Monetary

Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance.  Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. ​​​​​​​In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens.  Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary Wars Don’t Usually Affect Markets For Long Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested We expect the war in Ukraine to stay within its borders, and therefore to have little impact on global growth. Markets will be volatile, but we recommend allocators stay invested – with some moderate hedges in place. The Fed won’t tighten as fast as markets expect, and US long rates will not rise much further this year. So, within fixed-income, we raise government bonds to neutral. Flat rates remove a positive for the Financials equity sector, which we lower to neutral. The oil price will fall back to $85 by the second half, as Saudi and others increase supply. We reduce our recommendation for Canadian equities and the CAD. Recommendation Changes Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Bottom Line: Stay invested in risk assets, but have some hedges. We shift from Financials to the defensive-growth IT sector, raise our weight in UK equities, and suggest long positions in cash, CHF and JPY.   Recommended Allocation Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The war in Ukraine is likely to have only a limited impact on markets beyond the short term. As disturbing as the human tragedy is, Russia’s aims are limited to regime change in Kyiv. The European Union and US face restraints on how draconian sanctions against Russia can be, balking (so far at least) at blocking imports of Russian energy to the EU, given how much this would hurt the economy. The risk of the conflict spreading beyond Ukraine’s borders is low, limited perhaps to cyberattacks on Western targets. A Russian attack on a NATO member, such as Poland or one of the Baltic states, is extraordinarily unlikely – though Moldova and Georgia (not NATO members) might be more vulnerable at some point in the future. For more detailed analysis, please read the two reports on the Ukraine situation by our Geopolitical Service that we have made available to all BCA Research subscribers.1 Asset allocators need to look at these events dispassionately. Markets are likely to remain volatile over the coming months, as events in Ukraine unfold. But the lesson of most major conflicts is that they typically do not have a long-lasting impact on asset performance (Chart 1). There is little chance that the Ukraine war will significantly dent global growth. The only exception would be if the oil price were to rise much further to, say, $120 a barrel as some are forecasting. Certainly, in the past, a jump in the oil price has often been associated with recessions – even though the causality is unclear (Chart 2). But BCA’s Energy strategists expect to see an increase in oil supply by Saudi Arabia and Gulf states which will bring Brent crude back to $85 by the second half (from $98 now). Chart 1Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Chart 2But A Jump In Oil Prices Would But A Jump In Oil Prices Would But A Jump In Oil Prices Would Meanwhile, global growth remains robust, with all major economies expected to continue to grow well above trend this year, supported by robust consumption and capex (Chart 3). And sentiment towards equities has turned very pessimistic since the start of the year, with indicators such the US Association of Individual Investors’ weekly survey at its most bearish level since 2008 (Chart 4). These sort of sentiment levels have typically pointed to a rebound in risk assets. Chart 4Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Chart 3Economic Growth Still Above Trend Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested         Our advice now would be to stay invested, but with some moderate safe-haven hedges in place – largely as we have recommended since late last year. We continue to recommend an overweight in cash, but will look to allocate this to risk assets when it becomes clearer how the situation in Ukraine will pan out. The trajectory of markets over the rest of this year still largely comes down to what the Fed and other central banks will do. The hawkish turn by the Fed in December has been the driver of markets in the past two months, with the result that none of the major asset classes have produced positive returns year to-date – only inflation hedges such as commodities and gold (Chart 5). Chart 5Most Asset Classes Are Down Year-To-Date Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The futures market is pricing the Fed to raise rates seven times over the next 12 months, the fastest rate of predicted tightening since the early 2000s (Chart 6). We think that is a little excessive. Inflation, as we have argued previously, is likely to fade over the coming quarters, as the supply response to strong consumer demand for manufactured goods brings down the price of cars, semiconductors, shipping and other major items. The Fed may well start in March with the intention of raising rates by 25bps every meeting, but the slowing of inflation we expect, and the tightening of financial conditions already under way (Chart 7), make it unlikely that it will continue at that pace. And remember that Fed policy will need to be even more hawkish than the market is currently pricing in for it to have an incrementally negative impact on risk assets. Chart 6Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Chart 7Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened There are certainly risks to this scenario. The forward yield curve is pointing to inversion one year ahead, something which normally presages recession over the following 1-3 years (Chart 8). Higher prices are starting to hurt consumer confidence, though there is a big disparity between the two main US indicators (Chart 9). Chart 8Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Chart 9Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence What all this boils down to is how high a level of interest rates the economy is able to withstand. The futures markets imply that, in most countries, central banks will raise rates aggressively this year, but then be forced to stop or even cut rates after that because their actions cause an economic slowdown (Table 1). Our view is that the terminal rate is much higher than what is priced by markets and projected by central banks: In the US perhaps 3-4% in nominal terms.2 Even with seven Fed hikes over the next year, the policy rate would therefore remain well below neutral – an environment in which historically equities have outperformed bonds (Chart 10). Table 1Central Banks Will Hike Aggressively – But Then Stop Soon Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 10Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral One final comment: On long-term returns. As a result of the recent moderate equity correction, strong earnings growth, and higher long-term rates, the outlook is somewhat rosier than when we published our most recent report on Return Assumptions in May 2021 – though admittedly forward long-term returns are still likely to be lower than over the past 20 years (Table 2). This is not, then, a time to turn defensive. Table 2Long-Term Return Outlook No Longer Looks So Gloomy Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Fixed Income: In the short-term, government bonds look oversold (Chart 11). With inflation set to peak and the Fed likely to be less hawkish than the market has priced in, we do not see the 10-year US Treasury yield rising more than another 25 basis points or so above its current level this year. Accordingly, we are changing our duration call from underweight to neutral, and raise our recommendation for government bonds within the (still underweight) fixed-income bucket to neutral. For more cautious investors, a slight increase in government bond holdings might be warranted. Within credit, investment-grade bonds still offer little pickup, despite the moderate rise in spreads this year (from 92 to 121 in the US, for example), and so we lower this asset class to underweight. We continue to prefer high-yield bonds, which in the US now imply a jump in the default rate from 1.2% over the past 12 months to 4.5% over the coming year (Chart 12). As long as the economy grows in line with our expectations, that is very unlikely. Chart 11Government Bonds Look Oversold Government Bonds Look Oversold Government Bonds Look Oversold Chart 12Will Defaults Really Jump This Much? Will Defaults Really Jump This Much? Will Defaults Really Jump This Much?   Equities: With the economy continuing to grow above-trend, global earnings should remain robust. This will not be a classic year for equity returns, but we expect them to do better than bonds. We continue to prefer US over European equities. As was seen in the aftermath of the invasion of Ukraine, US stocks are more defensive, and European growth will continue to be under threat from higher energy prices (Chart 13). We also move our recommended portfolio a little in the defensive direction by going overweight UK equities (which have a particularly high weight in defensive growth sectors, such as a 13 point overweight in Consumer Staples); we fund this by lowering Canadian equities to underweight, given their close linkage with oil (Chart 14), and the vulnerability of the Canadian housing market to rising rates. We remain underweight EM, but Chinese stocks (which were very oversold in late 2021) have been a relative safe haven as China started to stimulate, and so we continue with our neutral position for now. Chart 13Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Chart 14Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Chart 15Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Our view that long-term rates have limited upside this year makes us more cautious on Financials stocks, which are closely correlated with rates, and so we cut this sector to neutral (Chart 15). A period of slowing growth points towards a preference for defensive growth, and so we raise our recommended weight in the IT sector to overweight from neutral. It is tempting to think of this sector as being composed of ridiculously overvalued speculative internet names, but it is in fact dominated by established hardware and software titans with deep competitive moats (Table 3). While the sector is not exactly cheap, its risk premium over bonds is quite reasonable by historical standards (Chart 16).   Table 3Tech Sector Is Not Made Up Of Speculative Stocks Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 16Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Chart 17Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Currencies: A neutral position on the US dollar still makes sense. Short-term rates are likely to rise somewhat faster in the US, relative to expectations, than in Europe or Japan (Chart 17). Nevertheless, the USD is expensive, and long-dollar is a consensus trade – reasons why the dollar has risen by less than 1% year-to-date on a trade-weighted basis, despite all the higher rate expectations and geopolitical shocks. Investors looking for hedges against downside risk might look to the Japanese yen, which is particularly cheap, and the Swiss franc. By contrast, the Canadian dollar, like Canadian equities, is closely linked to the oil price and a fallback in the Brent price would be negative; we move underweight. We also raise the CNY to neutral, since it may become a safe haven currency in the current geopolitical situation, though the Chinese authorities won’t let it rise too much since that would slow the economy. Commodities: China’s stimulus remains somewhat halfhearted (Chart 18). Although the credit and fiscal impulse has bottomed, we expect to see it rebound only moderately, with just minor cuts in interest rates and the reserve ratio. This will stabilize Chinese growth, but not cause a boom as in 2020, 2016 or 2013. The rise in industrial commodities prices, therefore, is likely to be limited from here. For oil, as mentioned above, we expect to see Brent crude return to around $85 by the second half, as new supply comes onto the market. Gold has done well, as expected, in the face of a major geopolitical event. But it is expensive by historical standards, vulnerable to a rise in real (as opposed to nominal rates) as inflation eases (Chart 19), and faces cryptocurrencies as a rival. We keep our neutral, as a hedge against the tail-risk of much higher inflation, but would not chase the price at this level. Chart 18China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices Chart 19Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see Geopolitical Strategy Special Reports, “Russia Takes Ukraine: What Next?” dated February 24, 2022, and "From Nixon-Mao To Putin-Xi," dated February 25, 2022. 2     Please see Global Investment Strategy, “The New Neutral” dated January 14, 2022.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The recent market turmoil means that a 50 bps rate hike is off the table for the March FOMC meeting, but the Fed will proceed with a 25 bps rate hike this month and signal a further steady pace of tightening. As of Monday morning, the market is priced for close to 150 bps of tightening during the next 12 months. This is reasonable assuming that inflation moderates in the second half of the year and that long-dated inflation expectations remain well contained. A moderation of inflation in H2 remains our base case, but the war in Ukraine increases the risk that inflation will be sticky and that long-dated inflation expectations will move higher. The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Bottom Line: An ‘at benchmark’ portfolio duration stance makes sense for now, but the recent drop in Treasury yields could eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Stay tuned.   Feature The Russian invasion of Ukraine is ongoing and financial markets will surely remain volatile until a resolution is reached. For more details on how we see the crisis evolving please refer to last week’s BCA Special Report.1  As we go to press on Monday, the market is trying to digest the impact of sanctions that will block the access of some Russian banks to the SWIFT financial messaging system and freeze some Russian central bank reserves that are held abroad in USD and EUR. Taken together, the sanctions will impart a large stagflationary impulse to the Russian economy and, as would be expected, the Ruble is depreciating rapidly on Monday morning. The reaction in US bond markets is so far more muted. The 10-year Treasury yield is currently 1.86% - down from 1.99% last Wednesday – and the 2-year Treasury yield is 1.44% - down from 1.58% last Wednesday (Chart 1). Movements in the real and inflation components of US Treasury yields do show that the US market is pricing-in some stagflationary contagion. The real 10-year Treasury yield is down to -0.71% (from -0.54% last Wednesday) and the 10-year TIPS breakeven inflation rate is up to 2.57% (from 2.53% last Wednesday). The same divergence between a falling real yield and rising cost of inflation compensation is seen at the 2-year maturity point (Chart 1, bottom 2 panels). The market has also moved to price-in a shallower path for Fed rate hikes compared to last week (Chart 2). The market-implied odds of a 50 bps rate hike this month are now slim and the market is now looking for only 139 bps of cumulative tightening (just under six 25 basis point rate hikes) by the end of this year. Chart 2Fed Funds Rate Expectations Fed Funds Rate Expectations Fed Funds Rate Expectations Chart 1A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock We agree with the market that the heightened uncertainty and tightening of financial conditions takes a 50 bps rate hike off the board for the March FOMC meeting. A 25 bps rate hike this month remains the most likely scenario. However, we also think the market might be over-estimating the extent to which contagion from Russia will limit the pace of Fed tightening later in the year. In fact, we are inclined toward the view that the lasting impact of the crisis on the US economy might be more inflationary than deflationary. Chart 3Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen The inflationary risk is that a sustained upward shock to the oil price could keep headline inflation higher than it would otherwise be. This could also bleed through into other commodity prices and possibly even to inflation expectations. The textbook central bank response should be to ignore a commodity price shock and set policy based on trends in core inflation. However, in the current environment it will be difficult for the Fed to ignore yet another inflationary shock, especially if long-dated inflation expectations move higher. On the other hand, the economic fallout from a Russian recession will be much worse for Europe than for the United States. European Central Bank (ECB) Chief Economist Philip Lane recently estimated that the Ukrainian war could shave 0.3%-0.4% off Eurozone GDP this year.2 If the shock leads to a wider divergence between Fed and ECB policy expectations, then we would expect to see a widening of US yields versus European yields and upward pressure on the US dollar. Given that US bond yields can only diverge so far from yields in the rest of the world, a stronger dollar may cap any increase in US bond yields and eventually limit the extent of Fed tightening. So far, trends in the dollar and dollar sentiment have been supportive of rising US bond yields, but it will be important to watch this situation in the coming months to see if it changes (Chart 3). Investment Conclusions The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The Fed is likely to proceed with tightening policy at a steady pace, starting with a 25 bps rate hike this month. Trends in inflation and financial conditions will determine the pace of rate hikes in H2 2022. Right now, our sense is that the lasting impact of the Ukrainian crisis on the US economy will prove to be more inflationary than deflationary. With that in mind, the recent drop in Treasury yields may eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Checking In With Our Golden Rule Given the current market turmoil, we think it’s a good time to step back and check in with our Golden Rule of Bond Investing.3  The Golden Rule is a framework that investors can use to implement portfolio duration trades. It states that investors should determine the expected change in the fed funds rate that is priced into markets for the next 12 months and then decide whether the actual change in the funds rate will be greater or less than what is priced in the market. If you expect the fed funds rate to rise by more than what is priced in (a hawkish surprise), you should keep portfolio duration low. If you expect the fed funds rate to rise by less than what is priced in (a dovish surprise), you should keep portfolio duration high. It is admittedly a simple framework, but it does have a strong track record of performance. In general, hawkish surprises coincide with the Bloomberg Barclays Treasury index underperforming cash and dovish surprises coincide with the index outperforming cash (Chart 4). Chart 4The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing More specifically, if we look at rolling 12-month periods going back to 1990, we see that dovish surprises have coincided with positive excess Treasury returns versus cash 85% of the time for an average 12-month excess return of 4.0%. Conversely, hawkish surprises have coincided with negative excess Treasury returns 72% of the time for an average 12-month excess return of -1.5% (Chart 5 & Table 1). Table 112-Month Treasury Excess Returns And Fed Funds Rate Surprises (1990 - Present) Waiting For The Fog To Clear Waiting For The Fog To Clear Chart 5The Golden Rule’s Track Record Waiting For The Fog To Clear Waiting For The Fog To Clear As of today, the market is priced for 149 bps of Fed tightening during the next 12 months. That is very close to six 25 basis point rate hikes at the next eight FOMC meetings. Given our view that inflation will moderate in the second half of the year, this seems like a reasonable forecast that is consistent with our ‘at benchmark’ portfolio duration stance. However, as noted above, we believe the war in Ukraine could lead to an increase in inflationary pressures in the United States. Therefore, we see the balance of risks as tilted toward more rate hikes than are currently discounted rather than fewer. It will be vital to monitor long-dated inflation expectations during the next few months to assess how the pace of Fed rate hikes will evolve. Using The Golden Rule To Forecast Treasury Returns One more application of our Golden Rule framework is that we can use it to create forecasts for Treasury index returns. This is done by first looking at the historical correlation between the Fed Funds Surprise – the difference between the expected 12-month change in the fed funds rate and the realized change – and the change in the Treasury index yield (Chart 6). A regression between these two variables allows us to estimate the change in the Treasury index yield based on an assumed Fed Funds Surprise. Chart 6The Correlation Between Treasury Yields And Fed Funds Surprises Waiting For The Fog To Clear Waiting For The Fog To Clear Once we have an expected 12-month change in the Treasury index yield, we can translate that change into an expected return using the index’s average yield, duration and convexity. The result of this analysis is presented in Table 2. Table 2Using The Golden Rule To Forecast Treasury Returns Waiting For The Fog To Clear Waiting For The Fog To Clear Table 2 shows that we would expect the Treasury index to deliver a total return of 1.82% in a scenario where the Fed lifts rates by 150 bps during the next 12 months. This would equate to the Treasury index beating a position in cash by between 0.07% and 0.83%, depending on whether rate hikes are front-loaded or back-loaded. A pace of one 25 basis point rate hike per meeting (+200 bps during the next 12 months) would lead to the Treasury index underperforming cash by between -2.35% and -3.02%. Conversely, we can see that the index is expected to beat cash by between 3.25% and 3.92% if the Fed only lifts rates four times during the next 12 months. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see BCA Special Report, “Russia Takes Ukraine: What Next?”, dated February 24, 2022. 2 https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/ 3 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Waiting For The Fog To Clear Waiting For The Fog To Clear Other Recommendations Waiting For The Fog To Clear Waiting For The Fog To Clear

Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected.   Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist   False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade A New Cold War A New Cold War For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years A New Cold War A New Cold War Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles.    Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5).  Chart 4Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… A New Cold War A New Cold War   Chart 8...Especially Against The Euro A New Cold War A New Cold War The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix A New Cold War A New Cold War Special Trade Recommendations A New Cold War A New Cold War Current MacroQuant Model Scores A New Cold War A New Cold War

Highlights The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Feature The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.1 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand March 2022 March 2022     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,2 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk March 2022 March 2022 Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1 For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 2 Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Executive Summary Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Copper Will Grind Higher Copper Will Grind Higher Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Copper Will Grind Higher Copper Will Grind Higher Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Copper Will Grind Higher Copper Will Grind Higher Chart 6Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Copper Will Grind Higher Copper Will Grind Higher Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher Copper Continues To Grid Higher Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Copper Will Grind Higher Copper Will Grind Higher Chart 10 Bitcoin Price Aligns With Gold Price And S&P 500 INDEX Bitcoin Price Aligns With Gold Price And S&P 500 INDEX     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing Global Inflation Pressures Easing Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak ​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply ​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions ​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive ​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Tactical Overlay Trades

Executive Summary The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Fed tightening cycle is likely to proceed in two stages. In the first stage, which is now well anticipated, the Fed will seek to restore its credibility by raising rates to 2% – the lower bound of what it regards as “neutral” – by early next year. The decline in goods inflation over the next 12 months, facilitated by the easing of supply-chain bottlenecks, will allow the Fed to take a break from tightening for most of 2023. Unfortunately, the respite from rate hikes will not last. The neutral rate of interest is around 3%-to-4%, significantly higher than what either the Fed or investors believe. A wage-price spiral will intensify starting in late 2023, setting the stage for the second, and more painful, round of tightening. Trade Inception Level Initiation Date Stop Loss Long June 2023 3-month SOFR futures contract (SFRM3) / December 2024 (SFRZ4) -8 bps Feb 17/2022 -30 bps New Trade: Go short the December 2024 3-month SOFR futures contract versus the June 2023 contract. Investors expect the fed funds rate to be somewhat higher in mid-2023 than at end-2024. They are wrong about that. Bottom Line: The market has priced in the first stage of the Fed’s tightening cycle, which suggests that bond yields will stabilize over the next few quarters. However, the market has not priced in the second stage. Once it starts to do so, the bull market in equities will end. Investors should remain bullish on stocks for now but look to reduce equity exposure by the middle of 2023.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing Russia’s geopolitical outlook over the long run. I hope you will find it insightful. Best regards, Peter Berezin Chief Global Strategist Who’s the Boss? Who sets interest rates: The economy or the Fed? The answer is both. In the short run, the Fed has complete control over interest rates. In the long run, however, the economy calls the shots. If the Fed sets rates too high, unemployment will rise, forcing the Fed to cut rates. If the Fed sets rates too low, the opposite will happen. Chart 1The Fed's Estimate Of The Neutral Rate Is Still Quite Low By Historical Standards The Fed's Estimate Of The Neutral Rate Is Still Quite Low By Historical Standards The Fed's Estimate Of The Neutral Rate Is Still Quite Low By Historical Standards Thus, over the long haul, it all boils down to where the neutral rate of interest – the interest rate consistent with full employment and stable inflation – happens to be. In the latest Summary of Economic Projections, released on December 15th, 9 out of 17 FOMC participants penciled in 2.5% as their estimate of the appropriate “longer run” level of the federal funds rate. Six participants thought the neutral rate was lower than 2.5%, while two participants thought it was higher (both put down 3%). Back in 2012, when the Fed began publishing its dot plot, the median FOMC participant thought the neutral rate was 4.25%. Investors have revised up their estimate of the neutral rate over the past two months. But at 2.09%, the 5-year/5-year forward bond yield – a widely-used proxy for the neutral rate – is still exceptionally low by historic standards (Chart 1). Desired Savings and Investment Determine the Neutral Rate Chart 2The Savings-Investment Balance Determines The Neutral Rate Of Interest A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If interest rates are above neutral, the economy will suffer from inadequate demand; if interest rates are below neutral, the economy will overheat. As Box 1 explains, the difference between aggregate demand and aggregate supply can be expressed as the difference between how much investment an economy needs to undertake and the savings it has at its disposal. Savings can be generated domestically by deferring consumption or imported from abroad via a current account deficit. Anything that reduces savings or raises investment will lead to a higher neutral rate of interest (Chart 2). With this little bit of theory under our belts, let us consider the forces shaping savings and investment in the United States. Desired Savings Are Falling in the US There are at least six reasons to expect desired savings to trend lower in the US over the coming years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and generous government transfer payments (Chart 3). While some of that money will remain sequestered in bank deposits, much of it will eventually be spent. Household wealth has soared. Personal net worth has risen by 128% of GDP since the start of the pandemic, the largest two-year increase on record (Chart 4). Conservatively assuming that households will spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 3.8% of GDP. Chart 3Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 4Net Worth Has Soared Net Worth Has Soared Net Worth Has Soared The household deleveraging cycle is over (Chart 5). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Corporate profit margins are peaking. As a share of GDP, corporate profits are near record-high levels (Chart 6). Despite a tight labor market, wage growth has failed to keep up with inflation over the past two years. Real wages should recover over time. To the extent that households spend more of their income than businesses, a rising labor share should translate into lower overall savings. Chart 5US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 6Corporate Profits Are Near Record Highs... But Wage Growth Has Failed To Keep Up Corporate Profits Are Near Record Highs... But Wage Growth Has Failed To Keep Up Corporate Profits Are Near Record Highs... But Wage Growth Has Failed To Keep Up Baby boomers are retiring. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from net savers to net dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). Chart 7Baby Boomers Have Amassed A Lot Of Wealth A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle Chart 8Fiscal Policy: Tighter But Not Tight A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle Investment Will Not Decline to Offset the Reduction in Savings A favorite talking point among those who espouse the secular stagnation thesis is that slower trend growth will curb investment demand, leading to an ever-larger savings glut. There are a number of problems with this argument. For one thing, most of the decline in US potential GDP growth has already occurred, implying less need for incremental cuts to investment spending in the future. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades (Chart 9). Moreover, US investment spending has been weaker over the past two decades than one would have expected based on the evolution of trend GDP growth. As a consequence, the average age of both the residential and nonresidential capital stock has risen to the highest level in over 50 years (Chart 10). Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Chart 10The Aging Capital Stock The Aging Capital Stock The Aging Capital Stock As the labor market continues to tighten, firms will devote greater efforts to automating production. Already, core capital goods orders have broken out to the upside (Chart 11). On the housing front, the NAHB reported this week that despite rising mortgage rates, foot traffic and prospective sales remain at exceptionally strong levels (Chart 12). Building permits also surprised on the upside. Chart 11The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright Chart 12Homebuilder Confidence Remains Strong Homebuilder Confidence Remains Strong Homebuilder Confidence Remains Strong Overseas Appetite for US Assets May Wane A larger current account deficit would allow the US to spend more than it earns without the need for higher interest rates to incentivize additional domestic savings. The problem is that the US current account deficit is already quite large, having averaged 3.1% of GDP over the past four quarters. Furthermore, as a result of the accumulation of past current account deficits, external US liabilities now exceed assets by 69% of GDP (Chart 13). It is far from clear that foreigners will want to maintain the current pace of US asset purchases, let alone increase them from current levels. Chart 13The US Has Become Increasingly Indebted To The Rest Of The World The US Has Become Increasingly Indebted To The Rest Of The World The US Has Become Increasingly Indebted To The Rest Of The World The Two-Stage Path to Neutral Chart 14The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% The Market Thinks The Fed Will Be Unable To Raise Rates Much Above 2% Investors expect the Fed to raise rates seven times by early next year and then stop hiking (and perhaps even start cutting!) in late 2023 and beyond (Chart 14). However, if we are correct that the neutral rate of interest is higher than widely believed, the Fed will eventually need to lift rates to a higher level than what is currently being discounted. It is impossible to be certain what this level is, but a reasonable estimate is somewhere in the range of 3%-to-4%. This is about 100-to-200 basis points above current market pricing. The path to the “new neutral” will not follow a straight line. As we have argued in the past, inflation is likely to evolve in a “two steps up, one step down” fashion. We are presently at the top of those two steps. Inflation will decline over the next 12 months as goods inflation falls sharply and services inflation rises only modestly, before starting to move up again in the second half of 2023. Falling Goods Inflation in 2022 Chart 15Goods Inflation Should Fade Goods Inflation Should Fade Goods Inflation Should Fade Chart 15 shows that the current inflationary episode has been driven by rising goods prices, particularly durable goods. This is highly unusual since goods prices, adjusting for quality improvements, usually trend sideways-to-down over time. As economies continue to reopen, the composition of consumer spending will shift from goods to services. At the same time, supply bottlenecks should abate. The combination of slowing demand and increasing supply will cause goods inflation to tumble. Investors are underestimating the extent to which goods inflation could recede over the remainder of the year as pandemic-related distortions subside. For example, used vehicle prices have jumped by over 50% during the past 18 months (Chart 16). Assuming automobile chip availability improves, we estimate that vehicle-related prices will go from adding 1.6 percentage points to headline inflation at present to subtracting 0.9 points by the end of the year – a swing of 2.5 percentage points (Chart 17). Chart 16AVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (I) Vehicle, Food, And Energy Prices Could All Retreat From Extended Levels (I) Vehicle, Food, And Energy Prices Could All Retreat From Extended Levels (I) Chart 16BVehicle, Food, And Energy Prices Could All Retreat From Extended Levels (II) Vehicle, Food, And Energy Prices Could All Retreat From Extended Levels (II) Vehicle, Food, And Energy Prices Could All Retreat From Extended Levels (II) Chart 17Even If Underlying Core Inflation Does Not Change, Inflation Will Fall This Year As Goods Prices Come Back Down To Earth A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle Along the same lines, we estimate that energy inflation will go from raising inflation by 1.7 points at present to lowering inflation by 0.3 points by the end of the year. This is based on the WTI forward curve, which sees oil prices retreating to $80/bbl by the end of 2022 from $91/bbl today. A normalization in food prices should also help keep a lid on goods inflation. Service Inflation Will Rise Only Modestly in 2022 Could rising service inflation offset the decline in goods inflation this year? It is possible, but we would bet against it. While certain components of the CPI services basket, such as rents, will continue to trend higher, a major increase in service inflation is unlikely unless wages rise more briskly. As Chart 18 underscores, the bulk of recent wage growth has occurred at the bottom end of the income distribution. That is not especially surprising. Whereas employment among medium-and-high wage workers has returned to pre-pandemic levels, employment among low-wage workers is still 6% below where it was in early 2020 (Chart 19). Chart 18The Bulk Of Recent Wage Growth Has Occurred At The Bottom End Of The Income Distribution The Bulk Of Recent Wage Growth Has Occurred At The Bottom End Of The Income Distribution The Bulk Of Recent Wage Growth Has Occurred At The Bottom End Of The Income Distribution Chart 19Employment Among Low-Wage Workers Still Lagging Employment Among Low-Wage Workers Still Lagging Employment Among Low-Wage Workers Still Lagging Chart 20Workers Are Starting To Return To Their Jobs Following The Omicron Wave Workers Are Starting To Return To Their Jobs Following The Omicron Wave Workers Are Starting To Return To Their Jobs Following The Omicron Wave Looking out, labor participation among lower-paid workers will recover now that enhanced unemployment benefits have expired. A decline in the number of life-threatening Covid cases should also help bring back many lower-paid service workers. According to the Census Bureau’s Household Pulse Survey, a record 8.7 million employees were absent from work in the middle of January either because they were sick or looking after someone with Covid symptoms. Consistent with declining case counts, February data show that fewer employees have been absent from work (Chart 20). Predicting Wage-Price Spirals: The Role of Expectations A classic wage-price spiral is one where self-fulfilling expectations of rising prices prompt workers to demand higher wages. Rising wages, in turn, force firms to lift prices in order to protect profit margins, thus validating workers’ expectations of higher prices. For the time being, such a relentless feedback loop has yet to emerge. Market-based measures of long-term inflation expectations have actually fallen since October and remain below the Fed’s comfort zone (Chart 21). Survey-based measures have moved up, but not by much (Chart 22). To the extent that US households are reluctant to buy a new vehicle, it is because they expect prices to decline (Chart 23). Chart 21Market-Based Expectations Remain Below The Fed's Comfort Zone Market-Based Expectations Remain Below The Fed's Comfort Zone Market-Based Expectations Remain Below The Fed's Comfort Zone Chart 22Survey-Based Measures Of Long-Term Inflation Expectations Have Ticked Up, But Not By Much Survey-Based Measures Of Long-Term Inflation Expectations Have Ticked Up, But Not By Much Survey-Based Measures Of Long-Term Inflation Expectations Have Ticked Up, But Not By Much Still, if it turns out that the neutral rate of interest is higher than widely believed, then monetary policy must also be more stimulative than widely believed. This raises the odds that, at some point, the economy will overheat and a wage-price spiral will develop. It is impossible to definitively say when that point will arrive. Inflationary processes tend to be highly non-linear: The labor market can tighten for a long time without this having much impact on inflation, only for inflation to surge once the unemployment rate has fallen below a critical threshold. The Sixties as a Template for Today? The sudden jump in inflation in the 1960s offers an interesting example. The unemployment rate in the US fell to NAIRU in 1962. However, it was not until 1966, when the unemployment rate had already fallen nearly two percentage points below NAIRU, that inflation finally took off. Within the span of ten months, both wage growth and inflation more than doubled. US inflation would end up finishing the decade at 6%, setting the stage for the stagflationary 1970s (Chart 24). Chart 23The Expectation of Lower Prices Is Keeping Many People From Buying A Car The Expectation of Lower Prices Is Keeping Many People From Buying A Car The Expectation of Lower Prices Is Keeping Many People From Buying A Car Chart 24Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Our guess is that we are closer to 1964 than 1966, implying that the US economy may still need to overheat for another one or two years before a true wage-price spiral emerges. When the second wave of inflation does begin, however, investors will find themselves in a world of pain. Stay overweight stocks for now but look to reduce equity exposure by the middle of next year. This Week’s Trade Idea Given our expectation that inflation will come down sharply in 2022 before beginning to rise again in late 2023 and into 2024, we recommend shorting the December 2024 3-month SOFR futures contract versus the June 2023 contract. Current market pricing provides an attractive entry point for the trade, with the implied interest rate for the June 2023 contract 8 bps higher than that of the December 2024 contract. We expect the interest rate spread to eventually widen substantially in favor of higher rates (lower futures contract prices) in 2024. Box 1The Neutral Rate Through The Lens Of The Savings-Investment Balance A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle Special Trade Recommendations Current MacroQuant Model Scores A Two-Stage Fed Tightening Cycle A Two-Stage Fed Tightening Cycle

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Image CAD/SEK At A Top CAD/SEK At A Top CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators 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   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators 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 Indicators To Watch - Interest Rate Expectations I Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Image   Indicators To Watch - Interest Rate Expectations III A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face Image    

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations