Policy

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

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

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

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

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

Executive Summary EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply The EU's failed foreign policy – premised on ever-deeper engagement with the Soviet Union and, after it collapsed, Russia – will drive its hot mess of an energy policy for years. In the short term, the EU's REPowerEU scheme proposed last week to fund the decoupling from Russia will lift its green-house gas (GHG) emissions, if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward. Markets traded lower over the week, to make room for the higher ETS pollution-permit supply. This could increase the volume of allowances sales needed to reach the €20 billion target. Another €10 billion investment in natgas pipelines also will be funded. Longer-term, the acceleration of the EU's renewable-power build-out via so-called Projects of Common Interest (PCI) will get an €800 billion boost, with another round of funding to be proposed for early next year. EU funding will lift base metals and steel prices – raising the cost of the renewables build-out – and keep fossil-fuels well bid.   Bottom Line: The REPowerEU scheme will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. The propensity of EU policymakers to interfere in its ETS market makes it unattractive. We remain long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. Tactically, we are getting long 4Q22 Brent calls struck at $120/bbl, anticipating an EU embargo of Russian oil imports. Feature Over the past three decades, foreign policy for the EU largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.1 This change-through-trade policy survived the Cold War, the collapse of the Soviet Union and rise of Russia from its ashes. It also survived Russia's first invasion of Ukraine in 2014. Indeed, following that invasion, Russia marked the completion of its Nord Stream 2 (NS2) natural gas pipeline – running parallel to NS1 – in September of last year. If NS2 were up and running now, it would have increased Russian gas flows into the EU and its revenue flows.2 As our Geopolitical Strategists noted, Germany even got the Biden administration to agree in summer 2021 to set aside any sanctions so that Germany could operate NS2 with Russia. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Yet Russia did not share the German commitment to economic engagement within a US-led liberal international order. Russia's second invasion of Ukraine in February was a bridge too far, and catalyzed the EU's response, again led by Germany, to de-couple from Russia in the energy sector. The EU's reversal of a failed foreign policy, which produced its dependence on Russian energy, leaves it with a hot mess of an energy policy that is evolving rapidly. In its wake, volatility in the EU carbon-trading market has ensued, along with the promise of an accelerated doubling-down on renewable-energy generation. Higher Emissions, Lower Emissions Prices Last week, the EU proposed its REPowerEU scheme, which is meant to enable the decoupling of the EU from Russian energy dependence by funding hundreds-of-billions-of-euros in new energy investments over coming years.3 Chart 1EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply In a history heavily laden with paradox, this new scheme will lift the EU's green-house gas (GHG) emissions – including CO2 – if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward.4 So, in the breach, the EU is willing to significantly relax its environmental goals – the E in ESG – to begin undoing its failed foreign policy. Markets already are making room for this increased ETS pollution-permit supply, which, as allowances prices weaken, will require additional supplies to reach the €20 billion target (Chart 1). This will lead to higher coal and fossil fuel usage during Germany's hot-mess de-coupling with Russia. In addition to raising funds by selling pollution permits, the EU will invest another €10 billion in natgas pipelines. This will help counter the likely loss of Russian gas when it embargoes Russian oil imports, but will take time (a few years) to actually put in the ground.5 The additional pipe would address one of the EU's weakest energy links: the lack of pipeline capacity to transport liquified natural gas (LNG) inland once it arrives in Europe. Europe pushed hard to re-load natgas inventories ahead of the coming winter season, and appears to have made progress in this regard (Chart 2). Europe was a strong bid for LNG in the first four months of this year, according to Refinitiv reporting.6 LNG imports were up 58% over the first four months of this year, totaling 45.3mm MT. This kept European natgas prices elevated vs. Asia (Chart 3). Chart 2Europe Re-Loads Storage One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Chart 3Europe Outbids Asia For LNG One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The back-and-forth between the Asian and European markets will continue for the rest of this year, particularly going into the Northern Hemisphere's summer, when demand for natgas in Asia, in particular, will remain strong. REPowerEU Will Boost Base Metals Demand Longer term, the EU's REPowerEU proposal, if approved, will accelerate the EU's renewable-power build-out via so-called Projects of Common Interest (PCI). The proposal contains €800 billion to support new renewable-energy proposals, with another round of funding proposed for early next year.   The doubling down by the EU on renewables will lift base metals and steel prices as soon as the REPowerEU program starts funding investments in renewable technology and short-term projects like pipeline buildouts (maybe sooner as hedges are placed). Given the tightness already apparent in the base metals markets, this will raise the price of critical materials – copper, aluminum, steel – and will, in the process, keep fossil-fuels well bid: large capital projects do not get done without a lot of diesel and gasoline being consumed.7  The EU is not alone in its desire to accelerate renewables investment: The US is funding a similar build-out, as is China, which will be accelerating its infrastructure and renewables investments. The constraint on all of these programs to build out renewables is low capex in base metals (Chart 4), and oil and gas (Chart 5). This has kept the level of supply from quickly responding to increased demand, which keeps these markets in sharp backwardations. Market tightness in metals and energy will be compounded by stronger bids from the three largest economic centers in the world – the EU, US and China.Chart 4Weak Capex Holds Base Metals Supply Growth Down … One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Investment Implications Chart 5… And Oil + Gas Supply Growth One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The EU's REPowerEU scheme is not a done deal, but we give it high odds of being adopted. It will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. In terms of where to take risk, now that this proposal has been floated, we would avoid getting long carbon permits traded on the EU's ETS carbon market, given the propensity of policymakers to meddle excessively, which, in and of itself, is a risk that is difficult – if not impossible – to forecast. However, we do continue to favor being long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating an EU embargo of Russian oil imports. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US officials involved in negotiations to restore the Iran nuclear deal appear to be signaling US interests could be served by agreeing such a deal.8 Allowing Iran back into the market as a bona fide oil exporter would return ~ 1mm b/d or more to global crude markets by year-end.  This would partly reverse the higher prices we expect in the wake of an EU to embargo Russian oil imports this week.  Presently, oil markets are rallying as the necessity for Russia to shut in oil production post-embargo is discounted (Chart 6).9 That said, a deal to allow Iran back into export markets would dampen the move we expect in the wake of an EU embargo. The market will remain tight after a US-Iran deal, but this might be attractive to the Biden administration as mid-terms approach, and to the EU, as it also would reduce the funds available for Russia to wage war on Ukraine.  On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating the EU embargo.  We will close this position out if the US and Iran reinstate the Joint Comprehensive Plan of Action (JCPOA), which would allow Iran to resume oil exports.   Precious Metals: Bullish The World Platinum Investment Council (WPIC) projects a 2022 surplus of 627 koz, slightly lower than the previous forecast of 657k oz for this period. This year, strong automotive demand is expected to be offset by reductions in jewellery and industrial demand. Car manufacturers’ switch from Russian palladium to platinum – as they self-sanction – will bullish for platinum. Russia accounts for ~40% of global palladium mined output. The organization predicts lower mine supply caused primarily by supply-chain bottlenecks and COVID-19 restrictions. Nornickel, one of the world’s largest platinum miners is expected to reduce mined output on the back of supply-chain disruptions due to Russian sanctions.    Base Metals: Bullish Iron ore prices rose on the wider than anticipated cut in China’s benchmark interest rate for mortgages on May 20th (Chart 7). The upcoming easing of lockdowns in Shanghai will further boost iron ore prices, as markets expect Chinese economic activity to pick up. However, if China sticks to its zero-COVID policy, lockdowns will continue to occur in different cities and regions. BCA’s Emerging Markets Strategy expects these ‘rolling lockdowns’ to last at least until the end of this year. This will affect manufacturing and steel production, primary iron ore demand drivers. Iron ore’s reliance on China’s economic health means price of the industrial metal will not meaningfully rise this year, barring a supply shortfall. Chart 6 Brent Prices Going Up Brent Prices Going Up Chart 7 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN     Footnotes 1     Please see The Former Chancellor Who Became Putin’s Man in Germany, published by the New York Times 23 April 2022.  This is an excellent precis of the history of German-Russian trade vis-à-vis the career of former German chancellor Gerhard Schröder, who held the office from 1998 – 2005.  The deep energy relationship with Russia began in the late 1960s under the chancellorship of Willy Brandt.  As much as 55% of Germany's gas needs were supplied by Russia prior to its invasion of Ukraine 24 February 2022.  Now its Russian gas imports are closer to 20%; Germany and the EU are scrambling to eliminate any and all energy trade with Russia, beginning with reducing gas imports by two-thirds this year, and likely embargoing all oil imports by year-end. 2     Russia completes Nord Stream 2 construction, gas flows yet to start, published by reuters.com 10 September 2021. 3    Please see REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition* published by the European Commission 18 May 2022.  Energy accounted for 62% of the EU's Russian imports in 2021, just under €100 billion worth of gas (40%), oil (27%) and coal (46%), according to the European Commission's tally in In focus: Reducing the EU’s dependence on imported fossil fuels published 20 April 2022.  In 2011, energy accounted for 77% of the EU's imports from Russia. 4    Please see Felix K. Chang's report Legacy of Ostpolitik: Germany's Russia Policy and Energy Security published by the Foreign Policy Research Institute in May 2014.  This includes a summary of the paradoxical nature of Germany's Ostpolitik policy following Russia's first invasion of Ukraine. 5    Please see German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 6    Please see LNG momentum swinging back to Asia as Europe demand eases: Russell published by reuters.com on 24 May 2022. 7     Please see Tight Commodity Markets: Persistently High Inflation, which we published 24 March 2022.  It is available at ces.bcaresearch.com. 8    Please see Analysis: Subtle shift in U.S. rhetoric suggests new Iran approach published by reuters.com 24 May 2022, and German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 9    Please see Oil, Natgas Prices Set To Surge, which we published last week. Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022 Summary of Closed Trades

Executive Summary Chart 1Quant Model Prediction Vs. Past Outcomes Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Complementing the US Political Strategy Quantitative Presidential And Senate Election Models, we introduce our Quantitative House Of Representatives Election Model. Our House election model measures the expected change in seats that will be won or lost by the incumbent party (Democratic Party) in the midterm election. The model predicts that Democrats will lose 21 seats, giving up control of the House and resulting in political gridlock from 2023 to 2025 even if the Democrats somehow hold onto the Senate. The “Blue Sweep” policy setting is effectively over. In a last ditch effort, Democrats will look to pass a budget reconciliation bill before the election. Post-midterm, financial markets will see gridlock as a marginal positive in 2023, as long as inflation levels off. In the very near term, however, US equities still face formidable hurdles that should warrant investors taking a defensive position. ​​​ Asset Initiation Date Return Long DXY (Dollar Index) 2022-02-23 6.1% Bottom Line: Stay tactically defensive until US election risk subsides and global macro risks stabilize.     The 2020 US election was hotly contested and future elections, like the upcoming 2022 midterm election, will be closely watched by investors. BCA’s US Political Strategy has introduced two quantitative models over the past year that aim to predict both the Presidential election in 2024 and the Senate election in 2022.  In this report we introduce our House election model, so that we now provide readers with a quantitative model-based estimate for all three major US elections. With the 2022 midterms scheduled for November 8, our House model provides valuable insight into control of Congress in 2023-24. In the 2020 election the Democrats held onto the House while winning the Senate and the White House – the so-called “Blue Sweep.” But the Democrats lost 13 House seats while the GOP gained 14, leaving a mere five-seat margin for President Biden today (221 versus 208 seats today, with six vacancies). In 2022, markets expect Republicans to take control of the House and Senate given the well-established pattern that the president’s party performs badly in midterm elections.1 Our House model agrees, and points to the Democrats losing 21 seats later this year. The Model And Variables Our House model uses a simpler modelling approach than our Presidential and Senate models. Unlike those two models, we do not predict any state level outcomes, nor do we assign a probability to any predictions. For starters, House elections do not occur at the state level but rather at the level of congressional districts. Secondly, we are primarily interested in the overall control of the House rather than individual elections. Therefore our model predicts the number of seats the incumbent party will lose or gain (seat swing), and hence its control of the House.  Our model is based off a simple linear regression. Uniquely, in our suite of three models, our House model does not include any economic variables. Rather, the model is based off three independent political variables that explain our dependent variable. Due to data constraints on one of our independent variables, our sample size is limited to 20 observable House elections, from 1982-2020. Our model is defined as: Change In House Seatsi= β0+β1Var1i+β2Var2i+β3Var3i+εi Change In House Seats. This is the dependent variable in the model and what we aim to predict. A negative change means the incumbent party will lose seats while a positive change means the incumbent party will win seats. Congressional approval (Var1). This variable measures the public’s approval rating on “how congress is doing its job.” We take the average net approval rating (approval less disapproval) in an election year. A positive net rating supports the incumbent party in gaining seats while a negative rating does the opposite.  Generic congressional ballot (Var2). The generic congressional ballot asks people which party they are likely to vote for in Congress in a given election. We take the average net support rate in an election year (that being whichever party leads the other in congressional ballot polling). The larger the president’s party’s deficit on the generic ballot rate, the more House seats it tends to lose. Defending House seats (Var3). The last independent variable is inspired by work from Sabato’s Crystal Ball.2 This measures the number of House seats defended by the incumbent president’s party in an election year. The more seats to defend, the more seats tend to be lost. One variable we omitted is presidential approval. Readers might find this surprising as presidential job approval ratings have tended to correlate reasonably well with House seats gained and lost in midterm elections. Our reason for excluding this variable is that three explanatory variables explain a high degree of variation in the dependent variable. Combined, our three variables explain more than 80% of the variation in the dependent variable. This is more than satisfactory from a statistical standpoint and keeps the model simplistic in nature. Democrats To Lose The House As it stands, our election model predicts that Democrats will lose control of the House in 2022 (Table 1). The Democrats are predicted to lose 21 seats. This prediction is based off current values of our independent variables as calculated and shown below. For the number of defending House seats, we allocate two of three vacant seats to the Democrats to defend.3 This adds up to 224 seats. Table 1Quant Model Predicts A Democrat Loss Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model For this report, we are only concerned with election outcomes pertaining to midterm elections. In this regard, our model’s prediction is in line with historical outcomes for the president’s party (Chart 1). That is, the president’s party almost always loses House seats in a midterm election. While our model does not provide any probability measure for the predicted outcome, it is in line with market expectations that Democrats will lose the House later in the year. Currently, market implied odds for the Democrats to retain the House are just 16%, as opposed to 87% for Republicans to gain control (Chart 2). Most other private forecasts for the House also point to Democrats losing control.4  Chart 1Quant Model Prediction Vs. Past Outcomes Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Chart 2Republicans Overwhelmingly Favored To Take The House Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Back Testing Our Model Chart 3In-Sample Back Testing Results Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Our House model performs well during in-sample back testing. For in-sample testing, we test our model over our entire sample period (1982-2020) but show results for midterm election outcomes only. Our model correctly predicted the direction of seat change (positive or negative) for 80% of outcomes, missing the direction of seat swing for just the 1998 and 2002 midterm elections (Chart 3). The latter two elections are the only two in the post-WWII period in which the president’s party gained seats and this was due to exceptional circumstances (i.e. the Dotcom Bubble and the September 11, 2001 terrorist attacks). During this same test, when our model correctly predicted the directional change in seat swing, it only over-predicted the change once (in 1986), highlighting a more conservative forecast over time. In 2022, given the stagflationary economic backdrop and President Biden’s weak approval rating, the voting public may very well punish the Democrats harder in November than our model expects. Chart 4Out-Sample Back Testing Results Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model During out-sample back testing, we look at a sample period of 2002-2018, comprising of just five midterm elections. Our model correctly predicts the direction of seat swing in 80% of the midterm elections, just like our in-sample testing showed (Chart 4). 2002 is again a standout election where our model incorrectly predicted the direction of seat swing. Closing In On Election Day The midterm election is approximately five months away. Our Senate model predicts the Democrats will lose control of the Senate. Our House model suggests Democrats will lose the lower chamber too. This view is in line with the consensus across markets, forecasters, and historical outcomes. Given the poor showing by Democrats in the 2020 House election, this House prediction will be hard to change. The Senate race could still see some surprises, such as via the Supreme Court. But all in all the “Blue Sweep” of 2020 is already over. The headwinds against the president’s party have gained even more momentum in the context of high inflation, falling consumer confidence, and low real wages. These factors were not measured in our model, but they do form a basis for voting intentions in elections. Coupled with President Biden’s low approval ratings, in general and in specific policy areas like the economy, the Democratic party will need to pull off  a political “Hail Mary” to retain the Senate, let alone the House, later this year. Investment Takeaways President Biden and the Democrats may look to the 1934, 1962, 1998, and 2002 elections for proof that the ruling party can perform well in the midterms. But 1998 was a period of nearly unprecedented peace and prosperity, while 2002 came in the wake of a historic attack on the homeland. The 1934 election reinforced a crisis-era government and as such could serve as a model for Biden, but today’s situation is not as dire as the Great Depression. The 1962 analogy is perhaps the best, since Biden, like President Kennedy during the Cuban Missile Crisis, could conceivably benefit from an escalating showdown with Russia this fall. But Kennedy’s Democrats still lost a net of four seats in the House that year – and Kennedy’s approval rating was above 60% while Biden’s is barely 40%. COVID-19 was an unprecedented shock that continues to play out across the economic and political environment in the US. But while the Republicans suffered from the pandemic itself, the Democrats now own the stagflationary aftermath. Democratic enthusiasm should revive a bit from now until the election, but it would take a massive shock to reverse the general trend. There is a strong correlation between opinion polling in the beginning of the year and the midterm election results. Facing a shellacking, Democrats will make one last-ditch effort to pass a budget reconciliation bill before the election. Given the energy crisis in Europe, there is potential for Biden’s renewable energy subsidies to be repackaged into a general “energy security” bill that drops the former hostility to fossil fuels. This could be matched with limited tax changes, including the 15% minimum corporate tax rate that Biden negotiated with other countries. Otherwise US fiscal policy will virtually freeze even if the Senate stays in Democratic hands. Taxes will no longer be able to rise from 2023 but spending will not be subject to cuts. Heading into 2024, gridlock will be reinforced by our presidential quant election model’s slightly higher odds of Democrats retaining the White House, which we think are underestimated at present. Hence Biden is lined up to retain veto power even if Democrats squander the House and Senate in 2022, as long as his administration avoids a recession. Financial markets will see gridlock as a marginal positive in 2023, as long as inflation levels off. In the very near term, however, US equities still face formidable hurdles that will keep us on the sidelines. Global growth is wobbly. Global supply chains remain constrained, affecting growth outcomes and adding to elevated price levels. China’s zero-covid policy and the absence of a credible plan for US-China tariff reduction and economic re-engagement continue to weigh on sentiment. Fed rate hikes are still generating uncertainty. The Middle East is unstable and likely to bring additional energy supply disruptions. Lastly, the Russia-Ukraine war has yet to come to a ceasefire and Russia is likely to reduce energy supplies to Europe in retaliation for Germany’s energy ban and NATO enlargement. With this backdrop in mind, we remain tactically defensive. We see the potential for improvement after the US election brings a reduction in policy uncertainty – as long as geopolitical risks and inflation also stabilize.   Guy Russell Senior Analyst GuyR@bcaresearch.com   Statistical Appendix Some clients may be curious to read through our model’s estimated regression coefficients as well as conditional forecasts given certain levels of our independent variables. These are discussed herein: Regression Coefficients As mentioned earlier, our model is estimated exclusively by political variables. The beta coefficients for the three explanatory variables are shown below alongside their t-statistics and p-values. All three of these variables tested statistically significant at 5% and 10% levels. The regression’s R-squared value is 0.8183, meaning that the explanatory variables help explain 81.83% of the variation in the dependent variable (Table A1). Clients can recreate the model’s prediction by multiplying the current level of each variable as it stands today by that variable’s respective beta coefficient and adding the constant at the end of the equation. Be sure to follow the methodology explained earlier in the text if such an exercise is of interest. Also, conditional forecasts can be created by holding certain parameters constant should clients want to better understand what differing levels of the three explanatory variables may imply for the change in House seats. Table A1Regression Coefficients Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Conditional Forecasts We will create simple conditional forecasts for two explanatory variables. Let’s start with the net congressional approval variable. Forecasts will be generated with data intervals calculated over the course of President Biden’s first term in office so far. The lowest net congressional approval rating was -67 ppt and the highest was -25 ppt. We will use 10 ppt intervals between -20 ppt an -70 ppt. Shading indicates the current level for the variable input. Table A2Conditional Forecasts Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model In Table A2, we hold our other explanatory variables constant at their prevailing levels while we assume differing levels for the net congressional approval variable. We will apply this method to conditional forecasts using the net generic congressional ballot. Table A2 shows us that a more negative net congressional approval rate suggests the president’s party will lose more House seats. Of course, the Democrats cannot lose a fraction of a seat (only whole seats), but this conditional forecast illustrates the point of the variable’s impact on the overall outcome. Table A3Conditional Forecasts Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Changing to the net generic congressional ballot, our conditional forecast for values ranging from -2 ppt to + 5 ppt are shown in Table A3. This range shows the high and low of the net generic congressional ballot through President Biden’s first term in office. Shading indicates the current level for the variable input. Like before, the results in Table A3 shows us that a more negative net generic congressional ballot suggests the president’s party will lose more House seats. Again, the Democrats cannot lose a fraction of a seat. But the results in Table A3 show that changes in House seats are more sensitive to changes in the net generic congressional ballot variable compared to the net congressional approval variable. This is due to two reasons: The net generic congressional ballot variable is a strong predictor of House election outcomes. It’s larger beta value indicates it’s high degree of sensitivity for the dependent variable, implying that it is the most important variable in our model, and that changes to it have the largest impact on the modelled outcome, that is predicted changes in House seats.   Footnotes 1     See The American Presidency Project. "Seats in Congress Gained/Lost by the President's Party in Mid-Term Elections," October 29, 2018. presidency.ucsb.edu 2     See Kyle Kondik, “The Kinds of Seats that Flip in Midterms,” Sabato’s Crystal Ball, May 11, 2022, UVA Center For Politics, centerforpolitics.org. 3    For our 2022 prediction, we allocate vacant House seats evenly between Democrats and Republicans. For example, if there are six vacant seats, each party will be allocated three seats to defend on top of the House seats that they already occupy. If there are an odd number of vacant seats, for example three, each party will receive one seat added to their count, then the incumbent party will receive the remaining seat. 4    See fivethirtyeight.com, 270towin.com and racetowh.com, among others. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Table A3US Political Capital Index Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Chart A1Presidential Election Model Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Chart A2Senate Election Model Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Table A4APolitical Capital: White House And Congress Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model Table A4BPolitical Capital: Household And Business Sentiment Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model ​​​​​​​ Table A4CPolitical Capital: The Economy And Markets Introducing The US Political Strategy Quantitative House Election Model Introducing The US Political Strategy Quantitative House Election Model ​​​​​​​

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

Executive Summary Indian Voter’s Economic Miseries Are Ascendant Indian Voter's Economic Miseries Are Ascendant Indian Voter's Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies India Has Been Trading At A Premium To EM Democracies India Has Been Trading At A Premium To EM Democracies ​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening Economic Miseries Of India's Median Voter Have Been Worsening Economic Miseries Of India's Median Voter Have Been Worsening ​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Chart 11India’s Debt Levels Are High And Rising Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech Strategic Trade: Long Indian Tech / Short Chinese Tech Strategic Trade: Long Indian Tech / Short Chinese Tech ​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials Tactical Trade: Short India / Long Brazilian Financials Tactical Trade: Short India / Long Brazilian Financials ​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Image Chart 4Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Image Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included ... Small Business Owners Included ... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Image Chart 9When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock   Image Chart 20B... But They Like Bonds Even Less ... But They Like Bonds Even Less ... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Image A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Special Trade Recommendations Current MacroQuant Model Scores Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A