Inflation/Deflation

Executive Summary European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Corporate bond spreads in the US and Europe have widened since early April, with European credit taking a bigger hit because of worsening growth and inflation momentum. European corporate bond valuations look fairly cheap, both for investment grade and high-yield.  This is true in absolute terms but also relative to the US, where spread valuations are more mixed.  An easing of stagflation fears in Europe is a necessary condition for a valuation convergence with the US. The US investment grade credit curve is steep relative to the overall level of credit spreads, making longer-maturity corporates more attractive. Energy bonds offer the most compelling combination of valuation and fundamental support (from high oil prices) within US investment grade. Within US high-yield, Energy valuations look much less compelling after the recent outperformance. The best medium-term industry values in European credit are in investment grade Financials and high-yield Consumer Cyclicals & Non-Cyclicals. Bottom Line: Continue to favor both US high-yield and European investment grade corporates versus US investment grade.  Stay neutral high-yield exposure on both sides of the Atlantic.  Within Europe, stay up in quality within both investment grade and high-yield until near-term macro risks on growth & inflation subside. Feature Corporate bonds in the US and Europe have gone through a rough patch in recent weeks, underperforming government bonds in response to the “triple threat” of high inflation, tightening monetary policy and slowing growth momentum.  European credit has taken the more severe hit compared to the US, with markets pricing in greater risk premia because of additional regional threats to growth (and inflation) from the Ukraine war. In this Special Report, jointly presented by BCA Research US Bond Strategy and Global Fixed Income Strategy, we assess credit spread valuations in US and European corporates after the latest selloff, across credit tiers, maturities and industry groups.  Stay Cautious On US Corporate Bonds Chart 1US Credit Spreads US Credit Spreads US Credit Spreads In a recent Special Report, we argued in favor of a relatively defensive allocation to US corporate bonds. Specifically, we advised investors to adopt an underweight (2 out of 5) allocation to US investment grade corporates and a neutral (3 out of 5) allocation to US high-yield. Our rationale was that a flat US Treasury curve signaled that we were in the middle-to-late stages of the economic recovery. Additionally, at the time, corporate bond spreads weren’t all that attractive compared to the average levels seen during the last Fed tightening cycle (Chart 1). Spreads have widened somewhat since we downgraded our allocation and, as such, we see some scope for spread tightening during the next few months as inflation rolls over and the Fed lifts rates by no more than what is already priced in the curve. That said, with the Fed in the midst of a tightening cycle, we think it’s unlikely that spreads can stay below average 2017-19 levels for any meaningful length of time. As a result, we maintain our current cautious allocation to US corporate bonds. US High-Yield Versus US Investment Grade The recent period of US corporate bond underperformance can be split into two stages based on the relative performance of investment grade and high-yield. US investment grade underperformed junk in the early stages of the selloff (between September and mid-March), as spread widening was driven by the Fed’s shift toward a more restrictive policy stance and not a meaningful uptick in the perceived risk of a recession and/or default wave (Chart 2A). Chart 2ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff But recession and default fears started to ramp up in mid-March, and this caused high-yield to join the selloff (Chart 2B). In fact, US investment grade corporates managed to recoup some of their earlier losses while lower-rated junk bonds struggled to keep pace. Chart 2BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff We contend that the risk of a meaningful uptick in corporate defaults during the next 12 months is low. In fact, we estimate that the US high-yield default rate will fall to between 2.7% and 3.7% during the next year, well below the 5.2% currently priced into junk spreads. Going forward, we expect the US corporate bond landscape to be defined by increasingly restrictive monetary policy and a benign default outlook. As we noted in the aforementioned Special Report, this environment is reminiscent of the 2004-06 Fed tightening cycle when high-yield bonds performed much better than investment grade. Investors should maintain a preference for high-yield over investment grade within an otherwise defensive allocation to US corporate bonds. US Industry Groups Chart 3A shows the performance of US corporate bonds in the early stages of the recent selloff, but this time split by industry group. High-yield Energy sticks out as a strong outperformer, though we also notice that every high-yield sector performed better than its investment grade counterpart. Chart 3ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 3B once again shows how the relative performance between investment grade and high-yield has flipped since mid-March, though we see that high-yield Energy, Transportation and Utilities have performed better than the rest of the index.  Chart 3BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Interestingly, despite the strong outperformance of high-yield Energy bonds, investment grade Energy credits performed mostly in line with other investment grade sectors. We believe this presents an excellent opportunity.  The vertical axis of Chart 4A shows our measure of the risk-adjusted spread available in each investment grade industry group. Our risk-adjusted spread is the residual after adjusting for each sector’s credit rating and duration. The horizontal axis shows each sector’s Duration-Times-Spread as a simple measure of risk. Our model shows that Financials, Technology, Energy, Utilities, Communications and Basic Industry all stand out as attractive within the investment grade corporate bond universe. We identify the investment grade Energy sector as a particularly compelling buy. Chart 4AUS Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff In a prior report, we demonstrated, unsurprisingly, that the oil price is an important determinant of whether Energy bonds perform better or worse than the rest of the corporate index. With our commodity strategists calling for the Brent crude oil price to average $122/bbl next year, this will provide strong support to Energy bond returns. Cheap starting valuations for investment grade Energy bonds make them look even more compelling. Chart 4B repeats our valuation exercise but for high-yield industry groups. Within high-yield, we find that Financials, Transportation, Communications and Consumer sectors stand out as attractive. Interestingly, high-yield Energy bonds now look slightly expensive compared to the rest of the junk bond universe, a result of the sector’s recent incredibly strong performance. Chart 4BUS High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff US Credit Curve We define the credit curve as the difference in option-adjusted spread between the “Long Maturity” and “Intermediate Maturity” sub-indexes for each investment grade credit tier, as defined by Bloomberg. We exclude high-yield from this analysis because very few high-yield bonds are classified as “Long Maturity”. To analyze the credit curve, we observe that credit curves tend to be steeper when credit spreads are tight, and vice-versa. This is because tight spreads indicate that the perceived near-term risk of default is low. As a result, short-maturity spreads tend to be lower than spreads at the long-end of the curve. Conversely, a wide spread environment indicates that the perceived near-term risk of default is high, and this risk will be more reflected in shorter maturity credits. Charts 5A, 5B and 5C show the slopes of the credit curves for Aa, A and Baa-rated securities. Immediately we notice that credit curves are positively sloped in each case, and also that each credit curve is somewhat steeper than would be predicted based on the average spread for the overall credit tier. Chart 5AAa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5BA-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5CBaa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff This strongly suggests that investors should favor long-maturity over short-maturity US investment grade corporate bonds. European Corporates Look Cheap Vs. US Equivalents – For Patient Investors Chart 6European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks Turning to the euro area, the Bloomberg investment grade OAS and high-yield OAS currently sit at 167bps and 490bps, respectively (Chart 6). These levels are well below the peaks seen during the 2020 COVID recession and the 2011/12 European debt crisis, but are in line with the spread widening episodes in 2014/15 and 2018. Our preferred measure of credit spread valuation, 12-month breakeven spreads, show that European investment grade and high-yield spreads are in the 75th and 67th percentile of outcomes, respectively, dating back to the inception of the euro in 1998 (Chart 7).1 These are both higher compared to the breakeven percentile rankings for US investment grade (48%) and US high-yield (52%). The gap between the breakeven percentile rankings for investment grade bonds in the euro area versus the US is the widest seen over the past two decades.  That gap reflects the fact that European economic growth has softened versus the US according to the S&P Global manufacturing PMIs, while European inflation has accelerated towards very elevated US levels (Chart 8).  Chart 7European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Chart 8European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation Both of those trends are a product of the Ukraine war, which has led to a massive spike in European energy costs given the region's huge reliance on Russian energy supplies, particularly for natural gas. While the US has also suffered a massive increase in its own energy bills, the inflation spike has been higher in Europe, leading to a bigger drag on economic confidence and growth. Thus, the widening spread differential between corporate bonds in Europe relative to the US likely reflects a growth-related risk premium. Chart 9A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? As euro area inflation has ratcheted higher, so have expectations of ECB monetary tightening. The euro area overnight index swap (OIS) curve now discounts 172bps over the next 12 months, a huge swing from the start of 2022 when markets were expecting the European Central Bank (ECB) to stand pat on the interest rate front. In comparison, markets are pricing in another 224bps of Fed tightening over the next 12 months, even after the Fed has already delivered 75bps of tightening since March. Importantly, the gap between our 12-month discounters, which measure one-year-ahead interest rate changes discounted into OIS curves, for the US and Europe has proven to be a reliable leading indicator – by around nine months - of the relative year-over-year excess returns (on a USD-hedged basis) of European and US corporate bonds, especially for investment grade (Chart 9). The fact that this is a leading relationship suggests that the upward repricing of ECB rate expectations seen so far in 2022 is not yet a reason to turn more cyclically negative on European corporate bonds versus the US. The earlier upward repricing of expected Fed tightening is the more relevant factor, and is signaling that both US investment grade and high-yield corporates should underperform European equivalents over at least the rest of 2022.  BCA Research Global Fixed Income Strategy already has a recommended allocation along those lines, with an overweight to euro area investment grade and an underweight to US investment grade. While the trade has underperformed of late, the combined messages from the relative 12-month breakeven spread rankings (cheaper European valuations) and 12-month discounters (the Fed is further ahead in the tightening cycle) leads us to stick with that relative cross-Atlantic tilt. The main risk to that stance is any deterioration of the flow of energy supplies from Russia to Europe that results in a stagflationary outcome of a bigger growth slowdown with even faster inflation. That is a scenario that would make it difficult for the ECB to back down from its recent hawkish forward guidance, resulting in European corporate spreads incorporating an even wider risk premium.  Given that near-term uncertainty, we are advocating that investors maintain no relative tilt on more growth-sensitive, and riskier, European high-yield relative to the US – stay neutral on both. Stay Up In Quality On European Corporates Looking at euro area corporate debt across credit ratings and maturity buckets, there are few compelling immediate valuation stories in absolute terms, although there are potential opportunities unfolding on a relative basis.  Within investment grade, credit quality curves have steepened during the recent selloff, with lower-rated credit seeing larger spread widening (Chart 10). The gap between Baa-rated and A-rated European corporate spreads now sits at 52bps, right in the middle of the 25-75bps range since 2014. In high-yield, the gap between Ba-rated and B-rated credit spreads is 222bps, and the gap between B-rated and Caa-rated spreads is 370bps (Chart 11) – both are still below the previous peaks in those relationships seen in 2012, 2015 and 2020. Chart 10European IG Credit Quality Curve Can Steepen ##br##More European IG Credit Quality Curve Can Steepen More European IG Credit Quality Curve Can Steepen More Chart 11European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks For both investment grade and high-yield, there is still room for credit curves to steepen if European growth expectations continue to deteriorate. However, when looking at spread valuations across the credit quality spectrum, and across maturity buckets, euro area corporate spreads look much cheaper than US equivalents. In Chart 12, we show a snapshot of the current 12-month breakeven percentile rankings for individual credit quality tiers and maturity groups, for investment grade and high-yield in the euro area and US.  The relative attractiveness of European credit relative to the US is evident, with European spreads now at higher percentile rankings across all quality tiers and maturity buckets. The largest gaps between 12-month breakeven percentile rankings are in the +10 year maturity bucket, the AAA-rated and AA-rated investment grade credit tiers, and the Ba-rated high-yield credit tier. This suggests any trades favoring European corporates versus the US should stay up in credit quality. Chart 12Corporate Spread Valuations By Maturity & Credit Rating Favor Europe Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Comparing European & US Industry Spread Valuations When looking at the industry composition of the euro area and US corporate bond indices, there are a few major notable differences. Within investment grade, there is a greater concentration of Energy and Technology names in the US, while Financials are more represented in the European index (Chart 13).  Those same three industries also have the largest relative weightings in the high-yield indices (Chart 14), although there is also a slightly larger weighting of high-yield Transportation companies in Europe compared to the US.  This means that a bet on European credit versus the US is essentially a bet on European Financials versus US Energy and Technology. Chart 13Investment Grade Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 14High-Yield Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff When looking at the same sector metrics that were shown earlier in this report for the US – comparing risk-adjusted spreads to Duration-Times-Spread – we find some interesting cross-Atlantic valuation differentials. For investment grade in Europe (Chart 15), only Energy and Financials have positive risk-adjusted spread valuations (after controlling for duration and credit quality), while having the highest level of risk expressed via Duration-Times-Spread. This contrasts to the US where more sectors have positive risk-adjusted spreads - Energy, Financials, Utilities, Basic Industry and Communications. Investors should favor the latter three industries in the US relative to Europe. Chart 15Euro Area Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Within high-yield in Europe, Energy and Financials also offer positive risk-adjusted valuations, but so do Consumer Cyclicals and Consumer Non-Cyclicals (Chart 16). This lines up similarly to US high-yield valuations. The notable valuation gaps exist in Transportation and Communications, which look cheap in the US and expensive in Europe, creating potential cross-Atlantic relative value trade opportunities between those sectors (and within an overall neutral allocation to junk in both regions). Chart 16Euro Area High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 12-month breakeven spreads measure the amount of spread widening that would be necessary to make the return on corporate bonds equal to that of duration-matched government bonds over a one-year horizon.  The spread is calculated as a ratio of the index OAS and index duration for the relevant credit market. We look at the historical percentile ranking of that ratio to make a more “apples for apples” comparison of spreads that factors in index duration changes over time. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Selloffs across financial markets and evidence of decelerating growth have reminded us to play it close to the vest, but they haven't made us bearish. The stability of intermediate- and long-run inflation expectations suggests that the inflation genie has not yet gotten out of the bottle and that the Fed will be able to hold off on squashing the expansion until late 2023 or early 2024. Households' willingness to dip into their excess savings to maintain their spending in the face of inflationary pressures bodes well for the economy for the remaining year and a half that the excess savings cushion can be expected to last. The definitive causes of reduced labor force participation continue to elude researchers but we expect participation will improve over the rest of the year as the low-paid workers responsible for the exodus return to the grind. The Fed Fever Has Broken The Fed Fever Has Broken The Fed Fever Has Broken Bottom Line: Investors have no end of things to worry about, but we remain disposed to see the glass as half-full. We expect the expansion to continue at least into the second half of 2023 and that risk assets will generate positive excess returns over Treasuries and cash for the next twelve months. Feature We have begun meeting clients face-to-face again, in addition to continuing with conference calls. Our discussions with investors and colleagues highlight how uncertain the market and economic landscapes remain. Conditions remain especially uncertain and our views depend on the flow of data; as more pieces of the puzzle emerge, the way we assemble it is subject to change. Conviction Levels In Uncertain Times You are among the optimists at BCA and have been for a while. Are the equity selloff and the current slowdown making you nervous? Do you still see the glass as half-full? It’s our job to be nervous. The way we see the money management ecosystem, managers are responsible for worrying for their clients and we’re responsible for worrying for the managers. We continually ask how we could be getting it wrong and actively seek out information that challenges our view. We are neither foolish nor inexperienced enough to be overconfident; we’re always looking over our shoulder and our head has been on a swivel ever since the pandemic arrived. Related Report  US Investment StrategyIt All Depends On Whom You Ask The recent equity decline and growth deceleration have not materially changed our already low conviction level. All investment researchers look backward to look forward. That is to say that we review past interactions between macro variables and financial assets for guidance about future interactions. We even build regression models to formalize our empirical studies, though we keep them in their proper place. We know that models have blind spots and do not rely solely on them any more than we would change lanes on the highway based only on a glance at our rear-view mirrors. A central challenge of the last two-plus years has been that real-time conditions are so unusual that there is little historical framework for evaluating them. Much of what has occurred over that stretch has lacked a close precedent: vast swaths of the economy had not previously been idled in the interest of public safety; Congress did not appropriate 25% of a year’s GDP for distribution to households, businesses and state and local governments in any prior 13-month stretch; job losses had not been so starkly concentrated among unskilled workers while leaving knowledge workers largely unscathed; aggregate household savings and net worth have never risen so much, so fast; and central banks have launched campaigns that would make William McChesney Martin’s head spin, much less Walter Bagehot’s. The scope of the economic challenges and the novelty of the policy responses limit the usefulness of analytical methods that depend on the notion that the future will largely resemble the past. It is therefore too soon to tell if we should be more nervous. As we write, the S&P 500 has blasted 8% off its intraday lows five sessions ago and incoming economic data continue to resist a blanket bullish or bearish interpretation. We empathize with investors’ impatience; one would think that the key macro questions should be settled by now, given how long we’ve been discussing them. They are not settled, though, and we will revisit open debates as new data arrive. The Term Structure Of Inflation Expectations Real-time inflation prints are terrible and much more concerning than tame inflation expectations. Why are you focusing almost exclusively on inflation expectations? We have been keeping a close eye on the course of inflation expectations over time, or their term structure, ever since inflation began to emerge from its extended hibernation. As unsettling as it has been to witness 40-year highs in inflation, we have taken solace from the fact that market prices have uniformly indicated that businesses and investors expect that inflation will recede to familiar levels over the longer run. As indicated by the arrows in the right-hand column, long-term inflation expectations are considerably lower than near-term expectations as implied by the TIPS and nominal Treasury markets (Table 1, top panel) and directly indicated by CPI swaps (Table 1, bottom panel). Expressed as a continuous time series, neither the Treasury (Chart 1, top panel) nor the CPI swaps (Chart 1, bottom panel) market has wavered in its view that high inflation will not persist beyond the near term. Table 1The Inflations Expectations Curve Is Sharply Inverted Another Round Of Questions Another Round Of Questions   That is important because it suggests that neither businesses nor investors will need to adjust their strategies to accommodate a lasting upward inflection in price pressures. For businesses, that means that they don’t foresee a need to fight tooth and nail to pass along increased costs. Investors continue to be content with nominal long-term Treasury yields vastly below current year-over year inflation, investment-grade corporate yields that are about half of it and high-yield corporate yields that are a percentage point below it. Chart 1Investors And Businesses Don't Foresee A Lasting Change ... Another Round Of Questions Another Round Of Questions ​​​​​​ Chart 2... And Neither Do Households ... And Neither Do Households ... And Neither Do Households Although high inflation seems to have spooked the households responding to University of Michigan consumer sentiment survey takers, they remain unperturbed about its long-run direction. The difference between University of Michigan respondents’ long-run and near-term inflation expectations remains around multi-year lows (Chart 2), as 5-year expectations have held steady at 3% for three straight months. The inference that University of Michigan survey respondents expect high inflation to be fleeting is supported by their views on the advisability of big-ticket purchases. The share of respondents who deem it a bad time to buy a car because prices are (temporarily) high remains near all-time high levels (Chart 3, middle panel), while those who think buying now is auspicious because prices won’t come down is near all-time lows (Chart 3, top panel). The difference between the two continues to set record lows (Chart 3, bottom panel). The consensus view on consumer durables purchases is the same – now is a bad time to buy because high prices won’t last (Chart 4). The economic takeaway is that consumers are willing to bide their time until prices come back to earth and will not exacerbate upward price pressures by clamoring to buy before prices go even higher. Chart 3Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Chart 4... Instead Of Exacerbating Them By Rushing To Buy Now ... Instead Of Exacerbating Them By Rushing To Buy Now ... Instead Of Exacerbating Them By Rushing To Buy Now Bottom Line: Economic participants adjust their behavior based on their long-run inflation expectations. If they think the current fever will break, businesses, investors and consumers will not act in ways that fuel a self-reinforcing cycle in which high prices beget still higher prices. The longer that economic actors expect inflation pressures will abate, the greater the chance that they will. Interest Rates And The Fed You’ve been calling for interest rates to stop backing up, but it still feels like they only want to rise. It has been quite a ride from 1.72% on 10-year Treasuries from the beginning of March to 3.12% at the beginning of May, but we have gotten 40 basis points of retracement over the last three weeks (Chart 5). The nearly unanimous view that rates would keep rising was a contrarian sign that the move may have been played out. Reduced expectations for Fed rate hikes have also played a part in bringing yields down. After peaking at 3.45% on May 3rd, the day before the FOMC wrapped up its May meeting, the expected fed funds rate in twelve months is down to 3.09% (Chart 6). Chart 5The Benchmark Treasury Yield ... The Benchmark Treasury Yield ... The Benchmark Treasury Yield ... ​​​​​ Chart 6... Has Moved With Rate-Hike Expectations ... Has Moved With Rate-Hike Expectations ... Has Moved With Rate-Hike Expectations ​​​​​​ Chart 7Everything, All At Once Everything, All At Once Everything, All At Once While the prevailing view among commentators is that the Fed waited too long to begin removing monetary accommodation, financial markets have moved swiftly to price in a policy shift. Chair Powell and his colleagues have been taking every opportunity to communicate their seriousness about combating inflation and financial conditions have responded to their public relations campaign without delay (Chart 7, top panel) – yields have backed up (Chart 7, second panel), spreads have widened (Chart 7, third panel), stocks have fallen (Chart 7, fourth panel) and the dollar has surged (Chart 7, bottom panel). Our Global Investment Strategy colleagues argue that the Fed may soon perceive that tighter financial conditions threaten its soft landing goals and dial back the hawkish rhetoric if inflation eases in line with our house view. The Fed’s hawkish surprises might be behind us for the time being. Lightning Round You have argued that households will be more inclined to spend their excess pandemic savings than hoard them and that those savings will provide a buffer against inflation’s bite. The latest Personal Income Report showed that April’s savings rate was nearly half of its pre-pandemic level; are you now worried that the savings are going too fast to cushion the economy? We stand by our view that households will spend their excess savings and continue to think our guesstimate that they will spend half of them will prove to be conservative. We consider the declining savings rate – 6% in January, 5.9% in February, 5% in March and 4.4% in April, versus February 2020’s 8.3% – to be good news, indicating that socked-away stimulus payments are having the beneficial time-release effect of keeping the consumer afloat despite high inflation. We calculate that April’s accelerated consumption as a share of disposable income amounted to $60 billion of dis-savings relative to our no-pandemic baseline estimate, knocking excess savings down to $2,150 billion. At that rate, one-half of the excess balance will last for another 17 months. Will labor force participation ever get back to its pre-pandemic levels? If it doesn’t, upward wage pressures could be greater than you expect, and a wage-price spiral could be brewing. No one has satisfactorily determined why participation remains muted. It seems most likely to us that COVID fears, as indicated by the Census Bureau’s Household Pulse Survey, are the principal driver. Lavish stimulus measures may have played a role as well, though their tailwind has surely faded for households at the bottom rungs of the wealth and income distribution. We expect that participation will recover across the rest of the year as COVID morphs from acute threat to manageable nuisance and as the low-income workers who account for the shrinkage in the labor force (Chart 8) are pressed by financial exigency to return to the grind (Chart 9). Chart 8Those Who Have Left The Work Force ... Those Who Have Left The Work Force ... Those Who Have Left The Work Force ... ​​​​​ Chart 9... May Have To Come Back Soon ... May Have To Come Back Soon ... May Have To Come Back Soon ​​​​​​ What is your view on inflation? If you think recession fears are overblown, you must not think inflation will be bad enough over the rest of the year to induce the Fed to kill the expansion. The difference between our view and the recession-is-imminent crowd’s is merely one of timing. We expect inflation will abate enough over the rest of the year that the Fed won’t have to break up the party until late 2023/early 2024. We do think, however, that Congress and the Fed overstimulated demand in the wake of the pandemic and sowed the seeds for the eventual end of the expansion and the bull markets in equities and credit. We don’t think the overstimulation will manifest itself until late 2023 or early 2024, however, so we expect that the expansion and the bull markets in risk assets will trundle along for another year. Housekeeping We planned to dial up the risk exposures in our ETF portfolio this week, in line with BCA’s recent tactical equity upgrade to overweight from neutral. It isn’t always easy to make tactical recommendations on a weekly publication schedule and while waiting out a five-and-a-half-hour flight delay at O'Hare last Friday, we wished that we could have pushed a button to increase our equity allocation. Now that the S&P 500 has rallied over 6.5% week-to-date as we go to press, we are going to hold off on making any adjustments until next week at the earliest. With apparent short-term resistance just 1% away at 4,200 (the previous triple-bottom support level), we expect that we may find a better entry point and are willing to wait patiently for it.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

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

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

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

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

Executive Summary KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Global financial markets appear to be moving away from inflation worries to pricing in a major growth slump. Global growth is downshifting, and financial markets have not yet priced this in. Given that the US dollar is a countercyclical currency, it will remain firm despite lower US growth and interest rate expectations. Emerging Asian currencies will drop further. A new currency trade: Go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile.   Recommendation INITIATION DATE RETURN Short KRW / Long JPY 2022-05-26   Bottom Line: Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields will likely roll over and bonds will outperform stocks in the near-term.     Global financial markets appear to be moving away from worries about inflation to pricing in a major growth slump. The recent simultaneous drop in US Treasury yields and US share prices indicate that the market theme is shifting from inflation to a growth scare. Chart 1A Sign of Peak In Bond Yields A Sign of Peak In Bond Yields A Sign of Peak In Bond Yields Interestingly, high-yielding currencies such as AUD, NZD, and CAD have recently started underperforming low-yielding JPY and CFH (Chart 1, top panel). The former are a play on global growth while the latter are vulnerable to rising US interest rates. Thus, the financial markets’ theme seems to be moving from inflation to weaker growth. The facts that this currency ratio correlates with 10-year US Treasury yields and has rolled over at its previous peaks signal that investors’ global growth concerns will likely intensify (Chart 1, top and bottom panels). As such, this currency ratio and US bond yields will continue drifting lower. Overall, the next phase of the selloff in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. A pertinent question for investors is whether global risk assets have already priced in a global growth slump. Is A Global Slowdown Priced In? Our hunch is that the unfolding global economic slowdown is not yet fully priced in global financial markets. Chart 2Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink In the near term, global share prices will continue to falter and odds are rising that US bond yields are putting in a major top. In short, global stocks will underperform US bonds, and the USD dollar will remain firm: First, global trade volumes are heading into contraction (Chart 2). Global export volumes are set to contract as US and European demand for goods ex-autos shrinks following the pandemic binge. Meanwhile, China’s recovery has been delayed to Q3. We discussed the reasons why we expect global exports will contract in H2 2022 in our April 21 report. Declining global trade volumes will support the greenback in the near term because the broad trade-weighted US dollar does well when global growth is weakening. Besides, US dollar liquidity is rapidly decelerating, which is also positive for the broad-trade weighted US dollar (the latter is shown inverted in Chart 3). Second, US rail carload is contracting, pointing to weakening growth in America (Chart 4). Chart 3No Sign Of Reversal In Trade-Weighted USD No Sign Of Reversal In Trade-Weighted USD No Sign Of Reversal In Trade-Weighted USD Chart 4US Growth Is Downshifting US Growth Is Downshifting US Growth Is Downshifting Related Report  Emerging Markets StrategyA Whiff Of Stagflation? This does not mean that a US recession is imminent. Yet, as we discussed in past reports US corporate profits can contract modestly even if GDP slows but does not contract. Third, US EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10% (Chart 5). Similarly, although our forward-looking indicator for EM EPS points to a contraction 12-month forward EPS growth expectations are still at 10% (Chart 6). Chart 5US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded Chart 6EM EPS Are Set To Contract EM EPS Are Set To Contract EM EPS Are Set To Contract We expect slower top line growth and shrinking profit margins to cause US and EM corporate profits to contract by about 5% and 10-15%, respectively, in the next 12 months. In brief, neither US nor EM stocks have priced in negative profit growth. Fourth, Chart 7 illustrates that slowing global broad money growth is typically associated with a compression in the P/E ratio of global equities. As of now, there are no sign of reversal in global broad money growth and equity multiples. Chart 7Will Global Equity Multiple Compression Continue? Will Global Equity Multiple Compression Continue? Will Global Equity Multiple Compression Continue? Chart 8US Stocks Are Set To Underperform US Treasurys In Near Term US Stocks Are Set To Underperform US Treasurys In Near Term US Stocks Are Set To Underperform US Treasurys In Near Term Finally, sentiment towards US stocks is very elevated relative to sentiment towards US Treasurys (Chart 8, top panel). Yet, the composite momentum indicator for the US stock-to-bond ratio is breaking below the zero line (Chart 8, bottom panel). This breakdown warns of a period of equity underperformance versus US Treasurys, which would be consistent with pricing in a material economic slowdown. As US growth slows, will the Fed back off from its hawkish rhetoric? Yes, it will tone down its hawkishness at a certain point – but it will not do so immediately. The basis is that even though core US inflation will roll over, it will remain well above 4% versus the Fed’s 2% target. Importantly, wages are a lagging variable, and they will surprise to the upside in the near-term amid tight labor market conditions. This will lead the Fed to err on the hawkish side to manage upside risks to inflation and inflation expectations. All in all, the Fed is not about to do a policy U-turn in the near term. Therefore, we maintain our view that the Fed and stock markets remain on a collision course. Bottom Line: Global growth is downshifting, and financial markets have not yet priced this in. As a result, US bond yields will likely roll over and bonds will outperform stocks in the near term. The US dollar as a countercyclical currency will remain firm despite lower US growth and interest rate expectations. Emerging Asian Currencies Will Depreciate Further Asian export volumes will contract in H2 2022. This is negative for emerging Asian currencies. Chart 9Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian exchange rates correlate with global trade and global manufacturing cycles, and these currencies will depreciate as global consumer goods demand shrinks (Chart 9). We use an equally-weighted average of KRW, TWD, SGD, THB, PHP and MYR versus the USD to measure the performance of emerging Asian currencies. We exclude the CNY and JPY as they exhibit different dynamics. Chinese imports of various goods and commodities were already contracting in March, prior to the broadening of mainland lockdowns (Chart 10). Weak demand from China will weight on other Asian economies. The CNY is likely to weaken a bit more versus the US dollar due to the challenges facing the Chinese economy. This will reinforce further depreciation in emerging Asian currencies. Relative share prices of global cyclicals versus defensives also point to more downside in emerging Asian currencies (Chart 11). Chart 10Chinese Imports Were Contracting Prior Lockdowns Chinese Imports Were Contracting Prior Lockdowns Chinese Imports Were Contracting Prior Lockdowns Chart 11Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio   Bottom Line: An impending contraction in Asian export shipments is negative for emerging Asian currencies. A New Trade: Long Japanese Yen / Short Korean Won One way to play the global trade contraction and peak in US interest rate expectations themes is to go long the JPY / short the KRW: The Korean won typically depreciates versus the Japanese yen when (1) the global manufacturing cycle enters a downtrend and (2) US bond yields decline (Chart 12). These two macro forces are about to transpire and will help the JPY to outperform the KRW. Chart 12KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Chart 13Trade-Weighted Yen Is At Its Historic Lows Trade-Weighted Yen Is At Its Historic Lows Trade-Weighted Yen Is At Its Historic Lows The Japanese yen has already depreciated significantly versus both the USD and the Korean won. In fact, the trade-weighted yen is close to its historic lows (Chart 13). In addition, investors are very short the yen (Chart 14). The overhang of short positions could cause a violent reversal in the JPY/USD exchange rate.   The Japanese yen is extremely cheap according to the real effective exchange rate based on unit labor costs (Chart 15, top panel). By that same measure, the Korean won is not cheap (Chart 15, bottom panel). Chart 14Investors Are Very Short Yen Investors Are Very Short Yen Investors Are Very Short Yen Chart 15The Yen Is Much Cheaper Than The Korean Won The Yen Is Much Cheaper Than The Korean Won The Yen Is Much Cheaper Than The Korean Won   Bottom Line: We recommend that investors go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile. On February 2, 2022, we booked profits on our short KRW/long USD position, which we initiated on March 25, 2021. Investment Recommendations Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields are likely peaking. Favor bonds over stocks within both global and EM balanced portfolios. Although the US dollar’s bull market is advanced, a final upleg is likely. Stay short the following EM currencies versus the US dollar: ZAR, PLN, HUF, COP, PEN, PHP and IDR. Consistently, emerging Asian currencies have more downside. A major buying opportunity in EM local currency bonds will emerge once the US dollar begins its descent.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Highlights The economic and financial market developments that have occurred over the past month are consistent with several of the risks that we identified in our recent reports. We warned in our April report that the outlook for equities had deteriorated meaningfully since the beginning of the year and recommended that investors maintain, at most, a very modest overweight toward stocks in a global multi-asset portfolio. We see the performance of the equity market over the past month as reflecting the beginning of the recession scare that we warned was coming. Still, several factors continue to suggest that this is indeed a scare, and not an actual recession. Section 2 of this month’s report reviews the US housing market for signs of an imminent recession. While a slowdown in the housing market is clearly underway, we do not yet see signs that this slowdown is recessionary. It remains an open question how forcefully Russia is willing to weaponize its natural gas exports in response to a seemingly imminent European embargo on Russian oil, and whether Russia will deploy this strategy now or later. For now, our base case view is that the euro area economy will slow and will probably contract in Q2, but it will avoid a debilitating energy-driven recession. China’s zero-tolerance COVID policy has failed to contain the disease, and it is now clear that more and more outbreaks will occur across the country over the coming months. Our base case view is that additional fiscal & monetary support is forthcoming if the spread of the disease progresses as we expect. We are likely to downgrade our outlook for global economic activity as well as our recommended allocation to risky assets if it does not materialize. Our profit margin warning indicators have deteriorated over the past month, and it is now our view that a contraction in S&P 500 margins is likely. Still, a major decline should be avoided, and we expect that S&P 500 earnings will grow at a low, single-digit rate over the coming year. We continue to recommend a marginally overweight stance towards risky assets over the coming 6-12 months, along with a neutral regional equity stance, a modestly overweight stance towards value over growth, an overweight stance towards small caps, a modestly short duration stance within a fixed-income portfolio, and short US dollar positions. Not Out Of The Woods Yet Chart I-1In May, Global Stocks Nearly Fell Into Bear Market Territory In May, Global Stocks Nearly Fell Into Bear Market Territory In May, Global Stocks Nearly Fell Into Bear Market Territory May was a painful month for the equity market. Globally, stocks fell more than 4% in US$ terms, led by the US. May’s selloff pushed global stocks close to bear market territory relative to their early-January high (Chart I-1), a threshold that was breached in intra-day terms in the US last week. We warned in our April report that the outlook for equities had deteriorated meaningfully since the beginning of the year and recommended that investors maintain, at most, a very modest overweight toward stocks in a global multi-asset portfolio. In our view, the economic and financial market developments that occurred over the past month are consistent with several of the risk we identified in our recent reports. We continue to recommend that investors remain minimally overweight risky assets. Our view that investors should not be underweight risky assets hinges on three expectations: the avoidance of a US recession over the coming year, a continuation of Russian natural gas exports to key gas-reliant European countries, and the announcement from Chinese policymakers of either significant additional stimulus in its traditional form or income-support policies of the type that prevailed in developed economies in the early phase of the COVID-19 pandemic. Confirmation of these expectations is likely to push us to upgrade our recommended stance toward risky assets, especially if equities continue to sell off in response to growth fears. Conversely, we are likely to recommend downgrading risky assets to neutral or underweight if evidence mounts that our expectations are unlikely to materialize. A US Recession Scare Is Underway We noted in last month’s report that the US economy would likely avoid a recession over the coming year, but that a recession scare was quite likely. We emphasized a probable slowdown in the housing market as the locus of investors’ recessionary concern, and the US housing market data is indeed now surprising significantly to the downside (Chart I-2). We see the performance of the equity market over the past month as reflecting the beginning of the recession scare that we warned was coming. Chart I-3 highlights that the composition of the US equity selloff since the beginning of the year has looked quite unlike the growth-driven selloffs that occurred over the past decade, in that real bond yields have been a strong driver of the decline in stocks. By contrast, May’s decline has looked more like a typical growth scare, with real bond yields somewhat cushioning the impact of a significant rise in the equity risk premium. Chart I-2The US Housing Market Is Clearly Slowing The US Housing Market Is Clearly Slowing The US Housing Market Is Clearly Slowing Chart I-3May’s Selloff Was Driven By Growth Fears, Not Rising Interest Rates June 2022 June 2022   Chart I-4 highlights that it is not just the housing market that is worrying investors. The chart shows that the Conference Board’s US leading economic indicator (LEI) is slowing quite sharply, in line with previous episodes of a major growth scare. And while the weakest components of the LEI modestly improved on average in April, Chart I-5 highlights that the collapse in real wage growth alongside the recently severe underperformance of consumer stocks has fed concerns that high inflation has eroded household purchasing power – and that a contraction in real spending is imminent. Chart I-4A Serious US Growth Scare Is Underway A Serious US Growth Scare Is Underway A Serious US Growth Scare Is Underway Chart I-5The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks The Decline In Real US Wage Growth Has Caused A Major Selloff In Consumer Stocks     In Section 2 of this month’s report we provide further analysis supporting the view that the US housing market will not drive the US economy into recession. But we do continue to believe that a slowdown in housing activity is likely, and that concerns about a housing-driven recession will linger. Still, several factors continue to suggest that the US is experiencing a recession scare, and not an actual recession: The Atlanta Fed’s GDPNow model is currently predicting US real GDP growth that is only modestly below trend in Q2, and the overall estimate continues to be dragged significantly lower by a sizably negative contribution from the change in inventories (Chart I-6). Without this negative inventories effect, the Atlanta Fed’s model would be forecasting real annualized growth of over 3%. After having decelerated significantly in the second half of last year because of a broadening in consumer price inflation, Chart I-7 highlights that real personal consumption expenditures reaccelerated and real personal income ex-transfers stabilized in Q1. Chart I-6No Sign Of A Major Decline In Q2 Consumer Spending June 2022 June 2022 Chart I-7Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating Real Income Growth Is Stabilizing, And Real Consumer Spending Is Accelerating     US manufacturing industrial production surged in April, led by motor vehicle production (Chart I-8, panel 1). It is true that industrial production is a coincident indicator and thus does not necessarily argue against the idea that a recession is imminent. A pickup in vehicle production is encouraging, however, as it suggests that the 15% surge in the level of new car prices over the past year that contributed to the erosion in household real incomes may be set to reverse (panel 2). Chart I-8A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power A Pickup In Auto Production Should Help Lower Car Prices And Improve Consumer Purchasing Power Services spending is likely to improve, as deliveries of Pfizer’s Paxlovid antiviral drug continue to ramp up and vaccines are eventually approved for children under the age of six. Charts I-9A and I-9B highlight several real services spending categories that remain below their pre-pandemic levels, which in our view have been clearly linked to the pandemic and are not likely to be permanently lower. Americans have not likely stopped going to the gym, amusement parks, movies, live concerts, or the dentist, nor have their stopped needing to put elderly relatives in nursing care homes. They are also highly unlikely to stop traveling. There is some internal debate at BCA about the impact that working-from-home trends will have on the level of services spending, but we would note that essentially all of the spending categories shown in Charts I-9A and I-9B have exhibited uptrends that only appear to have been affected by consumer responses to the Delta and Omicron waves of the pandemic. Widely-available treatment options that reduce the fatality rate of the disease close to that of the flu are likely to be perceived by the public as an effective end of the pandemic, boosting spending on lagging categories of services spending. Chart I-9AAn Eventual End To The Pandemic… June 2022 June 2022 Chart I-9B…Will Cause A Further Improvement In Services Spending ...Will Cause A Further Improvement In Services Spending ...Will Cause A Further Improvement In Services Spending     Based on high-frequency data from OpenTable, the number of seated diners in US restaurants is not exhibiting any major warning signs for US consumer spending (Chart I-10). Real spending in restaurants has been strongly correlated with overall real personal consumption expenditures over the past two decades, and thus Chart I-10 is not suggesting that a collapse in overall spending is imminent. Chart I-10High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending High-Frequency Data Does Not Yet Show A Major Pullback In US Consumer Spending As a final point concerning the risk of recession in the US, investors should note that the recent behavior of inflation expectations is encouraging and points to a potentially imminent peak in Fed hawkishness. Over the past few months, we have expressed our concern about the pace of increase in long-dated household inflation expectations. We highlighted last month that long-term market-based inflation expectations were also exhibiting some potential signs of becoming unanchored. However, Chart I-11 highlights that the momentum of long-dated household inflation expectations is now starting to flag, and that long-term market-based inflation expectations recently decreased in response to escalating growth fears. Chart I-12 clearly shows a slowing pace of core consumer prices, which will act to restrain further significant increases in long-dated inflation expectations. Chart I-11Long-Dated Inflation Expectations Point To A Potentially Imminent Peak In Fed Hawkishness June 2022 June 2022 Chart I-12Core Inflation Momentum Is Clearly Slowing Core Inflation Momentum Is Clearly Slowing Core Inflation Momentum Is Clearly Slowing     Chart I-13 highlights that investors expect the Fed to raise the policy rate by the end of the year to a level even higher than what Jerome Powell implied during the Fed’s May press conference: a target range for the Fed funds rate of 2.5-2.75%, corresponding to two more 50 basis point hikes and three 25 basis point hikes during the FOMC’s September, November, and December meetings. Chart I-13Expectations For Fed Rate Hikes This Year Are Likely To Come Down If Inflation Continues To Moderate June 2022 June 2022 It is likely that the market’s expectation for rate hikes this year will fall over the coming few months if the monthly pace of core inflation continues to slow. The Fed itself may soon signal a less intense pace of tightening than Powell recently implied – a perspective that we feel is supported by the minutes of the May FOMC meeting. That would allow the US economy to “digest” the recent adjustment in interest rates with less uncertainty about the economic outlook, which would lower the odds that a “mid-cycle slowdown” morphs into a full-blown recession. A Debilitating Energy-Driven Recession In Europe Is Not In The Cards, For Now The key issue pertaining to the European economic outlook remains the question of whether Europe’s imports of Russian natural gas will be interrupted. A European embargo of Russian oil now seems likely, which would likely cause Russian oil production to decline. Our Commodity & Energy strategy service now expects Brent oil to trade at $120/bbl on average for the remainder of the year, $5/bbl higher than current levels (Chart I-14). We agree with our Commodity & Energy Strategy team’s updated oil price forecast, but we have a different view about the odds that Russia will respond to a European oil embargo by cutting its natural gas exports to the EU. We still think this is a risk, not yet a likely event, although it may still occur later in the year. A full and immediate cutoff of natural gas exports to gas-dependent European countries such as Germany and Italy would not only destabilize the Russian economy by substantially reducing its current account surplus, it would also cause a severe recession in Europe through a combination of gas rationing to industries by government decree and surging energy prices (Chart I-15). Chart I-14A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl A European Embargo Of Russian Oil Will Cause Brent To Rise To $120/bbl Chart I-15A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession A Full Cutoff Of Russian Natural Gas Would Cause A Severe European Recession   That could erode European voters’ willingness to provide military support for Ukraine, but it could instead backfire and galvanize European public opinion against Russia – and remove leverage that may be potentially used to secure a ceasefire agreement that will preserve its military gains in eastern Ukraine. Chart I-16Europe Is Replenishing Its Gas Storage, But It Cannot Yet Withstand A Full Cutoff June 2022 June 2022 Russia may respond to an oil embargo by throttling the amount of natural gas exported to key European countries in a fashion that raises natural gas prices and prevents European countries from building up sufficient storage for the upcoming winter – a process that is underway but is far from complete (Chart I-16). But it remains an open question how forcefully Russia is willing to weaponize its natural gas exports, and whether it will deploy this strategy now or later. For now, our base case view is that the euro area economy will slow and will probably contract in Q2, but it will avoid a debilitating energy-driven recession. China: The Only Way Out Is Through Among the three pillars of the global economy – the US, China, and Europe – the last is arguably the least important. Today, the US and China are the core drivers of global demand, and we are therefore more concerned about the economic impact of China’s zero-tolerance COVID policy than we are about a slowdown or mild recession in Europe. Given how contagious the Omicron variant of COVID-19 has shown itself to be, and given how widespread recent outbreaks have been, it is now clear that China’s zero-tolerance policy has failed to contain the disease and that more and more outbreaks will occur across the country over the coming months. Despite public statements to the contrary, we suspect that Chinese policymakers are well aware of this situation, but are constrained by the consequences of removing the zero-tolerance policy. Recent studies suggest that China could face intensive care demand that is sixteen times existing capacity and upwards of 1.5 million deaths by removing the policy,1 roughly 1.5 times the cumulative amount of deaths that have occurred in the US during the pandemic. But the economic consequences of maintaining the zero-tolerance policy will also be severe, and therefore also likely represent a constraint on policymakers. Charts I-17 and I-18 show that China’s labor market and industrial sector have already slowed sharply over the past few months, at a pace and magnitude that is unlikely to be politically sustainable for much longer. In addition, Chart I-19 shows that China’s credit impulse fell meaningfully in April. Chart I-17China’s Labor Market Is Cratering… China's Labor Market Is Cratering... China's Labor Market Is Cratering... Chart I-18…As Is Its Manufacturing Sector ... As Is Its Manufacturing Sector ... As Is Its Manufacturing Sector       Chart I-19More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread More Fiscal & Monetary Support Will Be Needed In China Soon, If COVID-19 Cases Continue To Spread This would be tolerable if the decline in activity was likely to be short-lived as it was at the very beginning of the pandemic, but we no longer see this as a probable outcome. We acknowledge that reported cases of COVID-19 have steadily declined in cities in the Yangtze River region, and we agree that the Shanghai lockdown may soon end for a time. But we doubt that this will mark the end of outbreaks in the region, or prevent major outbreaks from occurring in other parts of the country. If China cannot relax its zero-tolerance policy or tolerate the degree of economic weakness entailed by its continued application, then additional fiscal and monetary support is likely. While China’s leadership has stepped up its pro-growth policy measures, as evidenced by the recent cut in the 5-year loan prime rate, we strongly suspect that more support will be needed. This support may take the form of traditional stimulus via local government spending, or it may involve the introduction of income-support policies of the kind that prevailed in developed economies in the early phase of the COVID-19 pandemic. Chart I-20The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies The Chinese Housing Market Is Slowing Significantly, Lowering The Risk Of Speculation From Income Support Policies Chinese policymakers who are eager to prevent another significant releveraging of the economy and who want to avoid another major deterioration in housing affordability may perhaps be forgiven for seeing the developed economy experience with these programs as a poor roadmap to follow. House prices have exploded in most advanced economies during the pandemic, which has significantly contributed to a major decline in affordability. However, with the benefit of hindsight, Chinese policymakers would likely be able to recalibrate any income support program to avoid some of the excesses that occurred in DM countries, such as policies that caused aggregate disposable income to increase in the US and Canada during the pandemic. In addition, Chart I-20 highlights that the starting point for the Chinese property market is one in which house prices are seemingly poised to contract at the worst pace since late 2014 / early 2015. The latter suggests that Chinese policymakers have more ability to support household income without causing an explosion in house prices and speculative activity than DM policymakers did in 2020. Regardless of its form, it is the view of the Bank Credit Analyst service that China cannot avoid the provision of significant additional fiscal/monetary support if it maintains its zero-tolerance COVID policy for the remainder of the year given our assumption that potentially major outbreaks will continue. It is our base case view that additional support is forthcoming over the coming weeks and months if the spread of the disease progresses as we expect. We are likely to downgrade our outlook for global economic activity as well as our recommended allocation to risky assets if it does not materialize. US Corporate Profits In A Nonrecessionary Slowdown Scenario Chart I-21US Forward Earnings Very Rarely Fall While The Economy Continues To Expand June 2022 June 2022 Chart I-3 highlighted that the US equity market selloff in May shifted from one that was strongly driven by rising real government bond yields to one in which a rising equity risk premium was the dominant driver. And yet, the chart showed that there has been no negative contribution to US stock prices from falling earnings expectations, with expected earnings having continued to rise since the beginning of the year. While it may seem counterintuitive to investors that forward earnings expectations are not falling in the middle of a major growth scare, Chart I-21 highlights that this is not abnormal. The chart highlights that forward earnings expectations rarely decline outside of the context of a recession, because actual earnings typically do not decline when the economy is expanding. This means that the potential for earnings to decline shows up as a rise in the equity risk premium during growth scares, which is what has generally occurred since the beginning of the year (excluding energy, forward EPS estimates have fallen slightly this year). In last month’s Section 2, we noted that nonrecessionary earnings declines almost always occur because of contractions in profit margins. We argued that risks to US equity margins might rise later this year. In fact, since we published our report last month, some of these risks have already materialized: our new profit margin warning indicator has jumped significantly (Chart I-22), and our sector profit margin diffusion index has fallen below the boom/bust line (Chart I-23). As such, it is now our view that a contraction in S&P 500 profit margins is likely over the coming year, which contrasts with analyst EPS growth expectations of 9.5% and sales per share growth expectations of 8% (meaning that analysts are currently forecasting a margin expansion). Chart I-22A Contraction In S&P 500 Profit Margins... A Contraction In S&P 500 Profit Margins... A Contraction In S&P 500 Profit Margins... Chart I-23...Now Looks Likely ...Now Looks Likely ...Now Looks Likely     Will a likely contraction in profit margins cause an outright decline in earnings over the coming year? Investors should acknowledge that this is a risk, but for now our answer is no. Chart I-24For Now, A Severe Contraction In Margins Does Not Seem Probable For Now, A Severe Contraction In Margins Does Not Seem Probable For Now, A Severe Contraction In Margins Does Not Seem Probable Taken at face value, our sector diffusion index shown in Chart I-23 suggests that profit margins are set to decline by 2 percentage points over the coming year, which would indeed imply a 7-8% contraction in earnings per share assuming 8% revenue growth. However, the index is much better at predicting inflection points in profit margins than the magnitude of the change; in several cases over the past three decades the model correctly predicted a decline in profit margins, but implied a much larger change in margins than what actually occurred. In addition, our model shown in Chart I-22 has yet to cross above the 50% mark into probable territory, and Chart I-24 highlights that net earnings revisions and net positive earnings surprises are falling but have not yet reached levels that would be consistent with a major margin decline. In sum, we expect that S&P 500 earnings will grow at a low, single-digit rate over the coming year given our expectation of a nonrecessionary slowdown scenario. This implies that US equity returns will be uninspiring over the coming year, but they will be likely be positive and will likely beat the returns offered from bonds. Investment Strategy Recommendations Considerable uncertainty remains about the global economic and financial market outlook, and there are several identifiable risks that would warrant an underweight stance towards risky assets were they to materialize. We agree that an aggressively overweight stance is not justified. Chart I-25Without A Recession, The US Equity Risk Premium Is Very Likely To Decline Without A Recession, The US Equity Risk Premium Is Very Likely To Decline Without A Recession, The US Equity Risk Premium Is Very Likely To Decline However, the fact that corporate profits do not usually fall while the economy is expanding underscores why investors should be reluctant to significantly cut their risky asset exposure unless a recession appears likely. Without a recession, the US equity risk premium is very likely to decline (Chart I-25), meaning that 10-year Treasury yields closer to 4% or a significant contraction in profit margins would be required for US stocks to post negative returns over the coming 6-12 months. We would not rule out either of these outcomes, but we also do not think that they are probable. To conclude, it is fair to say that global investors are not out of the woods yet, but we continue to recommend a marginally overweight stance towards risky assets on the basis that the US will avoid a recession over the coming year, Russia is not yet likely to push Europe into a debilitating recession, and China will further ease fiscal & monetary policy to support growth. In addition to a modest overweight towards stocks in a multi-asset portfolio, we continue to recommend the following: A neutral regional equity stance, with global ex-US equities on upgrade watch in response to an improvement in the European economic outlook and further fiscal & monetary support in China. The recent passive outperformance of global ex-US stocks has occurred mainly because US stocks have fallen more than global stocks, which have “caught up” to mounting US and global growth fears. As such, ex-US stocks have outperformed for the wrong reasons, and investors should wait for durable signs of an improving global growth outlook and a falling US dollar before shifting in favor of a global ex-US equity stance. A modestly overweight stance towards value over growth stocks on the basis of better valuation. However, most of the pandemic-related outperformance of growth stocks has already reversed (Chart I-26), suggesting that the outperformance of value is getting late. An overweight stance toward global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have remained resilient as global growth fears have intensified (Chart I-27). Chart I-26Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Modestly Favor Value Stocks Due To Better Valuation, But The COVID Effects On Equity Style Have Mostly Reversed Chart I-27Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap Small Cap Stocks Have Recently Proven Resilient, And Are Extremely Cheap   A modestly short duration stance within a fixed-income portfolio. Short US dollar positions, as the dollar is clearly benefiting from growth fears that will wane. In addition, the US dollar is very expensive, and extremely overbought. Concerning our recommended duration stance, we acknowledge that a slower pace of rate hikes than what investors currently expect and a slowing pace of inflation would normally argue for a long duration stance. But we do not expect the Fed to stop raising interest rates unless a recession seems likely, and a slower but steady path of tightening, in conjunction with easing inflation, makes it more likely that the US economy will be able to “digest” the recent adjustment in rates without tipping into recession. This, in turn, increases the odds that the Fed funds rate will peak at a higher level than investors currently expect, which should ultimately push long-maturity yields higher rather than lower. On balance, this suggests that investors should be modestly short duration, even if long-maturity bond yields move temporarily lower over the coming few months. Long-duration positions are perhaps reasonable on a 0-3 month time horizon, but over a 6-12 month time horizon we continue to recommend a modestly short stance. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst May 26, 2022 Next Report: June 30, 2022 II.  Is The US Housing Market Signaling An Imminent Recession? The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.2 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession June 2022 June 2022 When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors June 2022 June 2022 Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment June 2022 June 2022     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables Same Story For Large Household Durables Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators generally paint a pessimistic picture for stock prices. Our monetary indicator is at its weakest level in almost three decades, and our valuation indicator highlights that stocks are still expensive. Meanwhile, both our sentiment and technical indicators have broken down, and have not yet reached levels that would indicate an imminent reversal. Investors should be, at most, very modestly overweight stocks versus bonds over the coming year. Equity earnings will likely rise over the coming year if the US economy avoids a recession (as we expect), but analysts are pricing in too much growth over the coming year. A contraction in profit margins is now likely, signaling that earnings will grow at a low single-digit pace. Net earnings revisions are falling, but are not yet signaling a large enough decline in margins that would cause earnings to contract even in the face of positive revenue growth. Within a global equity portfolio, we recommend a neutral regional equity allocation. The recent passive outperformance of global ex-US stocks has occurred mainly because US stocks have fallen more than global stocks, which have “caught up” to mounting US and global growth fears. Investors should wait for durable signs of an improving global growth outlook and a falling US dollar before shifting in favor of a global ex-US equity stance. Within a fixed-income portfolio, long-duration positions are reasonable on a 0-3 month time horizon given that 10-year Treasurys are significantly oversold. But over a 6-12 month time horizon, we continue to recommend a modestly short stance. A slower but steady path of tightening, in conjunction with easing inflation, makes it more likely that the US economy will be able to “digest” the recent adjustment in rates without tipping into recession. This should ultimately push long-maturity yields higher rather than lower. Our composite technical indicator for commodity prices continues to highlight that commodities are overbought. Still, the geopolitical situation continues to favor higher energy prices, as a seemingly imminent European oil embargo against Russia will likely lower Russian oil production.  Additional fiscal & monetary support in China is likely to cause a renewed rally in industrial metals, although they may fall in the nearer-term as COVID-19 cases continue to spread across China. We remain structurally bullish on industrial metals prices given that Russia’s aggression has sped up Europe’s decarbonization timeline. US and global LEIs remain in positive territory but have now rolled over significantly from very elevated levels. Our global LEI diffusion index is now rising, which may herald a stabilization in our global LEI. Manufacturing PMIs are falling in the US and globally, but have not yet fallen below the boom/bust line and are far from levels normally consistent with a recession. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators     Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Cai, J. . et al., Modeling Transmission Of SARS-CoV-2 Omicron in China, Nature Medicine. May 10, 2022. 2     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.

Executive Summary Credit Demand Collapsed Credit Demand Collapsed Credit Demand Collapsed Business activity data from April showed a broad-based contraction in China’s economy. Credit growth tumbled as demand collapsed. Bank loan expansion slowed by the most in nearly five years and annual change in new household loans declined to an all-time low. Exports decelerated sharply in April. China’s export sector faces headwinds from Omicron-related supply chain disruptions and weakening global demand for goods. Export growth will rebound following the resumption of business activity in China’s major cities, but is set to decelerate from 2021 as external demand for goods weakens. The PBOC lowered the 5-year loan prime rate (LPR) by 15bps last Friday, following a cut in the floor rate of first-home mortgages to 20bp below the benchmark. These moves will help to arrest the ongoing deep contraction in the property market. However, these policies alone will not generate strong recovery in housing demand, amid near-term Covid-related disruptions and dampened household income growth. Barring major lockdowns, China’s economy will likely bottom around mid-2022. We expect a muted recovery in the second half of the year, despite an acceleration in policy easing. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio. Bottom Line: China’s economy has been hit by a relapse in demand and Covid-induced production disruptions. The economy will likely bottom by mid-year, but the ensuing recovery may be subdued. A Subdued Recovery In 2H 2022 A broad-based contraction in China’s economy in April reflects hit by a combination of slumping domestic demand and Covid-related disruptions. Growth in retail sales and industrial production contracted from a year ago and home sales shrunk further. Economic activity will rebound when the current Covid wave is under control and lockdown restrictions are lifted. However, we expect a much more muted recovery in the second half of this year compared with two years ago when China’s economy staged an impressive V-shaped recovery as it emerged from the first wave of lockdowns in spring 2020. Presently, reported virus cases have steadily declined in cities in the Yangtze River region, including Shanghai which aims to lift its lockdown on June 1st. The number of regions and cities under stringent confinement also fell. However, China firmly maintains its dynamic zero-Covid policy, which means tight mobility restrictions and some forms of lockdowns will occur across the country on a rolling basis going forward.  China’s leadership has stepped up its pro-growth policy measures, such as a 15bps cut in the 5-year LPR last week. Given the pace of credit expansion collapsed in April and private-sector sentiment remains in the doldrums, a recovery will not be imminent or strong despite this rate cut (Chart 1). In the near term, the poor economic outlook in China, coupled with jitters in the global equity market, will continue to depress the performance of Chinese stocks in absolute terms (Chart 1, bottom panel). From a cyclical perspective, we maintain our neutral view on China’s onshore stocks and underweight view on China’s investable stocks within a global equity portfolio. China’s economy is set to underwhelm investor expectations and stock prices probably are unlikely to outperform their global counterparts (Chart 2). Chart 1Weak Economic Fundamentals Undermine Stock Performance Weak Economic Fundamentals Undermine Stock Performance Weak Economic Fundamentals Undermine Stock Performance Chart 2Too Early To Upgrade Chinese Stocks In A Global Portfolio Too Early To Upgrade Chinese Stocks In A Global Portfolio Too Early To Upgrade Chinese Stocks In A Global Portfolio Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Credit Growth Slowed Notably As Loan Demand Slumps Credit expansion in April relapsed, as lockdowns exacerbated the weakness in business activity and further depressed the demand for credit. Bank loan growth plummeted to its worst level in almost five years (Chart 3). Notably, annual change in new household loans origination contracted the most since data collection began because Covid lockdowns and the property market slump sapped consumers’ willingness to borrow (Chart 4). In addition, household propensity to spend declined to an all-time low, highlighting that bleak sentiment will continue to curb demand for loans (Chart 4, bottom panel). Moreover, a rapid deceleration in corporate medium-and long-term loans versus soaring short-term bill financing indicates corporates’ weak demand for credit and investment (Chart 5). The deterioration in corporate sentiment is also reflected in business condition surveys (Chart 6). Chart 3Subdued TSF Growth Due To Collapsed Loan Demand Subdued TSF Growth Due To Collapsed Loan Demand Subdued TSF Growth Due To Collapsed Loan Demand Chart 4Annual Change In New Household Loans Contracted The Most In April Annual Change In New Household Loans Contracted The Most In April Annual Change In New Household Loans Contracted The Most In April Chart 5Corporate Demand For Credit Remains in The Doldrums … Corporate Demand For Credit Remains in The Doldrums... Corporate Demand For Credit Remains in The Doldrums... Chart 6... And Unlikely To Turn Around Soon Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Soon Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Soon Despite Accommodative Monetary Conditions Chart 7Early Signs Of Authorities Loosening Their Grip On Shadow Banking Early Signs Of Authorities Loosening Their Grip On Shadow Banking Early Signs Of Authorities Loosening Their Grip On Shadow Banking Local government bond issuance unexpectedly moderated in April after most of the front-loaded local government special purpose bonds (SPBs) was issued in Q1. In the January-April period this year, the amount of SPBs issuance was RMB 1.41 trillion. The SPBs quota for 2022 is 3.65 trillion, along with 1.1 trillion of SPB proceeds that can be carried over from last year. Given that most of the planned SPBs will be issued by the end of June, we will likely see a peak in SPB issuance in Q2.This entails about RMB 3 trillion of SPBs will be issued in May-June. The intensified SPB issuance will underpin total social financing (TSF) growth in the next two to three months. However, barring an increase in the SPB quota or an approval to issue Special Treasury bonds as occurred in 2H 2020, the support from government bonds issuance to TSF will likely decline sharply in the second half of this year. Notably, there has been stabilization in shadow bank financing growth, although it remains below zero (Chart 7). It may be an early sign that China’s leadership is allowing some shadow banking activity; a meaningful relaxation of local governments’ shadow banking activity would be positive for infrastructure investment. Exports: Weaker Than Last Year China’s exports growth softened sharply in April, led by an extensive reduction in shipments to major developed markets (Chart 8). In addition, exports by product group also indicate a wide ranging slowdown in both exports of lower-end consumer goods and tech products (Chart 9). The softness in China’s exports reflects Omicron-related supply chain and logistical disruptions along with a weakening external demand for goods. Chart 8China's Exports To Developed Markets Fell China's Exports To Developed Markets Fell China's Exports To Developed Markets Fell Chart 9A Broad-Based Decline Among Categories of Exported Goods A Broad-Based Decline Among Categories of Exported Goods A Broad-Based Decline Among Categories of Exported Goods Chart 10Weakening Global Demand For Goods Weakening Global Demand For Goods Weakening Global Demand For Goods South Korean exports, a bellwether for global trade, have also been easing in line with Chinese exports, which indicates dwindling global demand for manufacturing goods (Chart 10). In addition, the sharp underperformance of global cyclical stocks versus defensives heralds a worldwide manufacturing downturn (Chart 11). Falling US demand for consumer goods corroborates diminishing external demand (Chart 12). China’s exports will likely rebound from its April levels when manufacturing production resumes in Shanghai and supply-chain interruptions subside in the Yangtze River Delta region. Nonetheless, we expect a contraction in exports this year, as global consumer demand for goods dwindles. Chart 11Global Manufacturing Sector Is Heading Into A Downturn Global Manufacturing Sector Is Heading Into A Downturn Global Manufacturing Sector Is Heading Into A Downturn Chart 12External Demand For Chinese Export Goods Is Dwindling External Demand For Chinese Export Goods Is Dwindling External Demand For Chinese Export Goods Is Dwindling Recovery In China’s Manufacturing Sector Will Be Muted In 2H 2022 Manufacturing production growth contracted in April at the fastest rate since data collection began. The contraction was due to Covid-induced production troubles and weak demand (Chart 13). Chart 13Manufacturing Output Growth Contracted The Most Since Data Reporting Began Manufacturing Output Growth Contracted The Most Since Data Reporting Began Manufacturing Output Growth Contracted The Most Since Data Reporting Began Chart 14Mounting Product Inventory Mounting Product Inventory Mounting Product Inventory Chart 15Chinese Manufacturing Output And Capacity Utilization Face Headwinds From Weakening Exports Chinese Manufacturing Output And Capacity Utilization Face Headwinds From Weakening Exports Chinese Manufacturing Output And Capacity Utilization Face Headwinds From Weakening Exports The inventory of finished products soared to the highest point in the past 10 years due to port closures and domestic logistical issues (Chart 14).  Even when the impact of the current Covid wave wanes in the second half of this year, destocking pressures will dampen manufacturing production. In addition, Chinese manufacturing output and capacity utilization face headwinds from decelerating exports (Chart 15). While upstream industries, such as the mining, resources and materials sectors, benefit from strong pricing trends, profit margins for middle-to-downstream manufacturers remain very subdued (Chart 16). The large gap between prices for producer goods and consumer goods is a reflection of the inability of manufacturers to pass on higher input costs to consumers (Chart 17). Elevated input cost pressures and, hence, disappointing corporate profits, will continue to curb manufacturing investments and production in 2H 2022. Chart 16Manufacturing Sector's Profit Margins Are Further Squeezed Manufacturing Sector's Profit Margins Are Further Squeezed Manufacturing Sector's Profit Margins Are Further Squeezed Chart 17Manufacturers Are Under Rising Cost Pressures Manufacturers Are Under Rising Cost Pressures Manufacturers Are Under Rising Cost Pressures Housing Market Outlook Remains Gloomy The PBOC lowered the 5-year LPR by 15bps from 4.6% to 4.45% on May 20, the largest LPR rate cut since 2019. The easing measure followed a reduction in first-home mortgages to 20bps below the benchmark announced on May 15. The national-level mortgage rate floor and benchmark rate drops are clear signals that policymakers are ramping up policy easing measures in the property sector, given the failure of previous efforts to revive housing demand. Historically, mortgage rates tend to lead household loans and home sales by two quarters, suggesting that the housing market may see some improvement by year-end (Chart 18). However, as we pointed out in previous reports, without large-scale and direct fiscal transfers to consumers to boost household income, these housing measures will unlikely generate a strong rebound in household sentiment and home purchases (Chart 19). Chart 18Mortgage Rates Tend To Lead Consumer Loans And Home Sales By Two Quarters Mortgage Rates Tend To Lead Consumer Loans And Home Sales By Two Quarters Mortgage Rates Tend To Lead Consumer Loans And Home Sales By Two Quarters Chart 19Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Lockdowns in April exacerbated the slump in all housing market indicators, with the exception of a moderate improvement in floor space completed (Chart 20). Home prices, which tend to lead housing starts, decelerated even more in April following seven consecutive month-to-month declines. Moreover, our housing price diffusion index suggests that home prices on a year-on-year basis will contract in the next six to nine months, a further drop from the current 0.7% growth (Chart 21, top panel). Falling home prices will curb housing starts and construction activity (Chart 21, bottom panel). In addition, real estate developers’ financing conditions have not improved because the “three red lines” policy is still in place and home sales have collapsed (Chart 22). Chart 20A Further Deterioration In Housing Market Indicators In April A Further Deterioration In Housing Market Indicators In April A Further Deterioration In Housing Market Indicators In April Chart 21Housing Prices Are Set To Contract In 2H 2022 Housing Prices Are Set To Contract In 2H 2022 Housing Prices Are Set To Contract In 2H 2022 Chart 22Slumping Home Sales Exacerbate Real Estate Developers’ Funding Woes Slumping Home Sales Exacerbate Real Estate Developers' Funding Woes Slumping Home Sales Exacerbate Real Estate Developers' Funding Woes   A Collapse In Household Consumption Due To Covid Confinement Measures City lockdowns have taken a heavy toll on China’s household consumption. Both retail sales and service sector business activity experienced their deepest contractions since March 2020 (Chart 23). Notably, the growth of online goods sales slipped under zero in April, below that recorded in early 2000 and the first contraction since data collection began. Furthermore, both core and service consumer prices (CPI) weakened again in April, reflecting lackluster consumer demand (Chart 24). Chart 23Chinese Retail Sales Contracted The Most Since March 2020 Chinese Retail Sales Contracted The Most Since March 2020 Chinese Retail Sales Contracted The Most Since March 2020 Chart 24Weak Core And Service CPIs Also Reflect Lackluster Household Demand Weak Core And Service CPIs Also Reflect Lackluster Household Demand Weak Core And Service CPIs Also Reflect Lackluster Household Demand Labor market dynamics went downhill rapidly. The nationwide urban unemployment rate rose to its highest level since mid-2020, while the unemployment rate among younger workers climbed to an all-time high (Chart 25). Meanwhile, sharply slowing wage growth since mid-2021 has contributed to a deceleration of household income (Chart 26). The gloomy sentiment on future income also impedes a household’s willingness to consume (Chart 27). Chart 25Labor Market Situation Is Dramatically Worse Labor Market Situation Is Dramatically Worse Labor Market Situation Is Dramatically Worse Chart 26Household Income Growth Has Been Falling Household Income Growth Has Been Falling Household Income Growth Has Been Falling All in all, China’s household consumption will be hindered not only by renewed threats from flareups in domestic COVID-19 cases, but also by a worsening labor market situation and depressed household sentiment in the medium term. Chart 27Poor Sentiment On Funture Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Funture Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Funture Income Contributes To Consumers' Unwillingness To Spend Table 1China Macro Data Summary A Subdued Recovery In 2H 2022 A Subdued Recovery In 2H 2022 Table 2China Financial Market Performance Summary A Subdued Recovery In 2H 2022 A Subdued Recovery In 2H 2022   Strategic Themes Cyclical Recommendations

Executive Summary First IG, Then HY First IG, Then HY First IG, Then HY Corporate bonds are following the 2018 roadmap. Investment grade underperformed Treasuries as interest rate expectations rose from low levels, then junk joined the selloff once rate expectations moved above estimates of neutral. Inflation is too high for the Fed to abandon its tightening cycle, as it did in 2018/19, but the Fed will move more slowly than what is priced in the curve for 2022. Underlying economic growth is stronger than it was in 2018 and corporate balance sheets are in better shape. That being the case, even a modest dovish surprise from the Fed will be sufficient for corporate bond returns to form a bottom. Municipal bonds are attractively priced versus both Treasuries and credit, and state & local government balance sheets are in excellent condition. Stay overweight.   Bottom Line: We maintain our cautious stance on corporate bonds for the time being, but are now on upgrade watch. Signs of peaking inflation and/or dovish signals from the Fed could cause us to increase exposure in the relatively near term. Stay tuned.  Feature The similarities between recent market action and what occurred in 2018 are striking. Back in 2018, the Fed was in the process of lifting the policy rate back toward estimates of neutral. The yield curve flattened as a result, and investment grade corporate bonds responded to the removal of policy accommodation by underperforming duration-matched Treasuries (Chart 1). Chart 1The 2018 Experience The 2018 Experience The 2018 Experience Despite the Fed’s actions, high-yield initially performed well in 2018. That is, until the market started to believe that the Fed would over-tighten. Recession fears increased in late 2018 as near-term rate expectations surpassed estimates of neutral and high-yield sold off sharply, giving back all of its gains from earlier in the year and then some. Now let’s turn to the present day (Chart 2). Once again, investment grade corporates underperformed Treasuries as near-term rate expectations moved higher and the yield curve flattened. For its part, high-yield performed well during the early stages of the interest rate adjustment but returns plunged once 12-month forward rate expectations moved above survey estimates of neutral. Chart 2First IG, Then HY First IG, Then HY First IG, Then HY What’s Different This Time? While we think the 2018 roadmap is a good one, it’s important to consider the differences between 2018 and today before drawing any firm conclusions about future credit market performance. The first obvious difference is that the Fed had already been lifting rates for some time in 2018. In fact, the fed funds rate was above 2%. Today, the Fed is still in the early stages of its tightening cycle and the fed funds rate is only 0.83%. We think this difference is less significant than it initially appears because the level of the fed funds rate itself is less important than the perceived restrictiveness of monetary policy. Today, the market is priced for the fed funds rate to hit 3.18% in 12 months, higher than at any point in 2018 (Chart 3). We also see that the Treasury slope beyond the 2-year maturity point is about as flat today as it was in 2018 (Chart 3, bottom panel). This strongly suggests that the market perceives monetary policy as about as restrictive today as it was in late 2018. The second difference we identify is that inflation is much higher today than it was in 2018 (Chart 4). This is potentially bad news for future credit market performance. High inflation gives the Fed a strong incentive to keep lifting rates even if risky assets sell off. In 2018, the Fed reversed course on its tightening cycle once broad financial conditions tightened into restrictive territory. That’s an easy decision to make when inflation is close to 2%. It’s much more difficult to do with inflation where it is now. Chart 3Monetary Conditions Are Similar Monetary Conditions Are Similar Monetary Conditions Are Similar Chart 4Inflation Is Much Higher … Inflation Is Much Higher ... Inflation Is Much Higher ... High inflation makes it unlikely that the Fed will pull a 180 on its tightening cycle. But on the flipside, today’s strong underlying economic growth means that a complete reversal on rate hikes is probably not necessary to avoid a recession. Just look at the labor market. Labor market utilization, as measured by both the unemployment rate and the prime-age employment-to-population ratio, is in a similar place today as it was in 2018 (Chart 5). However, despite a tight labor market, job growth is running at a much stronger pace this year. Nonfarm payroll gains have averaged 523 thousand during the past three months. In 2018, in a similarly tight labor market, monthly job growth averaged just 191 thousand. Now turn to housing, arguably the most important channel through which interest rates impact the economy. In a prior report we identified that the 12-month moving average of housing starts dipping below the 24-month moving average is a good indicator for the end of a Fed rate hike cycle.1 In 2018, our housing starts indicator was barely positive. Today, it is extremely elevated (Chart 5, bottom panel). Chart 5… But Growth Is Much Stronger ... But Growth Is Much Stronger ... But Growth Is Much Stronger The key point is that with employment growth and housing starts trending at much better levels than in 2018, we can conclude that the Fed has a fair amount of scope to tighten policy before threatening to push the economy into recession. The upshot for corporate bond markets is that the threshold for Fed capitulation is also different. While a full backtracking away from rate hikes was necessary to avoid a recession and spur corporate bond outperformance in 2018, both the economy and financial markets likely require less of a Fed reversal today. The final difference we identify between 2018 and today relates to the health of corporate balance sheets (Chart 6). Compared to 2018, nonfinancial corporations are carrying much less debt as a percentage of net worth, have significantly higher interest coverage and are benefiting from net ratings upgrades. Much like with the labor market and housing indicators, there’s every reason to believe that corporations are better equipped to handle higher interest rates today than they were in 2018. Chart 6Balance Sheets Are Healthier Balance Sheets Are Healthier Balance Sheets Are Healthier The Way Forward If we look back at Chart 1, we see that the 2018 roadmap is for the Fed to abandon its tightening cycle, leading to a sharp drop in near-term rate expectations and a V-shaped bottom in excess corporate bond returns. We won’t get such a swift Fed reversal this year, but there are strong odds that the Fed will lift rates by less than what is currently discounted in the market between now and the end of 2022. As we noted in last week’s Webcast, we expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before shifting to 25 bps per meeting increments in September once it’s clear that inflation is trending down (Chart 7).2  We also see potential for relief at the long-end of the yield curve, where 5-year/5-year forward Treasury yields have room to fall back toward survey estimates of the long-run neutral rate (Chart 8). Chart 7Rate Expectations Rate Expectations Rate Expectations Chart 8Yields Above Fair Value Yields Above Fair Value Yields Above Fair Value It’s also worth noting that corporate bond valuations have improved markedly during the past few weeks. The 12-month breakeven spread for investment grade corporates is back above its historical median, and the junk index is priced for a 6.3% default rate during the next 12 months (Chart 9). Investment grade and high-yield index spreads are also now well above their respective 2017-19 averages, as is the spread differential between high-yield and investment grade (Chart 10). Chart 9Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation Chart 10Favor HY Over IG Favor HY Over IG Favor HY Over IG The bottom line is that we are slowly turning more positive on corporate bonds. Falling inflation will cause the Fed to tighten by less than what is expected this year, and it will soon become apparent that – as was the case in 2018 – the US economy is not close to tipping into recession. Spreads also present an increasingly attractive opportunity. That said, with the Fed still poised to deliver 100 bps of tightening within the next two months, we are not yet ready to abandon our relatively cautious corporate bond allocation. We maintain our underweight (2 out of 5) allocation to investment grade corporate bonds and our neutral (3 out of 5) allocation to high-yield, but we are now firmly on upgrade watch. Signs of peaking inflation and/or signals that the Fed will pivot to a hiking pace of 25 bps per meeting could cause us to increase our recommended corporate bond exposure in the relatively near term. Stay tuned. Seek Refuge In Municipal Bonds While we wait for clearer signs of a bottom in corporate credit, investors can more confidently deploy capital in the municipal bond market. Municipal / Treasury yield ratios have jumped in recent weeks, and they are now back above post-2010 averages across the entire yield curve (Chart 11). Long-maturity municipal bonds are even trading at a before-tax premium relative to US Treasuries (Chart 11, top 2 panels). Municipal bonds are also trading at above-average yields relative to credit rating and duration-matched corporate bonds (Chart 12). This is despite the recent back-up we’ve witnessed in corporate bond spreads. Chart 11Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 12Munis Cheap Versus Credit Munis Cheap Versus Credit Munis Cheap Versus Credit Not only are munis attractively priced versus both Treasuries and corporates, but state & local government balance sheet indicators show that municipal credit quality is sky high (Chart 13). Tax revenues have accelerated since the pandemic, but state & local governments have remained cautious about spending their windfalls. Despite being flush with cash, state & local governments have re-hired only a small fraction of the employees that were let go during the pandemic (Chart 13, panel 2). The result of this lack of spending is that state & local government net savings are the highest they’ve been in years (Chart 13, panel 3). Chart 13State & Local Government Health State & Local Government Health State & Local Government Health Bottom Line: Municipal bonds are attractively valued versus both Treasuries and investment grade corporates, and state & local government balance sheets are in superb condition. Investors should overweight municipal bonds in US fixed income portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 2 https://www.bcaresearch.com/webcasts/detail/537 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns