Real Estate

Highlights The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Feature Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.1 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession June 2022 June 2022 When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors June 2022 June 2022 Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment June 2022 June 2022     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables Same Story For Large Household Durables Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes ...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.

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

Executive Summary Real Estate Is A Poor Inflation Hedge The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy.  Despite being a real asset, our in-depth analysis shows that the sector appears to be a poor inflation hedge and underperforms the market when inflation is elevated. There is a great dispersion within the sector – correlations across REIT segments are low. Residential REITs offer solid protection against inflation: Rent growth outpaces inflation thanks to chronic housing underbuilding and a recent rebound in new household formation.  Likewise, we expect the Industrial REITs segment to offer inflation protection.  Following recent supply disruptions, companies are shifting away from the “just-in-time” to “just-in-case” model, spurring strong demand for warehousing, fulfillment, and logistics centers, and pushing up rents.  Office and Retail REITs segments will be the two industry laggards due to structural shifts in consumer and worker behavior. Bottom Line: Today we downgrade the S&P Real Estate sector from overweight to neutral while keeping a granular intra-sector allocation. Specifically, we recommend investors overweight Specialized, Industrial, and Residential REITs, while underweighting Office and Retail segments. Feature Related Report  US Equity StrategyHave US Equities Hit Rock Bottom? The last few months have been marred by a violent sell-off in US equities, with stubbornly high inflation, and the Fed’s well-telegraphed hawkishness being front and center of the market rout. While this is a toxic brew for most equity sectors, Real Estate finds itself in a crosscurrent of two opposing trends. It is a high-yielding real asset that, at least in principle, is well-positioned to withstand inflation (most landlords are able to raise rents at least in line with inflation). However, tightening monetary policy and rising mortgage rates present unique challenges for the sector, suppressing demand for real estate and compressing the present value of future cash flows, thus handicapping capital appreciation. The recent downside surprise in the NAHB housing market reading is a case in point: 69 reported while the consensus range was 75 -77, signaling a sharp deceleration in house price growth. There is also a pronounced turn in sales activity (Chart 1). However, just as the real economy is not the stock market, the housing market is only one of the segments of the Real Estate sector. In this report, we will provide an overview of the entire sector, including valuations and fundamentals, and will consider the effects of inflation and rate regimes on sector performance. We will also take a look at the various segments of the REIT equity sector and the key drivers of their performance in our quest for the best inflation hedge. Chart 1Real Estate Sales Have Turned Down Real Estate Sales Have Turned Down Real Estate Sales Have Turned Down The US REIT Overview The REIT Sector Has Experienced Strong Growth Over The Past Decade There are more than 225 REITs in the US registered with the SEC, 175 of which trade on the NYSE. The ever-expanding cohort of NYSE-traded REITs has experienced explosive growth over the past 10 years, as a result of investors' search for yield, and this cohort now has a combined equity market capitalization of more than $1.4 trillion (Chart 2). These are mostly equity REITs – trusts that own and operate income-producing assets and earn income mostly through rents. Thirty of these equity REITs comprise the S&P 500 Real Estate sector. The Real Estate sector is small at 3% of S&P 500 market capitalization but its share has been growing steadily over time (Chart 3). Chart 2Equity REITs Have Gained Popularity Over The Past Decade The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 3Real Estate Is A Small Sector But Its Share Has Been Growing Steadily Real Estate Is A Small Sector But Its Share Has Been Growing Steadily Real Estate Is A Small Sector But Its Share Has Been Growing Steadily REITs Are Equities, But Not Quite The business model of most REITs is rather simple: Lease space and collect rent on the properties, then distribute income as a dividend to shareholders. There are a number of IRS provisions that REITs have to comply with, of which the following are most relevant to investors: Invest at least 75% of total assets in real estate, cash, or US Treasuries; Derive at least 75% of gross income from rents, interest on mortgages that finance property, or real estate sales; and Pay a minimum of 90% of taxable income in the form of shareholder dividends each year.1 REITs are total return investments as they provide income as well as capital appreciation. Sector Composition The S&P 500 Real Estate sector consists of two industries – REITs, which represent roughly 98% of the sector, and Real Estate Management and Development, which is about 2% of the sector. We will focus on the REITs. The S&P 500 REIT industry is comprised of eight broad categories (Chart 4), of which Specialized REITs are by far the largest, at 45% of the sector market capitalization. The composition of the REIT market has changed over the years. While the traditional retail and residential segments dominated the market in the first years of the millennium, structural changes have shifted the balance towards specialized segments such as infrastructure, data centers, as well as industrial REITs (Chart 5). The pandemic and a shift toward remote work have accelerated many of the existing trends, such as a decline in the office segment. Consolidations of health care facilities and hospitals have reduced the Health Care REIT segment. Chart 4The S&P 500 REIT Industry Composition The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 5REITs Composition Is Changing Over Time The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Sector Performance Since 2010, in the aftermath of the GFC, the Real Estate sector has underperformed the S&P 500 by 20% (Chart 6). However, within the sector, there is a wide divergence in relative performance, with Industrial REITs beating the index by 10%, while Office, Hotels, and Health Care REITs lagging by some 50%. More recently, the Real Estate Sector has performed more or less in line with the S&P 500 (Table 1), in contrast to the wild swings in relative performance experienced by other sectors. Like their corporate brethren in the Health Care sector, defensive Health Care REIT performance was stellar, beating the S&P 500 by 10% over the past 12 months. Hotel REITs bounced back strongly after a prolonged period of underperformance because of a nascent post-pandemic recovery in travel. Clearly, there is significant dispersion in both long- and short-term performance within the sector – correlations across segments are low (Chart 7). It is important to understand the key drivers of each segment for better asset selection. Chart 6In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed Chart 7Correlations Across REIT Segments Are Low Correlations Across REIT Segments Are Low Correlations Across REIT Segments Are Low Table 1Performance Relative To The S&P 500 The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive REIT Dividend Yield And TINA One of the main attractions of REITs is their IRS-mandated high dividend payout. Indeed, currently, the Real Estate sector dividend yield is 2.9%, a whole 130 bps higher than for the S&P 500. In fact, all REIT sectors and subsectors (with the exception of the lodging/resorts sector) currently have dividend yields higher than those of public equities (Chart 8). However, for many investors, yield comparison goes beyond equities alone. For multi-asset investors, the REIT yield is usually competing with the yield on other fixed-income instruments (Chart 9). Currently, REITs offer yields on par with investment-grade bonds, but arguably they are more attractive thanks to capital appreciation potential. Chart 8Almost All REIT Segments Yield More Than The S&P 500 The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 9REIT Yield Is Attractive The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Performance Of The Real Estate Sector In Different Inflation And Rate Regimes Real estate is a real asset and resilience to inflationary pressures is literally embedded in its name. Unfortunately, empirical analysis of the performance of Real Estate sectors during periods of high inflation disappoints. Chart 10 demonstrates that Real Estate is quite simply not a good inflation hedge. The sector tends to have the strongest performance when inflation is in the 2-3.5% range, beating the S&P 500 54% of the time. As inflation rises, RE tends to lag the broad market. This result is surely confounding. The likely explanation is that rising inflation is literally an invitation to tighter monetary policy. As rates rise, Real Estate underperforms (Chart 11). Higher interest rates decrease the value of real estate assets by discounting future cash flows at a higher rate, thus impairing the capital appreciation component of the Real Estate total return. As such, cap rates and interest rates move in lockstep (Chart 12). Chart 10Real Estate Is A Poor Inflation Hedge The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 11REITs Tend To Underperform When Rates Are Rising The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive   Thus, when inflation is high and rates are on the rise, the sector is caught in the crosscurrents: While overall, the ability to raise rents insulates the sector from the adverse effects of inflation, higher rates dampen capital appreciation. Hence, it is not surprising that high inflation and the rising rate regime are unfavorable for the sector (Chart 13), with the sector’s median three-month performance in this regime since 1970 lagging the S&P 500 by 1.8%. In this regime, RE beats the market only 38% of the time. Chart 12Cap Rates And Interest Rates Move In Lockstep Cap Rates And Interest Rates Move In Lockstep Cap Rates And Interest Rates Move In Lockstep Chart 13High Inflation And Rising Rates Are Unfavorable For Real Estate The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive While the S&P 500 Real Estate Sector is a poor inflation hedge, for investors with the ability to be more granular in REIT allocations, drilling down to sub-categories of the market might be beneficial. The real estate market is diverse and different segments do not react the same way to rising interest rates or inflation. Bottom Line: It appears that in a battle between inflation (favorable for the sector yield) and rising rates (unfavorable for capital appreciation), rates have the upper hand. Fundamentals And Valuations Even though REITs are technically equities, their analysis requires different metrics. Whereas equity investors rely on multiples such as price-to-earnings (P/E) or price-to-book (P/B), for REITs price-to-funds from operations (P/FFO) is a more important valuation tool. FFO is favored over earnings since it adds back depreciation and amortization expense. FFO also adds any gains (or subtracts any losses) from sales of underlying assets to net income. REITs traded at a steady 17x FFO between the end of the GFC and the start of the pandemic. FFO fell by 30% in the first two quarters of 2020 compared to Q4 2019, pushing the P/FFO multiple to 24.7 – a level that appears to be an expensive “post-pandemic normal” (Chart 14). The risk premium for REITs (calculated as the FFO yield minus the real 10-year Treasury yield) – currently at 5.4% – remains higher than the pre-GFC bottom of 3.5%. Consider Chart 15: On this basis, REITs are attractive. Chart 14REITs Are Trading At An Easy Money Post-Pandemic High REITs Are Trading At An Easy Money Post-Pandemic High REITs Are Trading At An Easy Money Post-Pandemic High Chart 15Risk Premium Is Still Reasonable Risk Premium Is Still Reasonable Risk Premium Is Still Reasonable In terms of profitability, the sector appears to be thriving: Occupancy rates are rising (Chart 16) and FFO is growing. However, it is important to note that US economic growth is slowing, and that may reverse the fortunes of the sector, weakening demand for properties, and lifting vacancy rates. Bottom Line: Earnings continue to rise, and cap rates – while declining – remain high compared to the risk-free rate. A post-pandemic recovery is underway. However, slowing economic growth has a potential to reverse these favorable trends. Chart 16Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again REIT Balance Sheets Are Healthy The real estate sector has historically been seen as risky due to its high leverage, but leverage has been on the decline. Over the past decade, REIT reliance on equity capital has increased, with the equity/asset ratio rising from 32% in 2008 to 45% in 2022. The ratio of debt-to-book assets stands at around 48% , much lower than 58% during the GFC (Chart 17). REITs have also extended the average maturity of their debt from five years in 2008 to over 7.5 years today. The fall in interest rates over the past two decades has benefited equity REITs: As rates fell, so did the interest they paid on their debt. Liquidity ratios also improved, with coverage ratio (earnings relative to interest expense) rising to a solid 6.5x. Bottom Line: REIT balance sheet health has improved significantly as the share of equity financing continues to grow. Also, a downward trend in interest rates has made existing debt more manageable. Chart 17A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet REIT Segments And Their Economic Drivers The pandemic has accelerated some existing trends in the real estate sector and established new ones. Some sectors will struggle in this new environment, while others will flourish. There is a broad dispersion across the REIT segments in terms of yield vs capitalization, and the ability to withstand inflation and rising rates. REIT Segments In Charts – Residential and Industrial Appear Most Attractive Vacancy Rates are declining across all segments. The industrial segment has the lowest vacancy rate at 4.1%, followed by residential at 4.9%. Offices have the highest vacancy rates at 12.2% (Chart 18). Rents are rising. Apartments have experienced the steepest increase from 1.3% growth in 2020 to 11.3% in Q1-2022. Industrial rent growth has accelerated from 5.3% to 11%. Office rent growth is decelerating (Chart 19). Chart 18Vacancy Rates Recovered For All Segments But Office The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 19Residential And Industrial Rent Increases Outpace Inflation The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Acquisitions are increasing at a robust pace with apartments experiencing the most activity (Chart 20). Sales Prices are also increasing (Chart 21). Industrial sales prices on average were up 15% from one year ago, while multifamily property prices rose 10.5%. Both these assets are earning rental income and returns that are higher than the current inflation rate, which makes them attractive assets to hold at a time of high inflation. Chart 20Sales Activity Is Robust The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 21Industrial And Residential Properties Are Most Popular Among Investors The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive The Cap Rate is experiencing compression (Chart 22) as higher rents boost sales prices, making properties more expensive. As a result, multi-family properties, which boast the highest rent growth and the lowest occupancy rate, have the lowest cap rate at 3.2%. Low demand for office space due to the pandemic has pushed the cap rate to 4.9%. Total Return is a combination of the rising value of a property and its yield, which moves in the opposite direction. As of April, Apartments had the highest total annual return of 12.7%, followed by Industrial at 10.7%. The total return of all commercial segments, except for Office, has exceeded the rate of inflation. Furthermore, we will comment on each of the segments to explain the trends observed in the charts (Chart 23). Chart 22Cap Rates Are Relatively Low Across The Board The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 23Industrial and Residential Produced The Highest Total Returns The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Specialized REITs Are A Play On The Digitalization Of The Economy While other segment names are self-explanatory, Specialized is a little trickier. The specialized REITs segment accounts for properties not classified elsewhere. These REITs own and manage a unique mix of property types such as movie theaters, farmland, and energy pipelines. Also, a REIT that consists of, say, both office and retail properties, would also be classified as Specialized. This is the broadest and most diversified category, and it is not surprising that it accounts for nearly half of the sector by market cap. It is also the highest-yielding category with a dividend yield of 4.7%. The specialized category is particularly attractive as it includes many high-tech geared categories, such as communication networks and data centers. Properties that support the digital economy have attracted a lot of demand over the past couple of years, and FFO growth is strong (Chart 24). With a host of new technologies in the wings, demand for data centers is expected to continue to grow. Due to the high and complex technical set-up specifications, leases are usually longer (upwards of five years). Since lease terms are long, owners can’t reset rent to keep up with inflation. On the other hand, strong demand for data centers is pushing new rents up. Fundamentals for the segment are supportive: The cap rate, at 4.4%, is in line with the REIT benchmark (Chart 25). Chart 24Strong Demand For Data Centers Strong Demand For Data Centers Strong Demand For Data Centers Chart 25Data Center Cap Rate Is In Line With The Benchmark Data Center Cap Rate Is In Line With The Benchmark Data Center Cap Rate Is In Line With The Benchmark   Bottom Line: We favor the Specialized REIT segment. It is well diversified and resilient to market swings. It also has significant exposure to the technology sector and benefits from a shift towards a more digitalized economy. This should also immunize the sector over the economic cycle as dependence on data increases structurally. Key tickers for this segment are: AMT, CCI. Retail REITs Are Battling Headwinds From E-commerce The “death of retail” is not a new phenomenon – consumer spending continues to shift from in-store to online. Over the past two decades, non-store retail sales in the US have grown at an annualized 9.5%, compared to 3.1% for in-store sales. E-commerce has risen to almost 14% of total retail sales. This shift is reflected in the halving of the weight of retail REITs in the Real Estate sector over the past decade. The headwinds facing the sector – particularly shopping centers – have not abated. The retail REIT occupancy rate is among the lowest in the CRE: 96% as of Q4-2021. However, with little construction underway, rent growth is not likely to decline, and will rise to mid-3%. With rents not keeping up with inflation, retail properties are a poor inflation hedge. Bottom Line: We recommend investors underweight the retail sector within their broad real estate exposure. The structural headwinds are not likely to disappear, while inflation will remain a major headwind. Key tickers for this segment are: O, SPG. Office REITs – Workers Are Not Coming Back There has long been a close link between office demand and employment. As the labor market tightens, demand for offices increases, and rents rise. However, “this time is different” due to the tectonic shift brought about by the pandemic. According to the NAR, not all workers are returning to the office (Chart 26): 17% of office employees are still telecommuting. Worse yet, there is an ongoing decline in small business formatting, impairing demand for new office space. As a result, the sector is currently flush with supply, and the occupancy rate is down from 94% to 89% (Chart 27). Yet, asking rents continue to recover, albeit slowly, and lag the rate of inflation: As of April 2022, the average year-over-year growth was 1.3%.2 Given the ongoing construction of about 150 MSF, the vacancy rate will likely remain above 10%, but rents will continue to increase modestly as more workers return to the office.3 Chart 26Many Workers Are Not Returning To The Office The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 27The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics Bottom Line: Underweight the office sector within broad real estate exposure. A shift to remote work, elevated vacancy rates, and ongoing construction are likely to put the brakes on rent growth. Real rent growth is expected to be negative – this segment is a poor inflation hedge. Key tickers for this segment are: ARE, BXP. Residential REITs – Housing Shortages Are A Tailwind Residential REITs are primarily focused on apartments, but single-family homes and mobile homes fall under the same category (Chart 28). This segment is the closest proxy to the US housing market. The housing sector has been undersupplied for decades: The ratio of annual housing starts to the total number of households is 1.2 – 0.7 percentage points below its pre-GFC average (Chart 29). Chart 28Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Chart 29Housing Undersupply Is Not A New Issue... Housing Undersupply Is Not A New Issue... Housing Undersupply Is Not A New Issue...   This has pushed up prices, increasing unaffordability, particularly for first-time buyers (Chart 30). This increased the percentage of US housing inventory occupied by renters rather than owners (Chart 31). Chart 30...Making Home Prices Unaffordable ...Making Home Prices Unaffordable ...Making Home Prices Unaffordable Chart 31Pushing More People Towards Renting Pushing More People Towards Renting Pushing More People Towards Renting Recently, housing shortages have been further exacerbated by a post-pandemic rebound in new household formation (Chart 32). Rising mortgage rates tend to further increase the demand for rental units. Vacancy rates are bound to fall further, leading to sustained double-digit rent and price growth.  As of April, multi-family rents are up 9.4% year-over-year, higher than this inflation rate of 8.5%. Bottom Line: Chronic underbuilding and a recent rebound in new household formation have spurred demand for housing, putting upward pressure on rents, making the category an excellent inflation hedge. Key tickers for this segment are: AVB, EQR. Chart 32Household Formation Has Rebounded Household Formation Has Rebounded Household Formation Has Rebounded Industrial Property Industrial REITs manage industrial facilities, with the logistics segment being a key growth driver thanks to high exposure to e-commerce. Industrial properties include warehouses, fulfillment centers, and last-mile delivery and distribution. Research by Prologis shows that e-commerce requires more than 3x the logistics space of brick-and-mortar sales. That is why occupancy rates have been rising over the past decade, and are currently at an all-time high, four percentage points higher than their 20-year average (Chart 33). The pandemic has also revealed how vulnerable current supply chains are and has accelerated a trend BCA Research has highlighted for years: The decline of globalization. Going forward, companies will move to re-shore some of their production to gain greater control over supply chains transitioning from “just-in-time” to “just-in-case” inventory management to minimize supply disruptions. This shift will amplify the need for industrial space. As a result, Industrial REIT rent growth has been robust, with rents up 11% year-over-year, with 37% of 390 markets posting double-digit rent growth. Rent growth lower down the value chain closer to the end-consumer has been particularly strong: Asking rents for logistics space are up on average 12.4% year-over-year mostly due to the scarcity of permittable land (Chart 34). Chart 33Increase Demand For Warehouses Pushed Up Occupancy Rates Increase Demand For Warehouses Pushed Up Occupancy Rates Increase Demand For Warehouses Pushed Up Occupancy Rates Chart 34Logistics Rent Growth Is The Fastest Due To Scarcity The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Bottom Line: We expect the Industrial sector to continue to outperform the broad REIT market, supported by strong demand for fulfillment and logistics centers which is pushing rents up. Industrial REITs are an excellent inflation hedge. Key tickers for this segment are: PLD, DRE. Investment Implications The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy. However, despite being a real asset, the sector appears to be a poor inflation hedge, underperforming the market when inflation is elevated. High inflation is often accompanied by rising rates, which reduce the value of future cash flows, impair capital appreciation, and offset income gains brought about by rent increases. Further, slowing growth may become a significant headwind, reversing gains in occupancy rates. Out of an abundance of caution, we are downgrading Real Estate from overweight to equal weight. However, Real Estate is a diverse sector, with segments almost uncorrelated to each other. As such, we recommend a granular allocation within the sector. Overweight Specialized, Industrial, and Residential segments which benefit from positive long-term trends, enjoy low vacancy rates, and positive real rent growth. We also recommend underweight allocations to Office and Retail segments, which suffer from adverse trends brought about by changes in consumer behavior, that translate into elevated vacancy rates and negative real rent growth. Bottom Line: The Real Estate sector is sensitive to rising rates and is a poor inflation hedge. We are downgrading the sector from overweight to equal weight. However, the sector is diverse, and commercial real estate sectors have a low correlation to each other. Within the sector, we favor Specialized, Industrial, and Residential segments that benefit from favorable long-term trends, and offer strong wage growth and potential for capital appreciation. These segments are likely to be strong inflation hedges.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Investopedia 2     Commercial Market Insights, April 2022, National Association of REALTORS® Research Group 3    Ibid   Recommended Allocation Recommended Allocation: Addendum  The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive

Executive Summary China’s Property Market: Signs Of Improvement? China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead The slump in China’s property market is nearing its cyclical end. The accelerated policy easing in the housing sector should lift the sector out of deep contraction and put it on its recovery path in the second half of this year. Policy easing had supported a quick and strong recovery in Chinese property demand during 2H2020, following the first COVID wave to hit China.  This time, however, with the “three red lines” policy still in place and depressed household income growth, we expect only a moderate year-on-year growth (4-6%) in property sales during 2H2022. Chinese construction activity will also revive slightly, based on a mild recovery in project completions in 2H2022. Chinese property developers’ stocks could still have some downside in absolute terms before the pandemic situation in China stabilizes. Bottom Line: Chinese real estate market is still facing downside risks in the near term. However, accelerated policy easing from both the central government and local governments may result in a moderate recovery in Chinese property market in 2H2022. Feature Chart 1China Property Sector Woes China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead China’s aggressive housing-sector deleveraging campaign since late 2020 has triggered turmoil in the country’s property market, while this year’s COVID-induced lockdowns have exacerbated the slump. Property sales, starts, completions as well as home prices are all in deep contraction (Chart 1).  Is a demand recovery on the way and how strong will it be? Compared with the 2020 episode, we believe that this time it will take longer to restore homebuyer confidence and the strength of the recovery will be considerably weaker. In 2H2020, to stimulate a pandemic-hit domestic property market, the Chinese authorities announced a set of supportive policies to encourage housing demand as well as to help domestic home developers overcome their extreme funding shortages. This led to an 11% year-on-year (YOY) growth in property sales during 2H2020. Although this year housing-sector policies have loosened more than they did in 1H2020, demand for housing has been sluggish and real estate developers’ propensity to take on more leverage and to invest has fallen to a multi-year low. The “three red lines” policy applied to property developers as well as the lending constraints imposed on banks remain in place. Furthermore, China’s zero-COVID policy will likely lead to rolling lockdowns and frequent disruptions to the economy, depressing household income growth, which has fallen over the past two years. Hence, assuming that the COVID-induced full lockdowns in China’s large cities are lifted before the end of May (COVID cases in China have gradually come down in the past couple of weeks), we expect only a moderate pickup in home sales in the second half of this year – about 4-6% YOY growth –about half of that in 2H2020. In terms of China’s housing-related construction activity, we believe it will only recover slightly in 2H2022, in line with our projection of a modest rebound in home completion. Chart 2China’s Housing Demand: Structural Headwinds China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead As we discussed in previous reports, China’s housing demand is facing major structural headwinds, as demand for properties in China has already entered a saturation phase and the country’s working-age population (15-64 years of age) is shrinking (Chart 2). Despite short-term measures to stabilize the property market, China’s top leadership will likely stick to their overarching “housing is for living not for speculation” policy mantra and continue to make efforts to reduce the housing sector’s share in the economy. As such, our longer-term view on the Chinese property market remains negative. A Mild Recovery In Home Sales Chart 3The Recovery of Chinese Property Market Relies On Home Sales China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Home sales, which contributed to at least 50% of Chinese property developers’ funding, hold the key to the recovery of the Chinese property market (Chart 3). The core of the ongoing crisis in China’s housing market is Chinese property developers’ increasingly constrained financing due to rapidly falling home sales as well as stringent deleveraging policies. We expect a 4-6% annual growth in Chinese property sales (i.e. floor space sold in square meters) in the second half of this year. While this is a significant improvement from the 15% contraction in the past two quarters, the projected rebound will be much more muted than the 11% growth in 2H2020 and the 23% rebound in the 2016 housing-market recovery. In 2020, Chinese property sales tanked 40% YOY during January-February. After a flurry of supportive policiestook effect in March-April, the growth in home sales on a YOY basis turned positive in May 2020 and jumped to 11%YOY for the period of July-December 2020. Chart 4Slowing Household Disposable Income China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead While we think an acceleration in housing-market stimulus1 may be able to spur some rebound in demand for housing in the second half of this year, notably, economic fundamentals and household sentiment have both turned much less favorable this year than in 2020. COVID-related restrictions have exacerbated matters and have weighed heavily on the demand for housing. The growth rate of national disposable income per capita slowed by more than two percentage points (in nominal terms) in Q1 this year from the pre-pandemic era (Chart 4). Moreover, the PBoC’s quarterly urban depositor survey in Q1 showed subdued confidence in future household income (Chart 5). Household willingness to save also hit a record high and this sentiment is even more elevated than it was in early 2020; on the other hand, the propensity to invest has dropped to a multi-year low (Chart 6). Chart 5Subdued Confidence In Future Household ##br##Income China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 6More Chinese Households Intend To Save Rather Than Invest China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead There are some early signs that demand for housing, including pent-up demand that has been curbed by the ongoing COVID-induced full and partial lockdowns in China’s major cities, may see some modest rebound in 2H2022: Chart 7Banks Can Moderately Loosen Up Their Lending To The Property Sector China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead First, banks may be slowly increasing their lending to the real estate sector while complying with the real estate loan concentration management regulations (Chart 7). Second, household willingness to buy homes, although still significantly lower than a year ago, is improving somewhat. According to the Survey And Research Center For China Household Finance, the proportion of households planning to buy a house has been increasing, albeit moderately for two consecutive quarters (Chart 8). Third, we expect local governments to roll out more aggressive measures to stimulate housing demand. Land sales account for the lion’s share of the local government’s revenue but the developers’ land purchase has contracted (Chart 9). Against this backdrop, local governments will likely accelerate the implementation of supportive policies. Chart 8More Households Plan To Buy A House China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 9Local Governments Will Likely Push For More Supportive Policies To Boost Land Sales China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Bottom Line: Property sales are likely to grow by 4-6%YOY during 2H2022. Will Developers’ Funding Conditions Improve? Real estate developers’ funding conditions are likely to improve modestly in the rest of 2022 , mainly due to improved property sales, from what was an extremely dire situation in 2H21 (Chart 3 on page 4). Property development is an asset-heavy and capital-intensive business, and the government-led deleveraging mandate and depressed home sales have massively curtailed cash flows to homebuilders. Chart 10Chinese Real Estate Investment: A Breakdown Of Funding Source China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chinese homebuilders generally have several ways to finance themselves. Chart 10 shows a breakdown of the source of Chinese real estate investment funding, with 12% of the total funding from domestic and foreign loans, 33% from a self-raised fund through bond and equity issuances, or retained earnings, 37% from deposits and advanced payments (e.g., down payments), and 16% from homebuyers’ mortgages in 2021. Other than some modest rebound in home sales, property developers’ alternative cash flows – which account for the other 50% of their funding – will remain under constraint for the following reasons: Regulations on leveraging among property developers have not loosened much. The “three red line" policy, implemented in July 2020, has limited Chinese property developers’ borrowing capacity and has so far remained firmly in place. Under this policy, homebuilders who breach none of the three red lines can only increase their interest-bearing borrowing by 15% at most, while failing to meet all three “red lines” may result in them being cut off from access to new loans from banks. The lending ceilings imposed on banks − the real estate loan concentration management system– which came into effect on 1 January 2021, also remain in place. Due to these stringent rules, Chart 11 shows the year-on-year growth of loans to real estate developers had dropped to zero in Q3 2021 from the 25% growth in Q3 2018. As these rules are critical to containing the high leverage of the Chinese property market from evolving into a systemic risk, the Chinese authorities are unlikely to radically change them (Chart 12). Chart 11More Loans To Property Developers, Albeit Capped By A Lending Ceiling China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 12Chinese Homebuilders’ Leverage Is Still High China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 13The Increase In Self-raising Funds Will Be Limited This Yea China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Self-raised funds through bond and equity issuance also account for a large share of the Chinese real estate investment funding source. The recent riot in China’s stock market and the crisis in the offshore corporate bond market made such methods of raising fund less favorable. Indeed, self-raised funds have been in contraction since last September when the Evergrande default shocked investors (Chart 13). We do not see a sizeable increase in self-raised funds this year. Bottom Line: Developers’ funding conditions are likely to improve only moderately in 2H2022 as property sales see a mild rebound. The other sources of funding will continue to be constrained by the deleveraging policy.   What About Housing-Related Construction Activity? China’s housing-related construction activity will revive slightly in 2H2022. Property developers may accelerate completion of their existing projects, while the deep contraction in housing starts will likely narrow in 2H22. Chart 14Homebuilders Need To Deliver Their Unfinished Projects China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead In recent years, Chinese real estate developers have raised funds by selling more newly started buildings instead of completed properties. This resulted in a divergence between property sales and completions, suggesting that there is a considerable inventory of pre-sold but unfinished projects (Chart 14). With more funding available, mainly from property sales, and to a lesser extent from bank lending, property developers will likely speed up the construction of those pre-sold but unfinished buildings. We expect property completions to grow 2-4% YOY in 2H2022, based on the following observations: The authorities repeatedly emphasized that property developers should meet their obligations by finishing and delivering their pre-sold but unfinished properties on time. They also have fine-tuned policies to support building completions by developers. New policies announced in February 2022 stated that property developers must prioritize those properties from which they have received pre-sale funds such as down payments. Meanwhile, odds are that the growth rate of property starts will stop falling in 2H2022. However, it will remain in contraction. Once property developers have some financing from property sales, they will tend to purchase land and start construction of new properties in order to generate revenue from presold properties. However, with deleveraging polices still in place, homebuilders can only increase their property starts to some extent. Some early signs of bottoming in land sales may be emerging (Chart 15). The uptick in land sales, although very small, may suggest that the deep contraction in the indicator has come to an end. Since late last year, state-owned property developers have been the main land buyers as private property developers were in a severe shortage of financing. This year, improving home sales and increasing bank lending may allow these private developers to return to the land acquisition market. Land sale transactions are highly correlated with housing starts (Chart 16). The improvement in land sales, if sustained into the coming months, suggests housing starts will improve somewhat in 2H2022.  Chart 15Land Sales May Be Bottoming China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 16Land Sales Are Highly Correlated With Housing Starts China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 17Housing-related Construction Activity Will Likely Revive Moderately In 2H2022 China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Bottom Line: Housing-related construction activity will likely revive moderately on a mild recovery in project completions (Chart 17). Investment Implications Given the negative forces from rolling lockdowns and low homebuyer confidence in the property market, property developers’ stocks (both investable and A-share) could have more downside in the near term (Chart 18). In relative terms, property developers’ stocks (both investable and A-share) have outperformed their respective benchmarks (Chart 19). We are doubtful that this outperformance in property developers’ stocks will develop into a cyclical or structural bull markert since our overall outlook for the real estate sector remains downbeat beyond next 6-9 months. Chart 18Chinese Property Developers’ Stocks: No Bottom Yet Both In Absolute Terms… China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 19…And Relative To Benchmarks China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Chart 20Neutral On Prices Of Construction-related Commodities For Now China’s Property Market: Moderate Recovery Ahead China’s Property Market: Moderate Recovery Ahead Commodity prices have already been rising significantly across the board. Even though we expect a slight pickup in China’s real estate construction activity in the remainder of this year, the improvement will be only marginally positive for the country’s demand for construction-related commodities. As such, our view on the price of construction-related commodities (steel, cement, and glass) in the rest of 2022 remains neutral (Chart 20). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     By April 29, nearly 100 cities had rolled out favorable policies such as lowering down payment ratio, relaxing curbs on home purchases or offering subsidies or even giving out cash to homebuyers. In addition, banks in more than 100 cities have cut mortgage rates ranging between 20 basis points and 60 basis points. Strategic Themes Cyclical Recommendations

Executive Summary More Chinese Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest The Politburo meeting last Friday signaled that China is determined to achieve the 5.5% annual growth target set earlier this year. Policymakers vowed to accelerate the implementation of existing pro-growth measures and hinted that they may scale up stimulus due to domestic challenges and external uncertainties. However, Chinese policymakers are facing an “impossible trinity” of eliminating domestic COVID cases and avoiding an overshoot as they stimulate the economy, while trying to achieve a high rate of economic expansion. The Politburo did not mention any plans to boost income and consumption via direct fiscal transfers to households, a sector that has been a weak link in China’s economy in the past two years. China’s consumption growth and demand for housing will not recover any time soon without meaningful aids to shore up household income.  Bottom Line: Policy stimulus measures announced so far fall short of what is required to lift the economy. Given constraints on household consumption and the property market, China’s economic growth is set to underwhelm and Chinese stock prices will underperform their global counterparts.     China’s top leaders have pledged to provide more support to the economy. The Politburo meeting last week indicated that the 5.5% growth target set for 2022 will be maintained and stimulus measures will be accelerated. Chinese stocks in both on- and offshore markets rebounded sharply following the positive rhetoric. Related Report  Emerging Markets StrategyA Whiff Of Stagflation? In our view, however, Chinese authorities are facing an “impossible trinity” as they simultaneously attempt to achieve three goals: (1) pursuing a dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. The pro-growth measures announced last week by the government lack the needed elements to generate a quick and strong rebound in the economy, particularly in the household and property sectors. Hence, the rebound in Chinese stock prices will unlikely progress into a cyclical rally (over a 6- to 12-month time span). We maintain our neutral allocation in Chinese onshore stocks and an underweight stance on the MSCI China Index, within a global portfolio. An “Impossible Trinity” The messages from the Politburo meeting highlight policymakers’ determination to shore up the economy. However, the authorities are not backing away from the zero-COVID policy, which is taking a heavy toll as cities are forced into lockdown to contain outbreaks. In addition, the Politburo reiterated the housing policy principle that “housing is for living, not for speculation” and did not mention concrete measures to boost household consumption. Thus, the biggest challenge for China to achieve its growth target this year is how to normalize economic activity without resorting to another round of “irrigation-style” stimulus while keeping domestic COVID cases at bay. In an environment of frequent lockdowns, monetary and fiscal easing have limited effect as the private and household sectors are averse to taking risks. China’s zero-COVID policy comes with hefty economic costs. April’s PMI showed sharp declines in a wide range of business activities due to the prolonged lockdown in Shanghai and several other cities (Chart 1). The new orders, new export orders, and imports subindexes in the manufacturing PMI and services PMI, all fell to their lowest levels since Q1 2020 when COVID first hit China (Chart 2). Chart 1April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities ​​​​​​ Chart 2PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 Going forward, even if China manages to avoid a Shanghai-style month-long lockdown, the dynamic zero-COVID policy will have devastating ramifications on the economy. Notably, March economic data from the city of Shenzhen, China’s technology center, suggests that even a week-long lockdown has had large impact on the local economic activity. Chart 3Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown In contrast with the extensive outbreak in Shanghai, Shenzhen was able to contain its COVID cases at an early stage and endured a citywide lockdown for only one week in mid-March. However, Shenzhen’s export growth contracted by 12.8% year-on-year (YoY) in March, a stark contrast from the 14.7%YoY increase in exports on a national level. The city’s imports fell by 11.9%YoY, also significantly lower than China’s total import growth, which was flat (Chart 3). Retail sales of consumer goods in Shenzhen shrank by 1.6%YoY in March and home sales plummeted by a stunning 90%YoY during the week of March 13-20. On the national level, the Politburo has called for an acceleration in infrastructure investment through frontloading local government special purpose bonds (SPB) and fast-tracking infrastructure project approvals. However, the lack of details has created questions regarding the magnitude of incremental stimulus, or whether the stepped-up policy effort will involve an increase in SPB or a general bond quota for local governments. Chart 4Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown The stringent COVID containment methods will also undermine the effectiveness of China’s pro-growth measures. As expected, China’s construction activity PMI tumbled in April amid the lockdowns, but the new orders and business expectations components in the construction PMI had already started to slide in March (Chart 4, top and middle panels). Moreover, employment in the labor-intensive construction sector also declined substantially in March and April (Chart 4, bottom panel). The deterioration in these indicators is consistent with our view that even short and less draconian lockdowns spark considerable disruptions in business activities. Bottom Line: There is a low likelihood that China will deviate from its existing zero-COVID policy for the rest of this year. As such, boosting the economy via stimulus will be challenging due to frequent interruptions to economic activities. No Bazooka For Consumers China’s household consumption, which accounts for about 40% of the country’s aggregate demand, has been a weak link in the economy during the past two years. Last week’s Politburo meeting pledged to stabilize employment, create new jobs and encourage hiring from small and medium enterprises (SMEs). However, there was no mention of any large-scale fiscal transfer to households via cash or subsidy payments, which suggests that pro-consumer measures are not in the stimulus package. Chart 5Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle China’s retail sales growth has been muted in the current business cycle, a deviation from past economic recoveries when a revival in the general economy and moderate pro-consumption stimulus helped to lift household spending growth substantially above the rate of nominal GDP expansion (Chart 5). Since the pandemic, however, government stimulus to the household sector has been insufficient to revive consumption, due to the negative impact lockdowns have on both labor market demand and the service sector activities. Compared with the US and Europe, China’s fiscal transfer to the household sector has been very limited since the first wave of COVID in early 2020 (Chart 6). Local governments handed out vouchers in Q2 2020 aimed at boosting consumption, but the amounts were dismal and have had a minimal effect on the sector. Chart 6IMF Fiscal Monitor Database: Fiscal Response To The COVID-19 Pandemic China’s Trilemma China’s Trilemma Presently the RMB value in direct payments to the household sector is even smaller: some cities including Shenzhen distributed consumption vouchers ahead of the May holiday week. Nonetheless, the total value of consumption vouchers this year is estimated at around RMB 2billion. The amount, even with a multiplier effect of 3 on consumption, will be less than 0.1% of China’s monthly retail sales in nominal value. Hence, the coupons are unlikely to make any significant difference to the aggregate household spending. Bottom Line: Household consumption will be severely curtailed as lockdowns wreak havoc on the economy and household income, and the government so far has not provided meaningful direct transfers to the public. Rebound In Housing Demand Doubtful The Politburo encouraged local governments to further relax local housing policies, such as lowering mortgage rates and down payment ratios, and easing restrictions on home sales and purchases. However, we do not expect that these policies alone will restore homebuyers’ confidence amid short-term factors such as COVID outbreaks/lockdowns, and longer-term factors like slowing household income growth, high household debt and poor demographics (Chart 7A and 7B). Chart 7AProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Chart 7BProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics China’s household sector was struggling prior to recent lockdowns. The growth rate of national disposable income per capita slowed by more than two percentage points (in nominal terms) in Q1 this year compared with Q4 2019 (Chart 7A, top panel). In addition, the PBoC’s quarterly urban depositor survey (released before the Shanghai lockdown) in Q1 showed subdued confidence in future household income (Chart 8). Households’ willingness to save hit a record high and is even more elevated than in early 2020; on the other hand, the propensity to invest has dropped to a multi-year low (Chart 9).  Chart 8Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chart 9More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest Chart 10Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Despite lower interest rates and easier monetary conditions, Chinese consumers’ medium- to long-term loans continued to trend down in Q1, which indicates a declining appetite for purchasing real estate assets and durable goods (Chart 10). COVID-related restrictions have exacerbated matters and weighed heavily on the demand for housing. Home sales from 30 Chinese cities were down by 56% in April from a year ago (Chart 11). House prices have started to deflate in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. ​​​Furthermore, the unemployment rate has picked up, especially among younger workers (Chart 12). Job and income dynamics normally improve after the overall economic cycle bottoms. Therefore, without any measures to boost household income, the demand for housing will remain a drag on the economy in the near term.   Chart 11Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Chart 12Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Bottom Line: The real estate market has been vital to business cycle recoveries in China since 2009. However, the property market will not recover anytime soon without a substantial boost to household income and a normalization in social and economic activities. Investment Conclusions The policy rhetoric from the Politburo meeting helped to shore up market confidence last Friday. Nevertheless, we do not think that the stimulus measures will be sufficient to produce a rapid business cycle recovery or a sustainable stock market rally (Chart 13A and 13B). Chart 13AIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Chart 13BIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Given the negative forces from rolling lockdowns and shrinking demand, China’s economy requires a massive government stimulus via direct transfers to households and SMEs. Yet, Beijing is neither ready to abandon its dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. The policy stimulus measures announced so far still fall short of what is required to lift the economy. In light of the constraints on household consumption and the property market, economic growth in China is set to underwhelm and stock prices will likely underperform their global counterparts. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations

Executive Summary Economic Growth in Q2 Will Be Much Softer Economic Growth In Q2 Will Be Much Softer Economic Growth In Q2 Will Be Much Softer China’s GDP headline growth in Q1 was better than consensus, but it does not capture the full economic impact of ongoing city lockdowns. Other than infrastructure investment, business activity data from March shows a broad-based slowing in growth momentum. Manufacturing investment decelerated, while both real estate investment and retail sales contracted from a year ago. Exports in value terms continued to grow rapidly through March. However, the resilient rate of expansion is unsustainable given a weakening global manufacturing cycle and softening external demand for goods. China’s domestic supply-chain disruptions will also weigh on its export sector’s activity. Home sales contracted sharply in the first three weeks of April, particularly in larger cities. The lockdowns, coupled with poor funding dynamics among real estate developers, suggest that the real estate sector will remain a huge drag on China’s economy this year. Bottom Line: Even though business activities will resume after the lockdown restrictions are lifted, we do not expect China’s economy to rebound quickly and strongly as it did in 2H20. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio.   A slew of economic data released during the past two weeks suggests that the negative effects from the COVID-induced lockdowns in China’s largest and most prosperous cities are starting to emerge. The closings, which will likely continue through the end of April, are causing disruptions in both production and demand just as the economy was already in a business downcycle. Other than infrastructure spending, business activity data from March illustrates a broad-based slowing in growth momentum. The longer-term impact of the citywide shutdowns is still to come. Related Report  China Investment StrategyThe Cost Of China’s Zero-COVID Strategy The economic benefits of Beijing’s enhanced stimulus measures will be delayed to 2H22 at the earliest. Moreover, as we discussed in our last week’s report, the post-lockdown recovery in the second half of this year will be much more muted than in H2 2020 . The external environment is less reflationary than in 2H20; China’s domestic demand and sentiment among corporates and households were already declining prior to the latest lockdowns. The deteriorating economic outlook will continue to depress the absolute performance of Chinese onshore stocks in the coming months (Chart 1). Furthermore, against a backdrop of rising US Treasury yields, the interest rate differentials between China and US have become negative for the first time in a decade. A yield disadvantage, coupled with risk-averse sentiment across global financial markets, has discouraged portfolio flows into China. We expect foreign investment outflows to continue in the near term before China’s economy stabilizes sometime in 2H22 (Chart 2). Chart 1Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Chart 2...And Have Triggered Substantial Foreign Investment Outflows ...And Have Triggered Substantial Foreign Investment Outflows ...And Have Triggered Substantial Foreign Investment Outflows From a cyclical perspective, we maintain our neutral position on Chinese onshore stocks in a global portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com China’s Credit Conditions: Amble Supply Versus Lack Of Demand Although broad credit growth accelerated in March from the previous month, the improvement mainly reflects a sharp increase in local government bond issuance. Bank loan growth on a year-over-year basis has not improved yet. Loan demand for infrastructure investments escalated, supported by front-loaded fiscal supports in Q1 (Chart 3). However, private-sector credit demand remains very weak. The acceleration in the credit impulse –calculated as a 12-month difference in the annual change in credit as a percentage of nominal GDP –is much more muted when excluding local government bond issuance (Chart 4). Chart 3Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Chart 4The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Sentiment among the corporate and household sectors has plunged to a multi-year low, following two years of stringent COVID-containment measures and last year’s regulatory clampdowns (Chart 5). Furthermore, the corporate sector’s propensity to invest weakened sharply in Q1, despite much looser monetary conditions (Chart 6). A worsening private sector’s sentiment suggests that demand for credit is unlikely to pick up imminently. Chart 5Private-Sector Demand For Credit Remains in The Doldrums... Private-Sector Demand For Credit Remains in The Doldrums... Private-Sector Demand For Credit Remains in The Doldrums... Chart 6...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions Chart 7Significant Foreign Investment Outflows In China's Onshore Bond Market Significant Foreign Investment Outflows In China's Onshore Bond Market Significant Foreign Investment Outflows In China's Onshore Bond Market The PBoC announced a 25bps cut in its reserve requirement ratio (RRR) rate on April 15, but has kept its policy rate unchanged. The move was below the market’s expectation of a 50bps RRR cut and/or a policy rate cut. While we still expect that the PBoC will trim the loan prime rate (LPR) in Q2, the recent acceleration in the RMB’s devaluation may make the central bank more cautious in reducing rates and further diverging from the hawkish US Fed and other major central banks  (Chart 7). China GDP: Above-Expectation Growth In Q1, Mounting Concerns In Q2 China’s year-over-year GDP growth in Q1 accelerated to 4.8% from 4.0% in Q4 last year, beating the market expectation of a 4.2% increase. The Q1 growth was mainly supported by strong infrastructure investments and exports (Chart 8). On a sequential basis, however, seasonally adjusted GDP growth in Q1 was 1.3% (non-annualized), slower than Q4’s reading of 1.6% and below its historical mean (Chart 9). Meanwhile, private- sector investment and household consumption remain subdued and activity in the housing sector worsened. Chart 8Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Chart 9Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean The negative effect from broadening city-wide lockdowns and more supply-chain disruptions in Shanghai and surrounding cities in the Yangtze River Delta region will be much larger in Q2 than in Q1. We expect that year-over-year GDP growth in Q2 will drop well below 4%, sharply down from the 4.8% growth recorded in Q1. Furthermore, the aggregate economic impact from the lockdowns could reduce China’s real GDP growth in 2022 by 1ppt, which poses substantial risks to the country’s 5.5% annual growth target for this year. Exports Growth Set To Decelerate Although the growth of exports in value terms remained resilient in March, China’s exports will be challenged this year by the softening global demand for goods and domestic COVID-induced disruptions in the supply chain. A recent PBoC survey of 5,000 industrial enterprises shows that overseas orders dived sharply (Chart 10). In addition, global cyclical stocks have underperformed defensives. The underperformance has historically been a good leading indicator of a global manufacturing downturn, which will likely lead to a decline in demand for Chinese exports (Chart 11). The weakening external demand is also reflected in softening US demand and falling personal consumption expenditures on goods ex-autos (Chart 12).   Chart 10Overseas Orders For Chinese Industrial Enterprises Dived Sharply Overseas Orders For Chinese Industrial Enterprises Dived Sharply Overseas Orders For Chinese Industrial Enterprises Dived Sharply Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Furthermore, China’s imports for processing trade, which historically has been highly correlated with China’s total exports growth, decelerated sharply in March. The drop heralds a slowdown in the growth of Chinese exports in the coming months (Chart 13). Chart 12External Demand For Chinese Export Goods Will Likely Dwindle External Demand For Chinese Export Goods Will Likely Dwindle External Demand For Chinese Export Goods Will Likely Dwindle Chart 13Slowing Processing Imports Point To A Deceleration In Chinese Export Growth Slowing Processing Imports Point To A Deceleration In Chinese Export Growth Slowing Processing Imports Point To A Deceleration In Chinese Export Growth   Port congestions and supply-chain disruptions worsened in April after the Shanghai lockdown began on March 28. COVID-related supply-chain disruptions in China’s key ocean ports and reduced shipping volumes will curtail activity of the country’s export sector in the short term. Real Estate Sector Will Remain A Drag On China’s Economy March’s data reflects a broad-based deterioration in housing market activities (Chart 14). The growth in real estate investment rolled over, and all floor space indicators contracted further in March. Moreover, households’ sentiment in the property market remains lackluster (Chart 15). Funding among real estate developers has plummeted to an all-time low, which will continue to dampen housing construction activities (Chart 16). Chart 14A Broad-based Deterioration In Housing Market Indicators In March A Broad-based Deterioration In Housing Market Indicators In March A Broad-based Deterioration In Housing Market Indicators In March Chart 15Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Chart 16Housing Construction Activities Are Set To Slow Further Housing Construction Activities Are Set To Slow Further Housing Construction Activities Are Set To Slow Further Chart 17Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities The March housing transaction data only captures some early indications from the recent round of lockdowns. The negative upshot on home sales will be greater in April. Figures for high-frequency floor space sold show a substantial weakening in home sales, particularly in tier-one and tier-two cities, through the first three weeks of April (Chart 17). The shrinkage in home sales will likely continue through Q2 and poses a significant risk for property investment and construction activities in H2. Regional governments are allowed to initiate their own housing policies, therefore, an increasing number of regional cities have slashed mortgage rates and/or down payment thresholds (Chart 18). However, the easing measures have failed to shore up demand for housing. In addition, pledged supplementary lending, which the government used to monetize massively excess inventories in the 2015/16 market, resumed its downtrend in March after a short-lived rebound earlier this year (Chart 19). Chart 18More Regional Cities Have Eased Local Housing Policies Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2 Chart 19PSL Injections Resumed Downward Trend In March PSL Injections Resumed Downward Trend In March PSL Injections Resumed Downward Trend In March Subdued Domestic Demand And Household Consumption Chart 20Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments China’s domestic demand remained weak in March and will likely worsen in the next few months when more negative fallout from the recent lockdowns spill over to the aggregate economy.   Infrastructure investments picked up strongly in March. However, robust infrastructure investments were insufficient to fully offset the weakness in capital spending in the real estate and manufacturing sectors (Chart 20). The sluggish housing market and a deceleration in exports growth will likely slow China’s capital spending further in Q2. Growth in China’s imports in value terms contracted slightly in March; this was the first time since September 2020. Meanwhile, import growth in volume terms contracted sharply amid weak domestic demand and the early effects of supply-chain disruptions (Chart 21). Moreover, imports of major commodities in volume shrank deeper in March (Chart 22).  Chart 21Chinese Imports Value Growth Fell Into Contraction In March Chinese Imports Value Growth Fell Into Contraction In March Chinese Imports Value Growth Fell Into Contraction In March Chart 22The Volume Of China's Key Commodity Imports Contracted Further In March The Volume Of China's Key Commodity Imports Contracted Further In March The Volume Of China's Key Commodity Imports Contracted Further In March Household consumption has been a laggard in China’s economy in the past two years and the wave of city lockdowns are taking a heavy toll on consumption. Retail sales growth contracted in March, for the first time since August 2020 (Chart 23). Notably, online sales of goods also slowed to a multi-year low, highlighting not only subdued demand but also COVID-related logistic interruptions. Chart 23Retail Sales Growth Slipped Below Zero Retail Sales Growth Slipped Below Zero Retail Sales Growth Slipped Below Zero Chart 24Tame Core And Service CPIs Also Reflect Sluggish Household Demand Tame Core And Service CPIs Also Reflect Sluggish Household Demand Tame Core And Service CPIs Also Reflect Sluggish Household Demand Weakening core and service CPI readings also reflect a lackluster demand from consumers (Chart 24). We expect that the ongoing lockdowns will continue to weigh on service sector activity and household consumption, at least for the next couple of months (Chart 25). In addition, labor market dynamics are worsening rapidly and the nationwide urban unemployment rate rose to its highest level since mid-2020. The employment situation will also curb household consumption in the medium-term (Chart 26). Chart 26Labor Market Situation Is Deteriorating Sharply Labor Market Situation Is Deteriorating Sharply Labor Market Situation Is Deteriorating Sharply Chart 25Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Table 1China Macro Data Summary Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2 Table 2China Financial Market Performance Summary Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2   Footnotes Strategic Themes Cyclical Recommendations

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary China’s Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed Recent data showed a substantial improvement in the economy in the first two months of the year. However, the optimism is not well supported by other industry and high-frequency data. China’s exports were resilient, while infrastructure investment also rebounded sharply on the back of front-loaded fiscal stimulus. Nonetheless, domestic demand in China remains in the doldrums. Housing market indicators show a further deterioration in home sales and prices in January and February. Consumption in tourism during the Chinese New Year and service sector activities were also weaker compared with the same period last year. While we expect policymakers to roll out more measures to shore up domestic demand, China’s economy will likely have a choppy bottom in the first half of 2022. We maintain our neutral position on Chinese onshore stocks in a global portfolio. In absolute terms, we are cautious and are looking for a better price entry point in Q2. Bottom Line: Economic data in the first two months of the year sent mixed signals, which suggests that China’s economy has not reached a solid bottom. Feature Newly released economic data from January and February (i.e. industrial production, fixed-asset investment, retail sales and property investment) all generated sizable positive surprises. However, other industry and high-frequency data sent conflicting messages. The improvement in China’s total social financing (TSF) in the past few months has been due to local government (LG) bond issuance (Chart 1). Corporate credit showed little advancement, while household loans were extremely weak (Chart 2). In addition, further contracting home sales paint a bleak picture of housing demand. Soft readings in the service sector Purchasing Managers' Index (PMI) and core consumer price index (CPI) suggest that consumption remains sluggish. Chart 1The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) Chart 2No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit No Improvement In Corporate Or Household Demand For Credit Beijing is stepping up its pro-growth stimulus, particularly on the fiscal front. However, the country will unlikely undergo a strong recovery in its business cycle without a major reversal in the housing market and an improvement in demand from the private sector. Moreover, recent lockdowns to tame surging domestic COVID-19 cases amid China’s zero-tolerance pose major downside risks to the near-term economic outlook. Chinese equities sold off in response to lockdown news despite the release of better economic data earlier this month, highlighting investors’ weak sentiment. Chart 3China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed China's Business Cycle Has Not Bottomed We maintain our neutral view on China’s onshore stocks relative to their global peers, but we are cautious on Chinese equities in absolute terms.  On a cyclical time horizon (6 to 12 months), there are increasing odds that Chinese policymakers will stimulate the economy more aggressively, particularly in the 2nd half of the year. However, it is too early to turn bullish on Chinese equities (Chart 3). The ongoing war in Ukraine and elevated oil prices, coupled with risks of further lockdowns in China and a prolonged downturn in domestic demand, present significant near-term risks to the performance of Chinese equities. Investors should closely watch for more reflationary efforts from Beijing and we believe a better entry point to upgrade Chinese stocks may emerge in Q2.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Near-Term Outlook For The Housing Market Remains Bleak Real estate investment growth in January-February was surprisingly strong, according to data from China’s National Bureau of Statistics. However, headline growth in real estate investment deviates from the continued weaknesses in other housing market indicators (Chart 4). In addition, data on the production of some key construction materials showed little improvement (Chart 5). Chart 4Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Conflicting Signals From The January-February Housing Market Indicators Chart 5Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Demand for housing remains lackluster. February’s medium- to long-term household loan growth, which is mainly mortgage loans and is highly correlated with home sales, plunged to an all-time low (Chart 6). Meanwhile, the deep contraction in home sales growth continued in February, and sentiment among home buyers remains downbeat (Chart 6, bottom panel) Chart 6Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Chart 7Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Although authorities have reiterated that they want to stabilize the property market, the policy measures have been only fine-tuned. Regional governments have been allowed to initiate their own housing policies and some cities have eased processes for home purchases.1 However, given that maintaining stable home prices is an overarching goal and China’s leadership is trying to avoid further inflating the home price bubble, it is doubtful that the government will allow significant re-leveraging in the property market (Chart 7). Chart 8 shows that funds to real estate developers have slowed to the lowest level since 2010, which will further dampen housing construction. Chart 8Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Housing Construction Activities Will Weaken Further In 1H22 Chart 9The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales Moreover, high-frequency floor space sold data shows a broad-based decline in housing sales in tier-one, two and three cities through mid-March (Chart 9). The latest spike in China’s domestic COVID-19 cases and regional lockdowns will likely weigh on home sales in the short term. Property investment and construction will remain at risk without a decisive rebound in home sales. A Disrupted Recovery In Household Consumption Both retail and online sales of consumer goods held up better than expected in January and February (Chart 10). However, the subdued underlying data highlight that the strong reading in retail sales in the first two months of the year may be less than meets the eye. Chart 10Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Although Growth In Retail Sales Rebounded In January-February... Chart 11...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels ...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels Service sector and passenger activities are still well below their pre-pandemic levels, two years after the first COVID lockdowns in early 2020 (Chart 11). Consumption in tourism during the Chinese New Year holiday was weaker than last year. Households’ propensity to spend also showed few signs of rebounding (Chart 12 & 13). Chart 12Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Travel Consumption Was Weak During The Chinese New Year Chart 13Households’ Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Households' Propensity To Consume Continues To Trend Down Furthermore, both core and service CPI weakened in February, reflecting lackluster demand from consumers (Chart 14). Labor market dynamics have also worsened and the unemployment rate, particularly among young workers, has risen rapidly since the beginning of the year (Chart 15).  Chart 14Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Weak Core And Service CPIs In February Suggest Lackluster Household Demand Chart 15Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening The ongoing fight against mounting new COVID cases in China will likely drag down service sector activities in the coming months (Chart 16A & 16B). Importantly, the new round of lockdowns and mobility restrictions are primarily in busier and more developed coastal metropolitans, such as Shenzhen and Shanghai. Therefore, the negative impact from social activity restrictions will be more substantive compared with previous lockdowns. Chart 16AEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Chart 16BEscalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Escalating New Cases In China Will Constrain Domestic Consumption Strong Rebound In Manufacturing Investment Growth In January-February Probably Not Sustainable A strong rebound in the growth of manufacturing investment helped to support overall fixed-asset investment in the first two months of the year (Chart 17). Robust external demand for China’s manufacturing goods has likely contributed to the pickup in manufacturing output and helped to sustain Chinese manufacturers’ near-maximum capacity (Chart 18). Chart 17Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Strong Pickup In Manufacturing Investment Growth Chart 18Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization Robust Exports Support Chinese Manufacturing Output And Capacity Utilization While the volume of manufacturing output increased, prices that producers charge consumers have rolled over (Chart 19). Historically, prices have been more important in driving corporate profits than the volume of output. In addition, a strong RMB and sharply climbing shipping costs will also weigh on Chinese exporters’ profitability (Chart 20). Chart 19Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Manufacturing Output Picked Up While Prices Rolled Over Chart 20Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Chart 21Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed Manufacturing Sector's Profit Margins Will Be Further Squeezed The elevated prices of oil and global industrial metals will continue to disproportionally benefit upstream industries, which are mainly composed of commodity producers. Meanwhile, the manufacturing sector’s profit margins will be squeezed by rising input costs and sluggish final demand (Chart 21). Chinese manufacturers’ profit growth will likely weaken through 1H22 and the downtrend may be exacerbated by the ongoing struggle to contain COVID cases.  The impact from recent lockdowns in the northern city of Jilin (an auto production center), Shenzhen (a high-tech manufacturing production and export hub), and Shanghai (a city with major ports and a key logistics provider) will disrupt China’s manufacturing production and curb investment in the near term. Infrastructure Sector Will Remain A Bright Spot Through 1H22 Related Report  China Investment StrategyAiming High, Lying Low Infrastructure investment staged a strong recovery in January-February on the back of front-loaded fiscal stimulus (Chart 22). LG bond issuance started to accelerate last November and will boost both traditional and new-economy infrastructure spending at least through 1H22. Our calculations suggest that fiscal thrust will rise to more than 2% of GDP this year, a sharp reversal from last year’s negative impulse of 2% (Chart 23). Chart 22Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Fiscal Stimulus Is At Work Chart 23Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 24Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment However, shadow bank activity, which historically had a tight correlation with infrastructure investment, remains downbeat (Chart 24). February’s reading of shadow bank credit was extremely weak, highlighting that local governments still face constraints in off-balance sheet leveraging through local government financing vehicles (LGFVs). The trend in shadow bank loans bears close attention in the coming months because it will signal whether the central government will allow more backdoor financing to help local governments fund their infrastructure projects. A continued soft reading in shadow bank activities will likely limit the upside in infrastructure investment growth. Table 1China Macro Data Summary A Choppy Bottom A Choppy Bottom Table 2China Financial Market Performance Summary A Choppy Bottom A Choppy Bottom     Footnotes 1     Guangzhou lowered its down-payment ratio from 30% to 20%, along with a 20bp cut in mortgage rates. Zhengzhou marginally relaxed home purchase restrictions by allowing families who bring elderly relatives to live in the city to buy one extra home and also lifted the “definition of second home ownership by physical unit & mortgage history”. ​​​​​​​ Strategic Themes Cyclical Recommendations

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

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