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

Executive Summary China: Can The Economy Recover Without Housing Revival Can The Economy Recover Without Housing Revival Can The Economy Recover Without Housing Revival The rebound in China’s business activity in June reflects the release of pent-up demand from the economic reopening after lockdowns in April and May. China’s credit growth recovered meaningfully in June due to large local government (LG) bond issuance. Private sector sentiment and credit demand remain sluggish. Home sales relapsed in the first two weeks of July after a one-off improvement in June, corroborating that the housing market’s fundamentals remain gloomy. Despite posting strong growth in June, Chinese exports are facing strong headwinds from weakening external demand. A contraction in exports is very likely in the second half of this year. Chinese domestic demand remains weak. Renewed rolling lockdowns are likely in view of the escalating Covid-19 cases related to a more infectious Omicron subvariant. The RMB will probably continue to depreciate relative to the US dollar in the next few months. Bottom Line: Investors should maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. The risk-reward profile of Chinese onshore and offshore stocks in absolute terms is not yet attractive.   Chart 1High-Frequancy(Daily) Economic Indicators High-Frequancy(Daily) Economic Indicators High-Frequancy(Daily) Economic Indicators The recent recovery in economic activity in June mainly reflects the release of pent-up demand after reopening from lockdowns in April and May. Odds are that this rebound will fade. The relapse in house sales and slowdown in steel production during the first two weeks of July suggest that China’s economy is still struggling to gain traction (Chart 1). China’s business cycle recovery will be more U shaped rather than a repeat of the V-shaped resurgence experienced following the early 2020 lockdown. At that time, a quick and strong revival in the property market and exports shored up China’s recovery in 2H20. In contrast, the economy’s progress in the second half of this year will be dragged down by shrinking exports, weak consumption and depressed demand for housing. China’s recovery will be more U shaped than V shaped for the following reasons: New financing schemes for infrastructure investment recently announced by authorities will not lead to a surge in infrastructure investments in 2H22. The basis is that these new funding sources will largely offset a shortfall in local government (LG) revenues from this year’s land sales, as we discussed in last week’s report. Thus, there will be little new stimulus for infrastructure beyond what was already approved in the budget plan earlier this year. Rolling lockdowns will persist as long as China’s stringent dynamic zero-Covid policy remains in place. The recent flare-up of the more infectious Omicron BA.5 subvariant cases in a few cities raise the likelihood of more lockdowns. The number of cities under mobility restrictions or some form of lockdown climbed during the second week of July (Chart 2). These cities account for around 11% of China’s GDP. The rolling lockdowns will continue to disrupt the economy. Private sector sentiment remains in the doldrums. The willingness to spend or invest among households and enterprises remains very depressed (Chart 3). This will ensure that the multiplier effect of fiscal and credit stimulus will be small. Chart 2The Odds Of Renewed Lockdowns Are Rising The Odds Of Renewed Lockdowns Are Rising The Odds Of Renewed Lockdowns Are Rising Chart 3Sluggish Sentiment Among Chinese Households And Enterprises Sluggish Sentiment Among Chinese Households And Enterprises Sluggish Sentiment Among Chinese Households And Enterprises Chart 4China: Can The Economy Recover Without Housing Revival Can The Economy Recover Without Housing Revival Can The Economy Recover Without Housing Revival Since 2008 there has been no recovery in the mainland economy without buoyant real estate construction and surging property prices (Chart 4).  Chinese exports are set to contract as the demand for goods from US and European consumers continues to shrink. ​​​​​ Bottom Line: In absolute terms, the risk-reward profile of Chinese stocks is not yet attractive. We continue to recommend that investors maintain a neutral stance on China’s onshore stocks and underweight allocation on Chinese investable stocks within a global equity portfolio.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Peeling Off Credit Data Chart 5June's Credit Growth Was Largely Driven By LG Bond Issuance June's Credit Growth Was Largely Driven By LG Bond Issuance June's Credit Growth Was Largely Driven By LG Bond Issuance June’s strong credit growth was again driven by large LG bond issuance (Chart 5, top panel). Consequently, the credit impulse – calculated as a 12-month change in the flow of total social financing (TSF) as a percentage of nominal GDP – is much more muted when LG bond issuance is excluded (Chart 5, bottom panel). Medium- to long-term corporate loan growth only ticked up in June, but short-term bill financing has dropped dramatically (Chart 6). While it is difficult to quantify, it is highly likely that the modest upturn in corporate credit flow was due to (1) corporates’ pent-up demand for financing after the spring lockdowns and (2) the PBoC’s moral suasion used to boost the banks’ credit origination. Meanwhile, a PBoC survey released on June 29-30, showed that loan demand for all types of industrial enterprises plunged sharply in Q2, suggesting that sentiment is very weak among corporates (Chart 7). Chart 6Corporate Loan Growth Improved In June... Corporate Loan Growth Improved In June... Corporate Loan Growth Improved In June... Chart 7… But Corporate Loan Demand Remains Very Weak ... But Corporates Remain Low Demand Very Weak ... But Corporates Remain Low Demand Very Weak Household loan demand, which is highly correlated with home sales, remains shaky too (Chart 8, top panel). Medium- to long-term consumer loans continued to plunge, and the annual change in household loan origination remains negative (Chart 8, bottom panel). Chart 8Household Loan Demand Is Still Depressed Household Loan Demand Is Still Depressed Household Loan Demand Is Still Depressed Chart 9The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate Overall, our projections for the combined credit and fiscal spending impulse for the rest of this year suggest that the aggregate fiscal and credit impulse will be improving but will be smaller than in 2020, 2016, 2013 and 2009 (Chart 9). Property Market: A Vicious Cycle Unfolding Home sales relapsed in the first two weeks of July after a one-off rebound in June. The weakness was broad-based across all city tiers. This implies that June’s bounce was driven by pent-up demand after lockdowns and does not represent a sustained revival (Chart 10). Sentiment among home buyers remains downbeat. The percentage of households planning to buy homes slipped further according to the PBoC’s urban household survey released on June 29 (Chart 11, top panel). Moreover, the percentage of households expecting home prices to rise has dived to the lowest level since early 2015 according to the same survey (Chart 11, bottom panel). Chart 10No Snapback In Housing Sales No Snapback In Housing Sales No Snapback In Housing Sales Chart 11Downbeat Sentiment Among Home Buyers Downbeat Sentiment Among Home Buyers Downbeat Sentiment Among Home Buyers Chart 12Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Property developers are caught in a vicious cycle.  Financing has not strengthened because the “three red lines” policy remains in place, and developers’ borrowing from banks shows no signs of amelioration (Chart 12, top panel). Critically, the plunge in the sector’s financing is resulting in shrinking housing completions (Chart 12, bottom panel). As property developers are suffering from liquidity shortages, they are dragging on existing construction projects. The upshot is that many Chinese cities are seeing delays in the completion of new homes. The latter is depressing buyers’ sentiment, generating a reluctance to buy properties, and curtailing deposits and advances to developers. In recent years, deposits and advances accounted for 50% of property developers’ financing. Without a substantial improvement in their financing, developers will not be in a position to service their excessive debts and deliver houses they have presold in the recent years. The latter will undermine their financing, closing the vicious cycle. In short, real estate developers’ liquidity shortfalls are evolving into solvency problems. These will continue dampening construction activity. An Export Contraction Ahead China’s exports were robust in June as supply chain and logistic disruptions faded. This was corroborated by last month’s advance in suppliers’ delivery times and production subindexes of China’s official Purchasing Managers’ Index (PMI) (Chart 13). Chart 13Chinese Logistics And Backlog Orders Pressures Have Eased In June Chinese Logistics And Backlog Orders Pressures Have Eased In June Chinese Logistics And Backlog Orders Pressures Have Eased In June Yet, China’s new exports orders remain in contractionary territory (Chart 14). Moreover, the softness of Shanghai’s export container freight index is also signaling weakness in China’s exports (Chart 15).   Chart 14External Demand For Chinese Export Goods Will Be Dwindling External Demand For Chinese Export Goods Will Be Dwindling External Demand For Chinese Export Goods Will Be Dwindling Chart 15Signs Of Moderation In China's Exports Signs Of Moderation In China's Exports Signs Of Moderation In China's Exports The shift in consumer spending in developed economies from manufactured goods to services has created headwinds for Chinese exports. US and European consumption of goods (ex-autos) is set to decline below its long-term trend (Chart 16). Given that retail inventories in the US have skyrocketed well above their pre-pandemic trend, US demand for consumer goods and, hence, Chinese exports will dwindle significantly when US retailers start to destock (Chart 17). Falling real household disposable income in the US and Europe will also fortify the downward trend in demand for consumer goods that China is a major producer of. Therefore, we expect shrinking Asian and Chinese exports in the second half of this year. Chart 16Developed Economies’ Household Demand For Goods ex-Autos Will Shrink Developed Economies' Household Demand For Goods ex-Autos Will Experience Mean Reversion Developed Economies' Household Demand For Goods ex-Autos Will Experience Mean Reversion Chart 17Well-Stocked Shelves In The US Bode Poorly For Chinese Exports Well-Stocked Shelves In The US Bode Poorly For Chinese Export Well-Stocked Shelves In The US Bode Poorly For Chinese Export Very Sluggish Domestic Demand Both consumer spending and capital expenditure remain in the doldrums. Traditional infrastructure investments picked up strongly in June, while investments in the real estate sector weakened further (Chart 18). Contracting exports will weigh on investments in manufacturing. Even as infrastructure investment recovers modestly, the downtrend in manufacturing and property fixed-asset investments will cap China’s capital spending in 2H22. Capital spending in traditional infrastructure, real estate and manufacturing account for 24%, 19% and 31% of fixed-asset investment, respectively. Chart 18Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Chart 19Contracting Import Volume Reflects China's Sluggish Domestic Demand Contracting Import Volume Reflects China's Sluggish Domestic Demand Contracting Import Volume Reflects China's Sluggish Domestic Demand Imports for domestic consumption (excluding imports for processing and re-exports) are a good proxy for domestic demand trajectory. In June, import volumes contracted deeply at 12% on a year-on-year basis, reflecting sluggish domestic demand (Chart 19). Worryingly, import volume contraction is widespread from key commodities to semiconductors and capital goods (Chart 20A and 20B). Chart 20ABroad-Based Contraction In Imports Broad-Based Contraction In ... Chinese Imports Of Key Commodities Deteriorated In June Broad-Based Contraction In ... Chinese Imports Of Key Commodities Deteriorated In June Chart 20BBroad-Based Contraction In Imports ... Imports And key Imports Categories Chinese Domestic Demand Has Been Absent Over The Past 12 Months ... Imports And key Imports Categories Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 21Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Moreover, the recent increase in Covid-19 cases and ensuing lockdowns in China will curb household consumption and the service sector’s activities in the next few months (Chart 21). Newly released labor market data show a mixed picture. The nationwide urban survey-based unemployment rate fell in June, but the unemployment rate among younger workers surged to the highest point since data collection began in 2018 (Chart 22, top panel). Reflecting weak employment conditions, new urban job creation in the first half of the year withered compared with the same period last year (Chart 22, bottom panel). Rapidly deteriorating income prospects are reinforcing households’ downbeat sentiment. A PBoC survey released on June 29 shows that confidence of future income in Q2 plummeted to its lowest level during the past two decades, while the preference for more saving deposits soared to the highest level since data collection began in 2002 (Chart 23). The latter entails that households’ consumption recovery will be gradual and halting, at best, in the second half of this year.  Chart 22Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Chart 23Low Confidence In Future Income Contributes To Households' Unwillingness To Consume low Confidence In Future Income Contributes To Households' Unwillingness To Consume low Confidence In Future Income Contributes To Households' Unwillingness To Consume The RMB Is Facing Downside Risks In The Near Term Chart 24RMB Is Still Vulnerable RMB Is Still Vulnerable RMB Is Still Vulnerable The RMB has depreciated by about 6% against the US dollar since March, and we believe this trend will continue in the next few months. China’s interest rate differential versus the US dollar has fallen deeper into negative territory, and the gap may widen even more given that the inflation and monetary policy cycles in China and the US will continue to diverge (Chart 24, top panel). Thus, Chinese fixed-income market outflow pressures could endure this year (Chart 24, bottom panel). Moreover, as discussed in the section above, Chinese exports are set to shrink in the second half of the year. This will also weigh on the RMB. Notably, Chinese companies have started to increase their demand for USD. The net FX settlement rate by banks on behalf of clients has fallen below zero, albeit only marginally (Chart 25). This means more non-financial enterprises (such as exporters and investors) bought from than sold foreign currency to banks (Chart 25, bottom panel). Furthermore, foreign outflows from the onshore equity market have resumed and will likely be sustained, at least through the next few months (Chart 26). Foreign investors will likely flee from Chinese onshore stocks as global stocks continue selling off and China’s economic recovery disappoints in the second half of this year. Chart 25Contracting Exports Will Weigh On The RMB Contracting Exports Will Weigh On The RMB Contracting Exports Will Weigh On The RMB Chart 26Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Chinese Equity Market Technicals: Tell-Tale Signs Chart 27A-Shares Has Not Broken Above 200-Day Moving Average A-Shares Has Not Broken Above 200-Day Moving Average A-Shares Has Not Broken Above 200-Day Moving Average The rebound in China’s onshore CSI 300 stock index had been obstructed at its 200-day moving average (Chart 27). A failure to break above this technical resistance would imply non-trivial downside – a retest of its recent lows, at least. The relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – versus the global equity index has petered off at its previous troughs (Chart 28). This is a tell-tale sign of a major relapse. Chart 28A Tell-Sign Of Major Downtrend A Tell-Sign Of Major Downtrend A Tell-Sign Of Major Downtrend Chart 29Chinese Tech Stocks Still Appear Fragile Chinese Tech Stocks Still Appear Fragile Chinese Tech Stocks Still Appear Fragile The Hang Seng Tech index – which tracks Chinese offshore tech stocks/platform companies – has also failed to break above its 200-day moving average (Chart 29). This entails that the bear market in these share prices might not be yet over. Chart 30Two Large-Cap Chinese Stocks Two Large-Cap Chinese Stocks Two Large-Cap Chinese Stocks China’s two largest stocks (by market capitalization) – Tencent and Alibaba – may not be out of the woods:  Alibaba has failed at its 200-day moving average (Chart 30, top panel). Tencent has failed to rebound at all (Chart 30, bottom panel). Odds are it will likely drop more.   Table 1China Macro Data Summary China’s Recovery: U Or V Shaped? China’s Recovery: U Or V Shaped? Table 2China Financial Market Performance Summary China’s Recovery: U Or V Shaped? China’s Recovery: U Or V Shaped? Footnotes Strategic Themes Cyclical Recommendations

Listen to a short summary of this report.     Executive Summary The TIPS Market Foresees A Sharp Deceleration In Inflation What If The TIPS Are Right? What If The TIPS Are Right? TIPS breakevens are pointing to a rapid decline in US inflation over the next two years. If the TIPS are right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising again. This will bolster consumer confidence, making a recession less likely. The surprising increase in analyst EPS estimates this year partly reflects the contribution of increased energy profits and the fact that earnings are expressed in nominal terms while economic growth is usually expressed in real terms. Nevertheless, even a mild recession would probably knock down operating earnings by 15%-to-20%. While a recession in the US is not our base case, it is for Europe. A European recession is likely to be short-lived with the initial shock from lower Russian gas flows counterbalanced by income-support measures and ramped-up spending on energy infrastructure and defense. We are setting a limit order to buy EUR/USD at 0.981. Bottom Line: Stocks lack an immediate macro driver to move higher, but that driver should come in the form of lower inflation prints starting as early as next month. Investors should maintain a modest overweight to global equities. That said, barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. US CPI Surprises to the Upside… Again        Investors hoping for some relief on the inflation front were disappointed once again this week. The US headline CPI rose 1.32% month-over-month in June, above the consensus of 1.1%. Core inflation increased to 0.71%, surpassing consensus estimates of 0.5%. The key question is how much of June’s report is “water under the bridge” and how much is a harbinger of things to come. Since the CPI data for June was collected, oil prices have dropped to below $100/bbl. Nationwide gasoline prices have fallen for four straight weeks, with the futures market pointing to further declines in the months ahead. Agriculture and metals prices have swooned. Used car prices are heading south. Wage growth has slowed to about 4% from around 6.5% in the second half of last year. The rate of change in the Zillow rent index has rolled over, albeit from high levels (Chart 1). The Zumper National Rent index is sending a similar message as the Zillow data.  All this suggests that inflation may be peaking. The TIPS market certainly agrees. It is discounting a rapid decline in US inflation over the next few years. This week’s inflation report did little to change that fact (Chart 2). Chart 1Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Chart 2Investors Expect Inflation To Fall Rapidly Over The Next Few Years What If The TIPS Are Right? What If The TIPS Are Right? TIPS Still Siding with Team Transitory If the TIPS market is right, this would have two important implications. First, the Fed would not need to raise rates more quickly over the next six months than the OIS curve is currently discounting (although it probably would not need to cut rates in 2023 either, given our higher-than-consensus view of where the US neutral rate lies) (Chart 3). The second implication is that real wages, which have declined over the past year, will start rising again as inflation heads lower. Falling real wages have sapped consumer confidence. As real wage growth turns positive, confidence will improve, helping to bolster consumer spending (Chart 4). To the extent that consumption accounts for nearly 70% of the US economy – and other components of GDP such as investment generally take their cues from consumer spending – this would significantly raise the odds of a soft landing.  Chart 3The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 Chart 4Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Chart 5Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Of course, the TIPS market could be wrong. Bond traders do not set prices and wages. Businesses and workers, interacting with each other, ultimately determine the direction of inflation. Yet, the view of the TIPS market is broadly in sync with the view of most households and businesses. Expected inflation 5-to-10 years out in the University of Michigan survey has risen since the pandemic began, but at about 3%, it is close to where it was for most of the period between 1995 and 2015 (Chart 5). As we pointed out in our recently published Third Quarter Strategy Outlook, and as I discussed in last week’s webcast, the fact that long-term inflation expectations are well anchored implies that the sacrifice ratio – the amount of output that must be forgone to bring down inflation by a given amount — may be quite low. This also raises the odds of a soft landing. Investors Now See Recession as the Base Case Our relatively sanguine view of the US economy leaves us in the minority camp. According to recent polling, more than 70% of US adults expect the economy to be in recession by year-end. Within the investment community, nearly half of retail traders and three-quarters of high-level asset allocators expect a recession within the next 12 months (Chart 6). Chart 6Many Investors Now See Recession As Baked In The Cake What If The TIPS Are Right? What If The TIPS Are Right? Reflecting the downbeat mood among investors, bears exceeded bulls by 20 points in the most recent weekly poll by the American Association of Individual Investors (Chart 7). A record low percentage of respondents in the New York Fed’s Survey of Consumer Expectations believes stocks will rise over the next year (Chart 8). Chart 7Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Chart 8Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Resilient Earnings Estimates Admittedly, while sentiment on the economy and the stock market has soured, analyst earnings estimates have yet to decline significantly. In fact, in both the US and the euro area, EPS estimates for 2022 and 2023 are higher today than they were at the start of the year (Chart 9). What’s going on? Part of the explanation reflects the sectoral composition of earnings. In the US, earnings estimates for 2022 are up 2.4% so far this year. Outside of the energy sector, however, 2022 earnings estimates are down 2.2% year-to-date and down 2.9% from their peak in February (Chart 10). Chart 9US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date Another explanation centers on the fact that earnings estimates are expressed in nominal terms while GDP growth is usually expressed in real terms. When inflation is elevated, the difference between real and nominal variables can be important. For example, while US real GDP contracted by 1.6% in Q1, nominal GDP rose by 6.6%. Gross Domestic Income (GDI), which conceptually should equal GDP but can differ due to measurement issues, rose by 1.8% in real terms and by a whopping 10.2% in nominal terms in Q1. Chart 10Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates How Much Bad News Has Been Discounted? Historically, stocks have peaked at approximately the same time as forward earnings estimates have reached their apex. This time around, stocks have swooned well in advance of any cut to earnings estimates (Chart 11). At the time of writing, the S&P 500 was down 25% in real terms from its peak on January 3. Chart 11Unlike In Past Cycles, Stocks Peaked Well Before Earnings What If The TIPS Are Right? What If The TIPS Are Right? This suggests that investors have already discounted some earnings cuts, even if analysts have yet to pencil them in. Consistent with this observation, two-thirds of investors in a recent Bloomberg poll agreed that analysts were “behind the curve” in responding to the deteriorating macro backdrop (Chart 12). Chart 12Most Investors Expect Analyst Earnings Estimates To Come Down What If The TIPS Are Right? What If The TIPS Are Right? Nevertheless, it is likely that stocks would fall further if the economy were to enter a recession. Even in mild recessions, operating profits have fallen by about 15%-to-20% (Chart 13). That is probably a more severe outcome than the market is currently discounting. Chart 13Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Subjectively, we would expect the S&P 500 to drop to 3,500 over the next 12 months in a mild recession scenario where growth falls into negative territory for a few quarters (30% odds) and to 2,900 in a deep recession scenario where the unemployment rate rises by more than four percentage points from current levels (10% odds). On the flipside, we would expect the S&P 500 to rebound to 4,500 in a scenario where a recession is completely averted (60% odds). A probability-weighted average of these three scenarios produces an expected total return of 8.3% (Table 1). This is enough to warrant a modest overweight to stocks, but just barely. Barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. Table 1A Scenario Analysis For The S&P 500 What If The TIPS Are Right? What If The TIPS Are Right? What’s the Right Framework for Thinking About a European Recession? Whereas we would assign 40% odds to a recession in the US over the next 12 months, we would put the odds of a recession in Europe at around 60%. With a recession in Europe looking increasingly probable, a key question is what the nature of this recession would be. The pandemic may provide a useful framework for answering that question. Just as the pandemic represented an external shock to the global economy, the disruption to energy supplies, stemming from Russia’s invasion of Ukraine, represents an external shock to the European economy. In the initial phase of the pandemic, economic activity in developed economies collapsed as millions of workers were forced to isolate at home. Over the following months, however, the proliferation of work-from-home practices, the easing of lockdown measures, and ample fiscal support permitted growth to recover. Eventually, vaccines became available, which allowed for a further shift to normal life. Just as it took about two years for vaccines to become widely deployed, it will take time for Europe to wean itself off its dependence on Russian natural gas. Earlier this year, the IEA reckoned that the EU could displace more than a third of Russian gas imports within a year. The more ambitious REPowerEU plan foresees two-thirds of Russian gas being displaced by the end of 2022. In the meantime, some Russian gas will be necessary. Canada’s decision over Ukrainian objections to return a repaired turbine to Germany for use in the Nord Stream 1 gas pipeline suggests that a full cutoff of Russian gas flows is unlikely. Chart 14The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP During the pandemic, governments wasted little time in passing legislation to ease the burden on households and businesses. The European energy crunch will elicit a similar response. Back when I worked at the IMF, a common mantra in designing lending programs was that one should “finance temporary shocks but adjust to permanent ones.” The current situation Europe is a textbook example for the merits of providing income support to the private sector, financed by temporarily larger public deficits. The ECB’s soon-to-be-launched “anti-fragmentation” program will allow the central bank to buy the government debt of Italy and other at-risk sovereign borrowers without the need for a formal European Stability Mechanism (ESM) program, provided that the long-term debt profile of the borrowers remains sustainable. Get Ready to Buy the Euro All this suggests that Europe could see a fairly brisk rebound after the energy crunch abates. If the euro area recovers quickly, the euro – which is now about as undervalued against the dollar as anytime in its history (Chart 14) – will soar. With that in mind, we are setting a limit order to buy EUR/USD at 0.981.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn & Twitter   Global Investment Strategy View Matrix What If The TIPS Are Right? What If The TIPS Are Right? Special Trade Recommendations Current MacroQuant Model Scores What If The TIPS Are Right? What If The TIPS Are Right?

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales Beijing’s plan to bring forward RMB 2.6 trillion of financing for infrastructure expenditures in H2 2022 is a considerable stimulus. However, this new funding will not result in new investments. Rather, it will, by and large, offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what has been approved in the budget plan earlier this year. Not only is the credit and fiscal impulse smaller in this cycle than in the previous ones, but also the multiplier effect will be lower. This will hinder the recovery in domestic demand. After the one-off rebound in economic activity following the lockdowns in April and May of this year, China’s business cycle recovery will be more U shaped rather than V shaped. Bottom Line: For absolute-return investors neither A-shares nor investable stocks offer an attractive risk-reward profile. Within a global equity portfolio, we continue to recommend a neutral allocation to China’s A-shares and an underweight allocation to Chinese investable stocks. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable stocks. Maintain the long A-shares / short offshore investable Chinese stocks position.   Alleged plans of an additional RMB 1.5 trillion local government (LG) special bond issuance in H2 2022 have prompted investors to speculate about whether this stimulus initiative is sufficient to produce a considerable acceleration in infrastructure investment.  This stimulus would be added to RMB 800 billion and 300 billion of policy bank funding for infrastructure that the government approved earlier in Q2 this year. Hence, the combined new infrastructure financing made available by Beijing is RMB 2.6 trillion. Below, we elaborate on how this RMB 2.6 trillion of additional infrastructure financing will be largely offset by a drop in LG revenues from land sales. In short, the stimulus will preclude downside in infrastructure investment rather than herald a major acceleration.  In addition, the economic recovery still faces substantial headwinds from other segments of the economy. We believe that, approached as a whole, China’s business cycle recovery will be more U shaped than V shaped. Quantifying Infrastructure Stimulus The degree of new financing for infrastructure is considerable. This RMB 2.6 trillion in new financing in H2 2022 is equal to 7% of planned 2022 LG aggregate expenditures, 6% of planned 2022 aggregate total central and local government spending including budgetary and managed funds, 14% of fixed-asset investment (FAI) in traditional infrastructure, and 2% of GDP.  The composition of general government spending is presented in Table 1. Table 1Structure And Composition Of Government Spending In China Making Sense Of China’s New Stimulus Making Sense Of China’s New Stimulus However, a caveat is in order: this new funding will not result in new investments. Rather, it will, by and large, offset the drop in LG revenues from land sales. The primary source of financing infrastructure investment is LG managed funds. LG managed funds budgets, however, are under severe stress because of the plunge in revenues from land sales. Notably, proceeds from land sales account for 23% of aggregate LG expenditures (Chart 1). Land sales have contracted by about 30% in the January-June period of this year, and there is little hope that they will pick up in H2 2022. The reason is that property developers’ financing is down by 30% and is unlikely to recover soon (Chart 2). Chart 1Land Sales Are Critical For LG Expenditures Land Sales Are Critical For LG Expenditures Land Sales Are Critical For LG Expenditures Chart 2No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales Chart 3Property Developers Are Facing Debt Deflation Property Developers Are Facing Debt Deflation Property Developers Are Facing Debt Deflation As we have argued in our past reports, property developers carry a substantial inventory of real estate assets funded by a massive debt build-up (Chart 3, top panel). With housing prices beginning to deflate, property developers are about to face debt deflation – falling asset prices and a high debt burden (Chart 3, bottom panel). Thereby, they have little appetite or capacity to expand their assets and leverage. Assuming land sales for the full year will decline by 30%, this drop would lead to an RMB 2.52 trillion reduction in LGs managed fund revenues in 2022 (Table 2). Hence, the new RMB 2.6 trillion infrastructure financing will be used to offset the RMB 2.5 trillion shortfall in LG managed funds budgets because of the plunge in land transfer proceeds. Table 2China: New Stimulus For Infrastructure in H2 2022 Making Sense Of China’s New Stimulus Making Sense Of China’s New Stimulus On the whole, there will be very little new funding available to boost infrastructure spending beyond what has been approved by the 2022 National People’s Congress (NPC) earlier this year. Chart 4The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate Hence, for this full year, there is no change to the aggregate fiscal spending impulse that incorporates central and local government budgetary spending as well as managed funds’ expenditures (Chart 4, top panel). The two scenarios for the non-government credit impulse are shown in the middle panel of Chart 4. The optimistic scenario assumes non-government credit will accelerate to 9.5% from 8.7%, and the pessimistic scenario is based on no acceleration in non-government credit growth. Finally, the bottom panel of Chart 4 illustrates the projections for the combined credit and fiscal spending impulse for the remainder of this year. Although the aggregate fiscal and credit impulse is non-trivial, it is smaller than those in 2020, 2016, 2013, and 2009. Bottom Line: The government has announced RMB 1.1 trillion in infrastructure funding and will likely raise the LG special bond quota by RMB 1.5 trillion. Yet, this RMB 2.6 trillion financing will only offset the shortfall in infrastructure financing from plunging land transfer revenue.  In brief, there is little new stimulus for infrastructure beyond what has been approved in the budget plan from early this year.   Economic Headwinds Chart 5China's Reopening Rebound China's Reopening Rebound China's Reopening Rebound Economic activity in China has rebounded following the reopening of the economy. Chart 5 illustrates that high-frequency data, such as car sales, house sales, commercial truck cargo, and steel production have all recently improved. We expect the one-off renormalization of economic activity following the lockdowns in April and May to give way to more subdued growth. The reason is that the mainland economy is facing several major headwinds: The real estate market is unlikely to recover meaningfully given the “three red lines” policy has not been eased, and many of property market excesses have not been purged. Hence, the question remains whether the Chinese economy can stage a robust recovery without the participation of the property market. We doubt it can because of the vital role that real estate has played in the economy in the past 20 years as the result of its large share in GDP and its impact on consumer and business sentiment. Since 2008, there has been no business cycle recovery in China without the property market firing on all cylinders (Chart 6). Chart 6All Economic Recoveries Were Accompanied By A Revival In The Property Market All Economic Recoveries Were Accompanied By A Revival In The Property Market All Economic Recoveries Were Accompanied By A Revival In The Property Market Chart 7China: The Willingness To Spend And Invest Is Very Low China: The Willingness To Spend And Invest Is Very Low China: The Willingness To Spend And Invest Is Very Low Rolling lockdowns will likely persist. This will weigh on household and private business confidence. Diminishing confidence will undermine the willingness to spend, invest, and hire. Our marginal propensity to spend indicators for households & enterprises remain very depressed (Chart 7). Low propensity to spend entails that the multiplier effect of fiscal and credit stimulus will be lower in this cycle than in the previous ones. Not only is the credit and fiscal impulse smaller than in the previous cycles but also the multiplier will be lower. This will hinder the recovery in domestic demand. Finally, Chinese exports are set to contract in H2 2022 because of shrinking demand for consumer goods (ex-autos) in the US and Europe as well as mainstream EM. Bottom Line: After the one-off rebound in economic activity following the lockdowns in April and May, the business cycle recovery will be more U shaped rather than V shaped. Investment Conclusions For absolute-return investors, neither A-shares nor investable stocks offer an attractive risk-reward profile.   Within the A-share market, our strongest conviction is to overweight interest rate-sensitive sectors like consumer staples, utilities, and healthcare. Consumer discretionary stocks should also be a slight overweight now.   We continue to recommend a neutral allocation to Chinese A-shares and an underweight allocation to investable stocks within a global equity portfolio. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable Chinese stocks.   Maintain the long A-shares / short offshore investable stocks position.   The yuan, like all other emerging Asian currencies, is still facing near-term downside risk versus the US dollar. Chinese onshore government bond yields will likely drop further.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes Cyclical Recommendations

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL AT REVERSAL AT REVERSAL Chart 13AT REVERSAL AT REVERSAL AT REVERSAL Chart 14The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 15The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 16A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 26Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Rebounding Chinese Auto Sales Chinese Infrastructure Investment Growth: A Slowdown Ahead Chinese Infrastructure Investment Growth: A Slowdown Ahead China’s stimulus for auto purchases and an easing global auto chip shortage will lead to about a 10% recovery in domestic auto sales in 2022H2 from a year ago. Next year, we expect Chinese auto sales to grow only modestly (under 5%).  The share of new energy vehicles (NEVs) in auto sales is rising rapidly in China, crowding out internal combustion engine vehicles (ICEVs) at a fast rate. China is becoming more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Production of NEVs and the installation of NEV charging poles will expand rapidly. Yet, given the still-high valuation of these stocks, we will look to buy into these sectors at a better price entry point. Bottom Line: Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months on the expectation of improving car sales. Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. Feature Chinese total auto sales contracted by 12% year on year in the first five months of this year due to a deep 24% contraction in non-NEV sales. In stark contrast, Chinese NEV sales have more than doubled during the same period. However, the 1-million-unit increase in NEV sales failed to counteract the 2.4-million-unit loss in non-NEV demand. This raises two questions. Why have NEV sales skyrocketed at a time when non-NEV sales have tanked? Will Chinese auto sales recover in 2022H2 and 2023? If so, then how strongly will the recovery be? The answer to the first question lies in a major auto chip allocation strategy that many Chinese auto producers adopted last year. Under limited semiconductor supplies, auto producers in China prioritized the use of chips in their production of NEV models – which have higher profit margins –over traditional vehicles. The greater availability of NEVs than ICEVs has meant an increase in sales of the former and a deep contraction in the latter in 2022H1. Chart 1Chinese Auto Sales: A Recovery Ahead? Chinese Auto Sales: A Recovery Ahead? Chinese Auto Sales: A Recovery Ahead? For the second question, we believe that China’s stimulus package to boost auto sales and an easing global auto chip shortage will lead to about a 10% recovery in auto sales in 2022H2 from a year ago. On the other hand, growth in 2023 will be very modest (under 5%). Accordingly, the daily data of Chinese retail auto sales have already shown a strong rebound in the total sales of NEVs and ICEVs in the last three weeks of June (Chart 1). Auto Sales In China: A Gradual Recovery     China’s auto sales are set to have a gradual recovery in 2022H2. We expect auto sales to reach 26.2-26.8 million units by the end of this year, with NEV and non-NEVs rising to 5-5.3 million units and 21.2-21.5 million units, respectively1 (Chart 2). The reasons for our positive estimates include policy stimulus, improving technological advancement of NEVs, as well as an easing in the global auto chip shortage. First, the government has issued a flurry of policies since late May attempting to boost domestic auto demand. As Chart 1 shows, these policies have proved effective, at least for now. In previous episodes of stimulus aimed at boosting auto sales in 2009-2010, 2016-2017, and 2019-2021, authorities had implemented similar supportive measures. While the stimulus worked well in the first two episodes, it was not effective in 2019-2021 (Chart 3).   Chart 2Auto Demand In China: A Gradual And Moderate Rebound Auto Demand In China: A Gradual And Moderate Rebound Auto Demand In China: A Gradual And Moderate Rebound Chart 3Policy Stimulus Will Help Lift Chinese Auto Demand Policy Stimulus Will Help Lift Chinese Auto Demand Policy Stimulus Will Help Lift Chinese Auto Demand Box 1 shows our summary of those auto stimulus and a comparison of these episodes. Of all these policies, we believe that a sales tax reduction2 on certain vehicles has proved to be the most effective policy as it directly reduced the prices of these vehicles. In 2022H2, this policy will mainly benefit ICEVs sales as NEVs will continue to enjoy a full exemption from the 10% vehicle purchase tax. The government is also considering an extension of the exemption for NEVs to the end of next year.  Box 1China’s Stimulus Package For The Domestic Auto Industry The Chinese Auto Market: On A Path To Recovery The Chinese Auto Market: On A Path To Recovery ​​​​​​​ This year’s stimulus is more comparable to the 2009 and 2016 episodes as they share the same reduction in the sales tax rate from 10% to 5%. The main difference is that this time the policy targets cars with 2-liter engines or smaller, while back in 2009 and 2016 this policy only applied to vehicles with capacity no bigger than 1.6-liters. This means a larger range of vehicles will benefit from the reduction. In short, the current policy will allow an additional 23% share of total vehicles sold to benefit from the stimulus. Please note that for the period of 2019-2021 there was no sales tax reduction. This may be one of the reasons for the lack of recovery in vehicle sales in this episode; Chinese auto sales contracted in both 2019 and 2020. Second, Chinese NEVs buyers have been enjoying government subsidies, albeit on a sliding scale since 2019. The amount of subsidy has been dropping by 10%, 20% and 30% in 2020, 2021 and 2022, respectively (Table 1). We expect NEV sales to rise as the subsidy is set to expire by the end of this year. This may induce some buyers to buy NEVs before the subsidy ends. Table 1Government Subsidy For NEV Purchase in China The Chinese Auto Market: On A Path To Recovery The Chinese Auto Market: On A Path To Recovery Chart 4NEVs Become More Appealing To Chinese Consumers NEVs Become More Appealing To Chinese Consumers NEVs Become More Appealing To Chinese Consumers In addition, NEVs are becoming increasingly appealing for auto buyers. This is due to longer travel mileage per battery charge, constant improvement in NEV related technologies, and an expanded charging/battery swap framework (Chart 4). Further, in comparison to traditional ICEVs, NEVs have become increasingly more equipped with functions such as autonomous driving, intelligent interconnection, and other software application-based services. NEVs will also become more integrated with intelligent and interactive networks. All these features will make NEVs more attractive to automobile buyers as well.  According to the McKinsey China Auto Consumer Insights 2021 report, Chinese consumers are more interested than ever in smart vehicle technologies, and they are willing to pay a premium for innovative features. 80% of consumers report that autonomous driving will be a key factor in their decision-making when they buy their next car. Meanwhile, 69% of consumers consider that over-the-air update technology (OTA) is an important feature, and 62% of those are willing to pay for it. Chart 5NEV Sales In China Are Not Very Sensitive To Gasoline Prices NEV Sales In China Are Not Very Sensitive To Gasoline Prices NEV Sales In China Are Not Very Sensitive To Gasoline Prices Rising oil and gasoline prices have also encouraged NEV sales in the past six-to-nine months. But we believe high fuel prices are relatively less important factors to NEV demand in China than in the US and EU. For example, in 2020H2, when oil prices were only around US$40-50 and domestic gasoline price were low, Chinese NEV sales still rose strongly during the same period (Chart 5). Third, the deep contraction in non-NEV sales in China in 2021 was partially caused by the global auto chip shortage. Global semiconductor chip shortages are likely to continue easing in 2022H2 as demand-supply gaps decrease across most components. Demand for consumer electronics is set to contract in the US and the EU in the next six-to-nine months. Hence, some capacity for PC and smartphone chips could be used to produce auto chips in the months ahead. Bottom Line: Government initiatives to boost auto sales, improving technological advancement of NEVs, and an easing of the global auto chip shortage will lift Chinese auto sales to some extent. Structural Auto Demand: A New Normal? Auto sales peaked in 2017 and are since down by 13%. Even if auto sales registered a modest recovery as we expect in 2022 and 2023, they will still be about 6% below their 2017 peak. The reasons why we do not expect a brisk auto sales recovery are as follows: Household (HH) income growth is very weak and the unemployment rate has been rising (Chart 6). HHs have considerable debt (Chart 7). With house prices not rising, and potentially deflating, HH willingness to take on more debt has declined. Chart 6Falling HH Income Growth And Rising Unemployment Falling HH Income Growth And Rising Unemployment Falling HH Income Growth And Rising Unemployment Chart 7HH Debt Burden Is Already High HH Debt Burden Is Already High HH Debt Burden Is Already High ​​​​​​ Wage/income growth has downshifted and narrowed its gap with interest rates on consumer loans. The cost HH debt has therefore risen relative to their income growth, making consumers less willing to take on more debt.   Reflecting downbeat consumer sentiment, the HH marginal propensity to consume has fallen to very low levels and has not shown signs of improvement (Chart 8). With the mediocre structural auto demand outlook in China, NEV sales will rapidly gain market share from non-NEVs (Chart 9). NEVs currently account for about 18% of total auto sales in China, still much lower than the country’s goal of 40% in 2030. Chart 8HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume Chart 9Accelerating NEV Penetration In China Accelerating NEV Penetration In China Accelerating NEV Penetration In China Last week the EU passed a plan of a 2035 phase-out of new fossil fuel car sales. This is also a trend for China. Chinese auto makers such as Changan, BAIC Motor and Haima have already announced that they will stop ICEV production in 2025. Chart 10Decelerating Growth In Chinese Oil Demand Decelerating Growth In Chinese Oil Demand Decelerating Growth In Chinese Oil Demand Declining ICEV sales will lead to lower growth of these vehicles on the road (Chart 10). Consequently, gasoline and diesel demand growth from passenger and commercial autos will be decelerating in China in the coming years. Bottom Line: Passenger car demand in China will be settled in low single digit growth rates. The market share of NEVs will rise very fast at the expense of ICEVs. In turn, falling ICEV sales will result in slower growth in domestic petroleum demand.  China: Increasing Competitiveness Chart 11Increasing Competitiveness Of Chinese Auto Manufacturers Increasing Competitiveness Of Chinese Auto Manufacturers Increasing Competitiveness Of Chinese Auto Manufacturers China has become increasingly competitive in global auto manufacturing. This is a strong tailwind for the country’s auto exports. In fact, the country’s net exports of autos have been rising (Chart 11). China is the world’s largest auto producer and consumer, accounting for 32.5% and 32% of global auto production and sales, respectively. The country is also the world’s largest NEV producer. Chart 12China: The World’s Leading And Largest EV Battery Producer The Chinese Auto Market: On A Path To Recovery The Chinese Auto Market: On A Path To Recovery ​​​​​​​​​​​​​​The battery is the most important component of an NEV, and its technological progress holds the key to the speed of NEV penetration. China is the world leader in this battery technology. China’s CATL is currently the world's largest battery manufacturer, with a market share of 32.5%. CATL ranked first in the world for five consecutive years from 2017 to 2021. In addition, four out of the top ten global EV battery players are Chinese companies, with a total market share of 44%, up from 41% last year (Chart 12). Moreover, in late June, CATL launched its cell-to-pack (CTP 3.0) battery. With a record-breaking volume utilization efficiency of 72% and an energy density of up to 255 Wh/kg, it achieves the highest integration level worldwide so far, capable of delivering a range of over 1,000 km on a single charge. The CTP 3.0 batteries are expected to be mass produced and come onto the market in 2023. The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s competitive advantage in NEV production, including batteries, as well as related policy support. For example, the number of total public & private charging poles rose at a compound annual growth rate of 50% in the past five years. This allows China to collect more NEV charging-related data, which could be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development. This will help reduce the charging anxiety of Chinese NEV users. In terms of autonomous driving, five Chinese companies have been included in the world’s 10 best autonomous driving companies based on their technological edge, according to the global autonomous driving report released by the California Department of Motor Vehicles (DMV). In addition to test drives in the US, major Chinese NEV makers have also carried out test drives in China with long distances and more complicated driving conditions. For example, as of mid-March, Baidu Apollo’s autonomous driving has already exceeded 25 million kilometers. In comparison, the total test distance of autonomous driving of all autonomous driving test cars in California were only 6.4 million kilometers. Chart 13China: Faster NEV Penetration Versus Other Countries The Chinese Auto Market: On A Path To Recovery The Chinese Auto Market: On A Path To Recovery At 13.4%, the share of NEVs in total auto sales in China was high last year compared with other countries (Chart 13). The ratio has already risen to 21% in the first five months of this year. Bottom Line: China will become more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Investment Implications Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months, expecting improving car sales in the short-to-medium term (Chart 14). Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. A shakeout in broader Chinese offshore and onshore stocks is likely due to the following (Chart 15): Chart 14Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chart 15...A Pullback Is Due ...A Pullback Is Due ...A Pullback Is Due Chart 16Look To Buy Chinese NEV-related Stocks Look To Buy Chinese NEV-related Stocks Look To Buy Chinese NEV-related Stocks China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. Global equities have probably not completed their downtrend. It will be hard for Chinese stocks to continue rallying if global share prices continue to fall. That said, we have a bullish bias towards Chinese NEV producers. China’s NEV sector enjoys tailwinds from structurally strong demand and its technological edge, especially in batteries. Hence, we will look to buy Chinese NEV and battery stocks at a better price entry point (Chart 16).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     China Association of Automobile Manufacturers (CAAM) predicted Chinese auto sales to rise to 27.5 million units for the full year. We are a little bit less optimistic on that front. 2     The State Council of China is enacting 60-billion-yuan (US$9 billion) worth of tax cuts between June and December. The purchase tax on certain passenger vehicles will be reduced by half to 5% of the sticker price. The tax cuts target cars with 2-liter engines or smaller, priced at 300,000 yuan (US$ 44,800) or less. Strategic Themes Cyclical Recommendations

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Feature Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.1 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation A Broad-Based Pickup in Inflation A Broad-Based Pickup in Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem July 2022 July 2022   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI July 2022 July 2022 Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.2 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market A Very Tight US Labor Market A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble The US Economy is in Trouble The US Economy is in Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue Inflation is a 'Modern' Issue Inflation is a 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance A Simple Measure of the Monetary Stance A Simple Measure of the Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Globalization in Retreat Globalization in Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.3 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt No Releveraging Cycle in Household Debt No Releveraging Cycle in Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? A Peaking in Supply Problems? A Peaking in Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher Inflation Expectations Spike Higher Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. Footnotes 1This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 2 Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 3 A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.