption. With a 38% r-squared, the housing wealth regression generates a visibly tighter fit (Chart 3), inspiring more confidence in the posited relationship, though it is incomplete without considering any other variables’ role in influencing consumption. The housing wealth relationship is also considerably stronger on an unlagged basis (Table 1). Chart 3... Contrasting With Housing's Stronger, More Consistent Pull The Wealth Of Households The Wealth Of Households Table 1Simple Regression Output The Wealth Of Households The Wealth Of Households Chart 4Equities Are Owned By Low MPC Households The Wealth Of Households The Wealth Of Households It may seem surprising that relatively opaque changes in housing wealth exert a much stronger influence over consumption than immediately observable changes in equity wealth. We think the result is a function of the greater breadth of home ownership; nearly two-thirds of households own their home, and it is far and away the largest asset for all but the wealthiest of families. Stock ownership, on the other hand, is highly concentrated, with the top 1% of households by wealth owning over 50% of equities, and the top 10% owning nearly 90% of them (Chart 4). Fluctuations in the stock market mostly impact households with a low marginal propensity to consume but changes in home prices effect a much fuller sweep of Americans. The simple regressions set the stage for what we discovered when we performed multi-factor regressions, confirming previous researchers’ findings. Income is the primary driver of consumption, with a one-dollar change in nominal income provoking a 65-to-72-cent change in nominal spending, and its statistical significance in the models is beyond question (Table 2). Table 2Multiple Regression Output The Wealth Of Households The Wealth Of Households Equities’ wealth effect is not statistically significant in the unlagged model at a 5% significance level (it’s not even statistically significant at the more forgiving 10% significance level) and it is modest (about 1.5 cents on the dollar) in any event. The model would be better off without including equity wealth as an independent variable. In the model lagging consumption by two quarters, which produces a slightly better fit and accords more easily with our own intuition that wealth effects are not felt instantaneously, consumption moves inversely with equity wealth, falling 3 cents for every one-dollar increase in equity wealth and rising 3 cents for every one-dollar decrease. That result is statistically significant, albeit hard to wrap one’s head around. The housing wealth variable is comfortably significant even at a 1% significance level and its impact is quite large in both the unlagged (14.5 cents on the dollar) and the two-quarter-lagged (11.75 cents on the dollar) specifications. Both model specifications generate high r-squareds, explaining 58% and 60% of the variability in consumption, respectively, and the modeled values fit the actual values extremely well before the pandemic scrambled the relationship between consumption and its drivers (Chart 5). Chart 5A Tight Fit Before The Pandemic A Tight Fit Before The Pandemic A Tight Fit Before The Pandemic We also ran a version of the model that substituted Disposable Income for Personal Income, but it slightly weakened its explanatory power and we judge that the broader Personal Income series is a better input. We also ran a version of the model that used household real estate holdings and mortgage balances from the Fed’s quarterly Z.1 report to calculate a factor that translates gross housing wealth to net housing wealth to reflect that all households do not own their homes free and clear.4 Substituting net housing wealth reduced the model’s explanatory power by about two percentage points but left the individual variables’ significance largely intact while cutting housing’s unlagged and two-quarter lagged wealth effect to 7 and 5 cents, respectively (Table 3). Net housing wealth is more intellectually satisfying than gross housing wealth and the smaller wealth effect estimates are more in line with the peer-reviewed literature. Table 3Multiple Regression Output With Net Housing Wealth The Wealth Of Households The Wealth Of Households Whither Home Prices? Investors appear to be braced for a sizable decline in home prices even though nominal price declines are unusual in the five-decade history of the leading repeat sales price indexes. The Case-Shiller National Index has declined just 19% of the time on a sequential basis and 14% of the time on a year-over-year basis (Chart 6). Excepting the 21 consecutive quarters of year-over-year declines from 1Q07 through 1Q12, the Case-Shiller National Index has declined in just five quarters over 41 years, all during the 1990-91 recession that featured tax law changes sharply curtailing individuals’ ability to benefit from losses on real estate investments. The FHFA (née OFHEO) House Price Index has declined on a year-over-year basis just 11% of the time, with only one decline occurring outside of 2007 to 2012 (Chart 7). Chart 6Ex-The Crisis, Declines Are Rare, ... Ex-The Crisis, Declines Are Rare, ... Ex-The Crisis, Declines Are Rare, ... ​​​​​​ Chart 7... In Both Major Series ... In Both Major Series ... In Both Major Series ​​​​​​ Investors expecting a decline therefore appear to be anchoring to an extreme outlier. We cringe whenever we hear the term “housing bubble” used to liken today’s backdrop to the one that preceded the financial crisis. Make no mistake: it is not 2007 in the housing finance market in any way, shape or form. Residential mortgage originations have been made to vastly better borrowers than they were in the run-up to the crisis (Chart 8) and they’ve been made on far more solid terms, as the loan-to-value ratio for residential mortgages has shrunk by 25 percentage points in the immediate aftermath of the bust to its easily sustainable levels of the early ‘80s (Chart 9). Chart 8Mortgages Have Been Extended To Better Borrowers ... The Wealth Of Households The Wealth Of Households Chart 9... On Better Terms Than Before The Crisis ... On Better Terms Than Before The Crisis ... On Better Terms Than Before The Crisis Chart 10Housing Supply Is Tight Housing Supply Is Tight Housing Supply Is Tight Housing is broadly undersupplied, as evidenced by the record-low home vacancy rate (Chart 10). Higher mortgage rates have surely put monthly payments out of the reach of some aspiring buyers, sending them to the sidelines, but supply remains constrained and home prices fall slowly. Kahneman and Tversky demonstrated that people are quick to take gains by selling appreciated assets but slow to part with assets that are under water. Even if we are underestimating the eventual magnitude of a decline in home prices, we are confident that the decline will not be sudden. Homeowners with discretion over when they sell will wait to exercise it; turnover will slow as pricing softens and the reduced supply will help to mitigate the declines. Investment Implications We were inspired to explore the housing wealth effect by a striking assertion featured in a leading market periodical two weeks ago. An independent strategist stated that the wealth effect from a one dollar decline in home prices was a whopping 40 cents, while the effect of a like decline in equity prices was 10 cents. The assertion was passed on without comment or criticism by the publication, which has long touted its skepticism and unwillingness to accept bullish statements at face value. Alas for its readers, the standard apparently does not apply to bearish claims, no matter how far off the beam they may be. (Based on our results, we suspect these wealth effect estimates are based on simple regressions.) Divergent views are what make a market, but nothing in the body of peer-reviewed research supports the idea that the $6.5 trillion decline in directly owned equities and a hypothetical 10% decline in home equity from its nearly $30 trillion June 30th level will extinguish $650 billion and $1.2 trillion of consumption, respectively. That nearly $2 trillion hit would be punishing, given consumption's current $17 trillion annualized pace. It would also be unprecedented: since the Personal Consumption Expenditures series began in 1950, nominal consumption has only ever declined by a margin that can be seen by the naked eye during the Great Recession and the COVID pandemic (Chart 11). Those historic declines amounted to 3.5% from the 3Q08 peak to the 2Q09 trough and 11.4% from the 4Q20 peak to the lockdown 2Q21 trough. Chart 11Visible Declines In Nominal Spending Are Rare Visible Declines In Nominal Spending Are Rare Visible Declines In Nominal Spending Are Rare We are only too happy to take the other side of the view that another 11% decline could be in store, assuming the absence of nuclear war or another pandemic. We think the 3.5% Great Recession decline will likely remain out of reach, as well, given that the financial crisis emerged from a concatenation of events that cannot repeat now that regulators have so thoroughly clipped the banking system’s wings. Not every investor subscribes to Chicken Little warnings about the housing market, but the promiscuity with which the term bubble is thrown around strongly suggests to us that the consensus view overestimates the probability of a dire economic outcome. When subsequent events reveal that the shock probability has been overstated, the consensus economic and S&P 500 earnings views will have to be revised upward and we believe the eventual revisions will provide risk assets with a path to recover some of the ground they’ve lost this year. We continue to believe that it would be premature to implement full-on defensive asset allocation measures before they do.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      A breakout in long-run inflation expectations is the other. 2      Case, Karl E., John M. Quigley, and Robert J. Shiller, “Comparing Wealth Effects: the Stock Market versus the Housing Market,” Advances in Microeconomics, 5(1),2005: 1-32.  Case, Karl E., John M. Quigley, and Robert J. Shiller, “Wealth Effects Revisited: 1975-2012,” NBER Working Paper 18667, January 2013. 3      Case, Quigley and Shiller calculate housing wealth in time t, HWt, as the product of the number of US households, Nt, the homeownership rate, ORt, the average price of a single-family home in the base period (1Q75 in our study), AVGBASE, and a weighted repeat sales price index relative to its base period value, (PIt/PIBASE). We used the National Association of Realtors’ average existing home price series and the Case-Shiller National Index for variables AVG and PI, respectively, as per the following equation: HWt = Nt × ORt × AVG1Q75 × (PIt/PI1Q75) 4     HWt, described in the second footnote, is a gross measure of housing wealth. We divided outstanding mortgage debt by the value of households’ real estate holdings to calculate the aggregate residential mortgage loan-to-value ratio, LTV. We subtracted LTV from 1 to calculate the share of housing value that represented households’ aggregate home equity and multiplied it by HWt to produce an estimate of net housing wealth, NHW: NHWt = HWt × (1 – LTVt)