Economy

Executive Summary Unhappy Households Make Unhappy Voters US polarization while down is still near historic peaks. Negative sentiments are forming among households and businesses due to inflation and high gas price, which makes fiscal expansion unlikely in the near future. President Biden is running out of options to shore the Democrats’ political capital ahead of the midterm. Biden will resort to using executive orders and move on to foreign affairs as the legislative route is blocked. More actions in the international realm will inject geopolitical risks in an already volatile year. Asset Initiation Date Return Long US Health Care Vs. S&P 500 2021-06-30 13.5% Bottom Line: Higher political risk in the near term warrants a defensive posture. Feature Dear Client, This week’s report is brought to you by Jesse Kuri, Associate Editor of our US Political Strategy. Jesse provides an update of our US Political Capital Index, which enables us to quantify the Biden administration’s ability to get things done. Jesse measures precisely how far Biden’s political capital has fallen since his election in November 2020 and highlights the key indicators investors should monitor to assess whether the administration can regain effectiveness after the midterm election.  Jesse also updates our US Equity Sector Political Risk Matrix, which combines insights from our US Equity Strategist Irene Tunkel with our own assessments of whether politics will add upside or downside risk to each sector. Health care stocks are notable for facing policy risks skewed to the upside. All very best, Matt Gertken, Chief US Political Strategist Last week, the Supreme Court delivered two political shocks to the system. On June 23rd, the Supreme Court ruled that New York’s state limit on carrying guns in public violates the Second Amendment. Furthermore, on June 24th, the court delivered what was well known for almost a month: A ban on abortion by the state of Mississippi is constitutional, overturning a 49-year-old precedent set up by Roe v. Wade. Both rulings are set to aggravate the already elevated political tensions in the US. Related Report  US Political StrategyThe Supreme Court And Midterm Elections The high court rulings overshadowed a momentous bipartisan move in Congress – the passage of the first gun control bill in almost 30 years on June 24th. 15 Republican Senators and 14 Republican House Members joined their Democratic colleagues to pass the Bipartisan Safer Communities Act. This bill includes more stringent background checks for gun buyers younger than 21 years of age, more funding for mental health care programs, federal funding to encourage states to implement red flag laws to take guns away from questionable owners, and the closing of the boyfriend loophole. So, how should investors reconcile the seemingly contradictory moves in US politics: Extreme polarization and unrest punctuated by moments of bipartisanship? Investors should ignore the US gun law — and instead focus on women’s support of Biden in coming months. If women start becoming more active in voting and start approving Democrats much more than expected, then that will help Democrats marginally. But it will not likely change the outcome of the midterm, which favors Republicans heavily in the House at least. Is President Biden’s political capital too low to save his party from a political reckoning this year? Most likely the answer is yes. Biden’s Political Capital Roundup Political Polarization Chart 1Polarization: Declining But Near Peak It would be easier to push for a policy in a less divided country, as there is a consensus on what constitutes good policy among the stakeholders. But a country that is depolarizing in times of economic stress is a negative for the political capital of the government of the day, as there is a consensus that times are tough, and the acting government will be blamed for this. In June, our polarization proxy, constructed by differencing Democrats’ and Republicans’ approval of President Biden, increased. The polarization proxy increased as Democrats’ approval of Biden rose while Republicans’ approvals remained flat, relative to their respective levels in May. Also in May, our economic sentiment polarization indicator, which is the difference between the economic sentiment of Democrats and Republicans, increased from its level in April, as Republicans’ sentiment declined by 25%, while Democrats’ sentiment only fell by 7%. On the other hand, the Philadelphia Fed Partisan Conflict Index, another indicator that the US Political Strategy team tracks, declined in May. This is not surprising considering that this indicator is constructed by the Philly Fed from news headlines which had either been dominated by the war in Ukraine or by the skyrocketing inflation. The only other time that this indicator declined was during the pandemic because everyone was in agreement that the pandemic is a negative event, just like the war in Ukraine and inflation. All three indicators are below their respective levels of November 2020. While polarization declined, it is still close to its peak in 2019-2020 (Chart 1). Household Sentiment Chart 2Biden's Approval Plumbing New Lows A government with a high approval rating among households can afford to pass policies and painful reforms, as it is less likely to be punished at the ballot box if voters are happy. Unfortunately for President Biden, his approval rating is plumbing new lows; the American Rescue Plan, loose monetary policy, and external geopolitical shocks have all resulted in US inflation reading that were last seen 40 years ago. As a result, Biden was never rewarded by voters for the passage of the American Rescue Plan and the Infrastructure Investment and Jobs Act. To shore up his and the Democrats’ political capital, Biden is now attempting to strike deals with partners and adversaries in Europe, the Middle East, and China, but they are not likely to lend him or the Democrats a helping hand; and, even if deals could be reached, the damage to the Democrats’ midterm prospect has already been done, which goes beyond the pattern where the President’s party tends to suffer in the first midterm. In another sign of the souring mood among voters, the Conference Board Consumer Confidence Index declined by 2% in May on a month-over-month basis and 11% on a year-over-year basis. While the consumer confidence index is higher now than it was in November 2020, it is 17% below its peak in the summer of 2021. What would have been a comeback year for US consumer spending is going to be dampened by high energy prices and general price inflation due to external shocks (Chart 2). Business Sentiment Governments also need the support of the business community to implement policies: Negative sentiment in the business community would subdue capital spending and job growth, which would affect household sentiment and subsequently, the ability of the government to pass its agenda. In May, high-frequency business indicators pointed to business sentiment turning negative. The capex intention survey declined by 20% from April and 37% compared to May of last year. Every activity indicator from the ISM, apart from the manufacturing employment index, is below their respective levels in November 2020, when the pandemic was raging, and vaccines had not yet been rolled out (Chart 3). The small business surveys conducted by the NFIB is indicative of the underlying reasons behind negative business sentiment: Despite lower concern about regulation and taxes, business concerns over inflation and labor costs are up by 1300% and 100%, respectively, since November of 2020. Concerns over taxes and regulation have largely been allayed as the Democrats have failed to use their second chance at reconciliation, with moderate senators objecting to higher taxes. But this decline in worries over taxes and regulation have given way to concerns about inflation and labor costs, and President Biden and the Democrats are struggling to address these concerns (Chart 4). Chart 3Businesses Are Downbeat...​​​​​​ Chart 4... Due to Inflation and Labor Costs​​​​​​ Government Sector Chart 5The Purse String Will Be Tightened The government can use fiscal policy to shore up its diminishing political capital. In Q1 2022, the fiscal thrust for the federal government was -14.3% of GDP, a 27 percentage-point swing from Q1 of last year when the Biden administration passed the American Rescue Plan (Chart 5). It is unlikely that fiscal thrust would recover anytime soon considering that fiscal stimulus early in Biden’s term had contributed to the inflation that the economy is experiencing now. While the Democrats have one last chance at using reconciliation, at best they would pass a deficit neutral budget, as there is no appetite for another extravagant budget in this inflationary environment; at worst, they could be pushed by moderate Democrats towards increasing revenue through tax hikes. Hence, Biden’s political capital through the use of fiscal policy is unlikely to recover. Economic Conditions The economy is the one bright spot underpinning Biden’s political capital (Chart 6). The unemployment rate was unchanged at 3.6% in May, close to an all-time low and 3.1 percentage points below November 2020. For the first time in his term, the stock market-to-wage ratio fell in April to below the level of November 2020 – mainly due to the sell-off in the stock market. While this is positive for reducing inequality, the Fed’s attempt to cool down the economy will also affect wage growth and household wealth via the stock market. In May, policy uncertainty was still lower than what it was in November 2020, but on a month-on-month basis, uncertainty in the US increased by 12%. Personal bankruptcies in Q1 barely increased from Q4 2021, while business bankruptcies declined by 3% during the same period. Consumer loan delinquencies also remained flat at 1.6%. Financial distress levels are still significantly below their pre-pandemic level (Chart 7). Chart 6Recovery Is Going Well...​​​​​ Chart 7... And Household And Business Finances Are Improving...​​​​​​ Chart 8... But Inflation And Gas Price Overshadow the Recovery If voters weigh these indicators equally, Biden will have strong political capital underpinned by the strong economy (78% of these indicators are sending positive signals), but there are two indicators with outsized impacts on household and business sentiment: inflation and gas prices (Chart 8). Inflation is close to an all-time high, and the high inflation will force the Federal Reserve to act to raise rates which will, in turn, cool down economic activity. The latest readings of gas prices pin them at 5 dollars per gallon, a 138% increase from November 2020. The oil/energy shock is happening at a time when Americans are experiencing their first summer without restrictions since 2019. High gas prices, high inflation, and the potential for a recession may threaten the much-awaited pent-up demand. Asset Market Chart 9Stock Market Woes Add To The Negative Sentiment The equity market is also a component of political capital – while a booming stock market is not guaranteed to be a tailwind for the President as seen from the case of President Trump during the midterm of 2018, a bear market will compound the negativity that is abound in the economy. The S&P 500 is down 18% from December 2021 and the 2-year Treasury yield is up by 231 bps. The S&P 500 is only 8% above its November 2020 level and if one takes into consideration inflation since then, the S&P 500 is below its level of November 2020 (Chart 9). Our colleagues at the Emerging Markets Strategy service have estimated that the recent selloff has wiped out roughly US$12 trillion from the US equity market and US$3.5 trillion from the US bond market. Political/Constitutional Strength An immutable component of political capital is the constitutional strength of the President – majorities in the Electoral College and popular votes, and control of Congress and the Supreme Court. President Biden, unlike Presidents Bush and Trump, had majorities in both the electoral college and national popular votes. But his control of Congress was significantly weaker; in 2017 Republicans had a seat majority in the Senate and a 23-seat advantage in the House, while the Democrats a one seat advantage in the Senate, via the Vice President, and a 4-seat majority in the House at Biden’s inauguration. Furthermore, Trump started his term with an evenly split Supreme Court, which later was expanded to 5-4 once Justice Gorsuch was confirmed, while Democrats have a 3-6 disadvantage due to the passing of Justice Ginsburg in 2020. Biden’s constitutional strength is weaker than Trump’s and Obama’s. Bottom Line: Biden’s political capital had been greatly diminished and he will unlikely be able to push for his agenda through legislative means. He is also unlikely to be able to replenish his political capital anytime soon due to skyrocketing inflation, which makes fiscal policy unpalatable to the public. As the midterm closes in, Biden will be desperate to shore up his and the Democrats political capital, and as the legislative route will be unavailable, he will resort to regulatory, executive, and foreign policy actions. Investment Conclusions As a foreign energy shock is mainly responsible for high gasoline prices in the US, Biden will attempt to have a reset with oil producers in the Middle East; but this will come at the cost of diplomacy with Iran, while attempting to restart nuclear negotiations with Iran will come at the cost of further alienating oil producers and allies in the Middle East. The Democrats domestic approach which was to disparage oil producers for alleged price gouging will also inject downside risk to the energy sector. Europe and Japan will be weighed down by the global energy shock as they are both net importers of energy, unlike the US. This will affect the sales of US industrial products abroad and by extension, the US industrial sector. Geopolitical risks will depress capex spending in Europe. The consumer discretionary sector could trade sideways as inflation bites and the stock market declines, yet strong household finances – as seen by low delinquency rates and massive pent-up demand from 2 years of lockdowns – will be tailwinds for the sector. The tech and communication services sectors will benefit from near-peak polarization, yet there are regulatory challenges at home and abroad which could weigh these sectors down. Financial regulations will pick up from low levels at end-2021 due to changes at the Fed. Plus, the Democrats and regulatory agencies will not look too kindly on banks aiding companies in merging and consolidating in a market where inflation is sky-high. The increases in rents could spur action from local governments to act on housing market which may include anti-market policies such as rent control and stabilization, which will negatively impact the real estate sector. Health care is the only sector with political risks to the upside – Biden had punted on radical changes to the health care system and even if he seeks to make changes, he lacks the political capital to do so. His actions abroad will also put a floor under global geopolitical risks, ensuring the USD remains well bid, and health care tends to do well when the dollar is in a bull market.     Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Depressing Housing Market And Service Sector Activity May’s economic data ticked up from extremely depressed levels in April, driven by a normalization in the supply chain and a resumption in production. The service sector and housing market continued to shrink on a year-on-year (YOY) basis and sentiment among households and corporates remains lackluster. The rebound in exports growth in May will likely be unsustainable. Chinese exports are set to contract from 2021 as external demand for goods weakens. The rapidly worsening labor market dynamics reinforce households’ unwillingness to consume and hence, will hinder the recovery in household consumption. Although industrial production showed a decent rebound in May, the manufacturing production recovery might be derailed by rolling lockdowns and prolonged logistic bottlenecks. Barring major lockdowns, China’s economy will likely improve in 2H 2022 from the very low base in Q2. That said, the country’s economic recovery faces several challenges and the magnitude of the rebound will be subdued. Bottom Line: The elements for a robust and sustainable recovery in the Chinese economy are not yet in place. The recent rally in the A-share market reflects a mean-reversal to the pre-March lockdown price level, rather than the beginning of a cyclical bull market. Investors should remain cautious on Chinese equities in the next several months. Feature China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply chain and a resumption of production post-lockdown in Shanghai and other cities led to a modest recovery in business activities. However, indicators from the service sector and housing market continued to shrink on a YOY basis, highlighting persistent weaknesses on the demand side. Chart 1Import Dynamics Reflect Weak Domestic Demand May’s import data also reflects sluggish domestic demand. The increase in imports value from a year ago was largely driven by the elevated prices in energy and agriculture products. China’s imports in May, in volume terms, continued to contract on a YOY basis, albeit improved from its historical low in April (Chart 1). Barring major lockdowns, China’s economy will likely improve in the second half of this year. However, the economic recovery in 2H 2022 will be very subdued due to the following challenges: Downbeat sentiment among households and enterprises; Continued real estate woes; A contraction in exports; Deteriorating labor market conditions; and Risk of rolling lockdowns and persistent logistic bottlenecks. The recent rebound in the A-share market reflects an improvement in investors’ sentiment buttressed by the easing of lockdowns and a resumption of production. In other words, the rebound in Chinese stock prices is probably a mean-reversal to pre-lockdown levels, rather than a sustainable rally (Chart 2). Our cautious view on Chinese equities is also corroborated by the divergence between falling raw industrial prices, which reflect weak China’s growth, and rising Chinese equity prices (Chart 3). Overall, we continue to recommend a neutral stance in Chinese equities within a global portfolio. Chart 2Too Early To Turn Bullish On Chinese Stocks Chart 3Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Downbeat Household And Corporate Sentiment Chart 4Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Although China’s credit growth improved sequentially in May after a very weak reading in April, the magnitude of May’s credit rebound is much more subdued compared with the months following the first lockdowns in early 2020 (Chart 4). In addition, May’s rebound in credit growth was mainly driven by an acceleration in local government bond issuance. The modest pickup in the credit impulse - calculated as a 12-month change in total social financing (TSF) as a percentage of nominal GDP - is much more muted when excluding local government bond issuance (Chart 5). Furthermore, as noted in our previous report, given that most of the planned local government special purpose bonds (SPBs) will be issued by the end of June, barring any increase in this year’s SPBs quota, the support from local government bond issuance to TSF growth will likely wane significantly in the second half of 2022. Meanwhile, confidence among consumers and businesses remained downbeat through May (Chart 6). The poor private-sector sentiment will continue to dampen credit demand and thus, limit the effectiveness of monetary stimulus. Chart 5The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Chart 6Gloomy Sentiment Among Chinese Households And Enterprises Private-sector credit demand remains very frail. Household medium- to long-term loans are still contracting from previous month, while bank loans to corporate peers were also weak in May (Chart 7 & 8). Chart 7Depressed Household Loan Demand Chart 8Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Chart 9Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions On the other hand, corporate bill financing as a portion of new bank loans, although rolled over from April’s record high, remained very elevated through May (Chart 8, bottom panel). Moreover, enterprises’ financing and investment expectations deteriorated further in May (Chart 9).   Persisting Real Estate Woes The near-term outlook for China’s property market remains uninspiring. So far, easing measures in the housing sector have not been successful in reviving home sales and homebuyers’ sentiment. Residential property sales and real estate investment growth ticked up slightly in May after plummeting by 43% and 10% in April, respectively (Chart 10). However, the modest improvement in May does not mark the start of a full-fledged cyclical recovery. High-frequency data show a renewed weakening in floor space sales, particularly in tier-one and tier-two cities, during the first two weeks of June (Chart 11). Chart 10The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery Chart 11Renewed Deterioration In Home Sales In June Chart 12Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Funds to real estate developers have been contracting at the fastest rate since data collection began in 1998. The lack of funding for real estate developers will further depress housing construction activities in the near term (Chart 12). Moreover, new home prices, which tend to lead housing starts, started to decrease on a YOY basis in May. This was the first price contraction since 2016. Our housing price diffusion index suggests that home price growth will continue to shrink in the next six to nine months (Chart 13). Many local cities reduced mortgage rates, by anywhere from 15 to more than 100 basis points, after the PBoC lowered mortgage rate floor and the benchmark rate (5-year LPR) in May. However, the average cost of mortgage loans remains higher than households’ income growth, making mortgage borrowing less attractive to ordinary households (Chart 14). Chart 13Housing Prices Are Set To Decline Further In 2H 2022 Chart 14Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth In addition, the widening gap between the average mortgage rate and the pace of housing price appreciation implies that housing has become much less appealing to residents who purchase homes as investment (Chart 14, bottom panel). In short, property purchases will remain weak given neither “to live in” nor investment demand for properties is likely to recover fast. China's Exports Are Set To Contract In 2H 2022 China’s exports rebounded in May from the April low as supply chain interruptions subsided and logistic disruptions began to ease. However, as US and European consumer spending on goods (excluding autos) declines, Chinese shipments will shrink in the months ahead. May’s improvement in suppliers’ delivery times and product inventory subindexes of China’s official Purchasing Managers’ Index (PMI) suggests that logistics were less of a drag on economic activity than in April (Chart 15). In addition, Shanghai and China’s exports freight indexes recovered significantly on a month-over-month basis (Chart 16) with the lifting of lockdown measures. Chart 15Chinese Logistics Pressures Have Eased Slightly In May... Chart 16...And Export Freight Indices Have Rebounded Chart 17Global Demand Is Dwindling Meanwhile, global demand for goods has been weakening. Korean exports volume growth, a bellwether for global trade, has been trending down since late 2021 (Chart 17). Moreover, the US and Euro Area manufacturing PMIs have been falling (Chart 17, bottom panel). Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are well above their pre-pandemic trend, suggesting that the demand growth for Chinese goods will dwindle when US retailers start to destock their inventories (Chart 18). Falling US and Euro Area real household disposable income will also reinforce the downward trend in external demand (Chart 19). Therefore, China's exports are set to shrink in the second half of this year. Chart 18Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 19A Contraction in US and Euro Area Household Real Disposable Income Deteriorating Labor Market Conditions Will Curb Household Consumption Recovery Although improved from April’s extreme low, Chinese retail sales and service activity remained in contractionary territory in May, highlighting sluggish household demand (Chart 20). In addition, the cinema audience, which is used to gauge the impact of the pandemic on the service sector, indicates a further deterioration in the sector’s activity in June (Chart 20, bottom panel). The lackluster consumer demand is also evidenced by soft core and service consumer prices (CPI) in May (Chart 21). Chart 20Chinese Retail Sales And Service Activity Continued To Contract In May Chart 21Soft Core And Service CPIs Also Reflect Lackluster Household Demand   Labor market conditions have also worsened. Although the nationwide urban survey-based unemployment rate fell moderately in May, the 31-large city surveyed unemployment rate climbed to an all-time high in the 10-year history of this survey. Moreover, employment in the service sector deteriorated to the worst level since mid-2020 (Chart 22). Furthermore, urban new job creation fell into deep shrinkage on a YOY basis, while the unemployment rate among younger workers rose to the highest point since data collection began in 2018 (Chart 23). Chart 22Labor Market Situation Is Worsening Rapidly... Chart 23...Particularly Among Younger Workers Chart 24Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume The rapidly worsening labor market dynamics and income prospects reinforce households’ downbeat sentiment (Chart 24). The latter will impede household consumption recovery in the second half of this year.   Production Recovery Faces Risks Of Persistent Logistic Bottlenecks   The uptick in industrial activity in May was due to a lifting of Covid-related lockdown restrictions. Although industrial production showed a decent rebound, underlying data suggest that economic fundamentals remained subdued. Chart 25Industrial Activity Improved Only Slightly In May Chart 26Construction Material Production Continues To Shrink On A YOY Basis Electricity output remained in contractionary territory through May (Chart 25). Cement and steel output continued shrinking from the same period last year (Chart 26). Moreover, their prices have been falling even though production growth has been waning, which indicates that demand in the construction sector is depressed (Chart 3, bottom panel). Consumer durable goods production also remains well below their levels from a year ago (Chart 27 & 28). Chart 27Auto And Smartphone Production Keeps Decreasing From A Year Ago... Chart 28… As Well As Production Of Home Appliances Chart 29Prolonged Logistic Bottlenecks Chinese manufacturing investment rebounded in May. However, since exports will likely shrink in the second half of this year, it will create a major headwind for manufacturing investment and output. Moreover, China’s manufacturing production will likely be challenged by persistent logistic bottlenecks in 2H 2022. Chinese road freight was still declining in the first three weeks in June from the same period last year as shown in Chart 29. The risk of renewed Covid-induced lockdowns or mobility restrictions are nontrivial since China will maintain its zero-Covid policy at least through the end of this year.   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Strategic Themes Cyclical Recommendations

Special Report

Executive Summary High food and fertilizer prices are at risk of morphing into a full-blown food crisis in several developing countries. Some countries were plagued by severe food insecurity even before the Ukraine war broke out. The Ukraine war has upended two crucial aspects of food security: availability of food grains as well as the availability of fertilizers. A few Middle Eastern and African countries, who are dependent on both imported cereals and crude oil, are experiencing the greatest difficulty. The stock-to-use ratio of food grains is alarmingly low in several countries. Some of them also have high twin deficits (i.e., fiscal and current account deficits) – indicating that governments there would be hard-pressed to provide necessary relief. Several Countries Need To Import Over 90% Of Their Cereal Consumption Bottom Line: All aspects considered, we reckon Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka to be the most at risk of experiencing a food crisis, and consequent socio-political upheaval. Feature Food prices have surged in most parts of the world. In some developing countries however, food inflation is threatening to morph into a food crisis. In the year ahead, high food and fertilizer prices could accentuate food insecurity in several poorer countries − with major socio-political ramifications. In this report, we identify the nations most at risk, especially among countries included in the MSCI Emerging and Frontier Equity Indexes. Our research indicates that Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are the most vulnerable to a food crisis, and consequent socio-political upheaval. Food Inflation: In The Stratosphere In a few countries such as Lebanon and Venezuela, food inflation is at a mind-boggling 370% and 200%, respectively. It is abnormally high in many other developing countries as well – including Turkey (92%), Argentina (64%), Iran (49%), Sri Lanka (45%), Ghana (30%), and Egypt (28%). In several other countries such as Colombia, Nigeria, Hungary, Bulgaria, and Kazakhstan, food prices are rising at about 20% or more. That is also the case in war-torn Ukraine and Russia (Chart 1). Chart 1Food Inflation Has Become Extremely Painful In Some Countries In a few countries such as Turkey, Pakistan and Sri Lanka, currency depreciation could explain part of the rise in food prices. Chart 2Food Prices Began To Surge Well Before The Ukraine Crisis That said, given that only a minor share of all food consumed is imported by these countries, the sharp rise in overall food prices cannot be explained away by currency depreciation alone. Rather, it points to genuine price pressures in domestically grown food. That is also the case in all other countries where food inflation is higher than currency depreciation. Notably, in many of these countries, food inflation was quite high even before the Ukraine war broke out. Indeed, global food grain prices had begun to surge in mid-2020 – well before Russia’s invasion began (Chart 2). And yet, the onset of the Ukraine war and the resulting sanctions and logistics bottlenecks have worsened the situation dramatically. Even though food prices have eased marginally in the past couple of weeks, they are still extremely elevated compared to pre-pandemic levels. More worryingly, many countries are now at risk of experiencing a full-blown food crisis.  Pre-existing Food Insecurity Some developing countries are more susceptible to a food crisis than others. This is because they were already plagued by food insecurity even before the Ukraine war broke out. The x-axis of Chart 3 shows the extent of “severe food insecurity”1 in various developing nations, as per the United Nations’ Food and Agriculture Organization (FAO). Kenya, Nigeria, South Africa and Peru stand out in this respect among the countries included in the MSCI EM & Frontier market equity indexes: as high as 18 to 26% of the total population in these countries experienced severe food insecurity between 2018 and 2020. Chart 3Countries With Pre-Existing Food Insecurity Are More At Risk Notably, these countries also happen to have high fiscal deficits; and in some cases, high public debt (Chart 3, y-axis). This leaves their governments with less room to provide necessary relief should an acute food crisis hit their population. Not surprisingly, some of the countries plagued by severe food insecurity are highly dependent on grain imports to meet their domestic demand. The x-axis of Chart 4 shows the cereal import dependency of various countries as a percentage of their cereal intake. Most middle eastern countries such as Lebanon, Jordan, Kuwait, Saudi Arabia and Oman need to import nearly all of their cereal consumptions, as per FAO data. That said, what sets the truly vulnerable cereal importers apart from the rest is that some of them do not have much export earnings to pay for their rising food import bills. For instance, in Lebanon, food imports alone cost two-thirds of its total goods export revenues before the pandemic, according to FAO. For Egypt, Jordan and Kenya, food imports used up over 40% of their export earnings (Chart 4, y-axis). Chart 4Several Countries Need To Import Over 90% Of Their Cereal Consumption These figures must have gone up further as food prices have risen significantly in the past two years. If high food prices persist, the balance of payments of these countries will deteriorate further. That, in turn, will negatively affect their currencies and general inflation.  High Oil Prices Adding To The Woes Many oil and gas producers in the Middle East and Africa are also large net importers of food. Current high crude prices, however, are helping them to foot their food bills. But countries who need to import both food and oil and gas are facing a double whammy. Chart 5 shows that several food importers are indeed large net importers of oil and gas too. On this parameter, Lebanon, Pakistan, Jordan and Kenya appear to be facing the most acute pain − their annual food plus net oil import bills are very high, ranging from 60 to 120% of their goods export revenues. Needless to say, if both food and oil prices remain elevated, these nations could face major socio-economic upheavals. Chart 5Countries Which Need To Import Both Food And Fuel Are The Most Distressed Chart 6Industrial Metals And Ore Producers Will Face More Pain Going Forward On a separate note, many producers of industrial metals/raw materials such as Chile and Peru may also soon experience more difficulties. The reason is that industrial metal prices have recently rolled over relative to food prices (Chart 6). Going forward, slowing global growth will likely push down industrial metal prices further, robbing these nations of a major source of income. Falling income amid high food prices would hurt the population even more, as the former will also limit the authorities’ ability to provide relief. The Implications Of The Ukraine War Could Linger The Ukraine war has upended the two most crucial aspects of food security: availability of food grains and fertilizers. Notably, the exportable surplus of food and fertilizers in the world are concentrated in only a handful of countries. Russia and Ukraine are key among them. In the case of wheat, 28% of global exports (in volume terms) in 2021 came from Russia (18%) and Ukraine (10%),  as per the FAO. In the case of barley, their share was 24%, and for corn (maize) 12%. Chart 7Grain Prices Have Surged Across The Board These two countries are dominant in some oilseed exports as well. Ukraine (37%) and Russia (26%) together held about two-thirds of the global sunflower oil export market share. In the case of rapeseed, Ukraine had about 20% of global export share. Much of these supplies now face severe logistical hurdles. That, in turn, has pushed up grain and edible oil prices globally, hurting all countries whether they are dependent on food imports or not (Chart 7). That said, the countries who are heavily dependent on Russian and Ukrainian supplies are particularly hit hard. Chart 8 shows the import dependency of some countries on Russian and Ukrainian wheat. Turkey, Lebanon and Egypt will have to urgently find alternative suppliers as a very large share of their imports now face uncertainty. The same can be said about Eritrea, Somalia and some former Soviet republics.    In the case of fertilizers, Russia was the largest supplier of nitrogen-based fertilizers2 (the kind that is most heavily used) at 17% of global exports in 2021. The country was also the second largest exporter of potassium-based fertilizer (23%), and the third largest in phosphorus-based fertilizers (16%). Ukraine, however, has not been a big exporter of fertilizers. Just like in the case of wheat, several countries had been highly dependent on Russian fertilizers. Among EM countries, Peru procured 42% of its fertilizer needs from Russia last year. Brazil, Mexico, and Colombia each imported about 22% from Russia. That figure was substantially higher for some other developing countries such as Ghana (37%), Cameroon (47%), and Honduras (50%) (Chart 9). Given the numerous sanctions imposed on a multitude of Russian entities, shipments of Russian fertilizers are now at risk. As such, all these countries need to find substitute suppliers urgently.  Chart 8Russia And Ukraine Supplied Over 80% Of Wheat Imports For Many Countries Chart 9Russia Supplied Over 40% Of Fertilizer Imports For Many Countries   Notably, it’s not just the logistics/availability issues that fertilizer users must contend with. Prices of fertilizers have also surged by a massive 200 to 300% compared to pre-pandemic levels. The reason for that is sky-high natural gas prices, which is the primary feedstock of (nitrogen-based) fertilizers (Chart 10). Chart 10High Natural Gas Prices Will Keep Fertilizers Expensive Since Russia is also a major natural gas producer, the current situation does not bode well for the fertilizer price relief outlook. New western sanctions on Russia and countermeasures by Russia are continuing relentlessly. As such, one can expect that natural gas prices will likely stay elevated for the foreseeable future. That will keep fertilizers expensive. Meanwhile, the scarcity and/or high prices of fertilizers would force farmers in many poor countries to curtail their fertilizer use during the ongoing / upcoming crop season. That in turn would imperil their domestic food production, accentuating overall food scarcity. Where Do Countries’ Food Stocks Stand Now? Chart 11 shows various developing countries’ combined stockpile of food grains (wheat, corn and soybean) relative to their yearly usage (i.e., the stock-to-use ratio). Chart 11The Stock Of Foodgrains Is Precariously Low In Many Countries Among the countries who have high cereal import dependency (and, who are not oil producers), the stock-to-use ratio is particularly low for Lebanon, Jordan, Chile, Peru, and Egypt. Since some of the countries with low food stock-to-use ratio are also dependent on imported food and fertilizers, they are even more susceptible to an outright food shortage this year. Lebanon, Egypt and Peru are three such countries among MSCI included ones. If various countries’ stock-to-use figures are juxtaposed with their twin deficits, their wherewithal to provide necessary relief should their food stocks become inadequate can be demonstrated. Chart 12 shows that several countries with a low food stock-to-use ratio are also plagued by high twin deficits, and therefore low capacity to provide relief. Examples are Lebanon, Jordan, Egypt, Nigeria and Venezuela. Chart 12Some Countries With Low Food Stock Have A Low Capacity To Provide Relief Food Price Shock: Is It Inflationary Or Deflationary? High food prices can sometimes lead to higher general inflation. The starting point of that is usually household inflation expectations: facing higher grocery prices every day, consumer expectations of future prices become unmoored. That said, whether the higher inflation ‘expectations’ will evolve into higher ‘realized’ inflation depends on households’ (labor) power to negotiate wages. If they are successful to gain higher wages, core inflation also begins to rise in tandem with food inflation, which might eventually lead to a wage-inflation spiral. In most developing nations, however, that does not look to be the case. Wages are rising sharply in only a handful of countries. Moreover, since a very high share of consumer spending in developing countries is accorded to food (25% to 55%), higher food bills are eating substantially into households’ real discretionary spending. That does not bode well for (non-food) corporate earnings. In addition, the central banks in many developing economies are raising interest rates in response to high inflation. All these will likely push many developing economies on the brink of a recession.   Investment Conclusions Currently, most emerging and frontier market nations are facing a deteriorating growth outlook – thanks to tight fiscal and tightening monetary policies domestically, a very strong US dollar, rising global interest rates, and a subpar Chinese recovery. High food and/or fuel prices are additional ‘taxes’ on their economies, and especially for the import-dependent ones. As a result, their growth will be stymied further. The consequence could well be socio-political volatility. Incidentally, the last time global food prices witnessed a major surge (about 40%) was back in 2010. That was soon followed by social upheavals in much of the Middle East (known as the ‘Arab Spring’) and elsewhere in the developing world. In the present episode, food prices have risen by 70% in two years. As mentioned, some of the countries facing food and fertilizer scarcity are also plagued by low grains stocks (relative to requirement) and have weak fiscal and external accounts. Considering all the aspects, we reckon that Lebanon, Jordan, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are most-at-risk of slipping into a food crisis this year and beyond. Incidentally, the Emerging Markets Strategy team holds a bearish view on the near-term performances of EM stocks and bonds. Investors should stay underweight EM relative to global equities and bonds. Absolute return investors should stay on the sidelines. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Sebastian Rodriguez Research Associate sebastian.rodriguez@bcaresearch.com     Footnotes 1     Severe food insecurity refers to missing meals and/or reduced food intake because of financial constraints 2     The three main type of chemical fertilizers are nitrogen-based (urea and ammonia), potassium-based (potash), and phosphorus-based (phosphates).

Executive Summary An Optimal Control Policy We could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, but we caution against turning overly bullish on bonds even if you anticipate a recession. An optimal control approach to monetary policy tells us that the Fed should be willing to accept a significant increase in the unemployment rate to tame inflation. The implication is that the next recession may not be met with the dramatic easing of monetary policy we have become accustomed to. Short-maturity real yields remain deeply negative, but they will move into positive territory before the end of the economic cycle. Indicators of corporate balance sheet health are not flashing red, but they are moving in the wrong direction.   Bottom Line: Investors should keep portfolio duration close to benchmark, maintain a defensive posture on corporate bonds and short 2-year TIPS.   The Return Of Optimal Control Bonds rallied into the close last week and, as of Monday morning, their gains have only been partially unwound. The 2-year Treasury yield is down to 3.07% from its recent high of 3.45% and the 10-year yield is down to 3.16% from its recent high of 3.49% (Chart 1). The 2-year/10-year Treasury slope remains close to inversion at 9 bps (Chart 1, bottom panel). Increasingly, the message from the Treasury market is that the Fed is no longer playing catch-up to runaway inflation. Rather, the dominant market narrative is that the Fed may have to moderate its hiking pace to avoid an economic recession. With the unemployment rate at 3.6% and nonfarm payroll growth averaging +408k during the past three months, the US economy is clearly not in a recession today. That said, leading indicators are pointing to increased risk of a downturn within the next 12 months. For example, the S&P Global Manufacturing PMI fell sharply last week from 57.0 to 52.4 (Chart 2). The more widely tracked ISM Manufacturing PMI remains elevated at 56.1, but regional Fed surveys and trends in financial conditions suggest that the ISM could dip into contractionary territory during the next few months (Chart 2, bottom 2 panels). Chart 1Treasury Yields Chart 2Recession Risk Is Rising This is obviously a tricky situation for the Fed as there is a risk that its two mandates of price stability and maximum employment could come into conflict. Not surprisingly, the Fed has a playbook for these sorts of situations, one that was described by Janet Yellen as “optimal control” in a 2012 speech.1 Under an optimal control approach to policymaking the Fed specifies a loss function that is based on deviations of inflation from its 2% target and of the unemployment rate from its estimated full employment level. Understanding that it will be impossible to perfectly achieve both of its objectives, the Fed attempts to set policy so that the output of the loss function is minimized. One example of a simple loss function was given by St. Louis Fed President James Bullard in a speech from 2014.2 That function is as follows: Distance From Goals = (π – π*)2 + (μ - μ*)2 Where: π = inflation π* = The Fed’s target inflation rate μ = the unemployment rate μ* = The Fed’s estimate of the unemployment rate consistent with full employment Chart 3An Optimal Control Policy Let’s apply Bullard’s loss function to the present-day economic situation. The top panel of Chart 3 shows the square root of the function’s output. The Fed’s goal, of course, is to get that line as close to zero as possible. First, let’s see what happens if we input the median FOMC member’s forecast for core PCE inflation and the unemployment rate. That forecast has core PCE inflation falling to 4.3% by the end of this year and it has the unemployment rate edging up to 3.7%. Not surprisingly, this scenario leads to a modest improvement in Bullard’s loss function. Now let’s examine an alternative scenario where core PCE inflation falls to 4% by the end of the year but we set the loss function to remain at its current level. That outcome can be achieved even with the unemployment rate rising to 6.68%. This scenario is instructive. It tells us that, from an optimal control perspective, the Fed would be willing to tolerate an increase in the unemployment rate all the way up to 6.68% if it meant that inflation would fall back down to 4%. Why is this example important? It’s important because it gives us some perspective on what sort of labor market pain the Fed may be willing to tolerate to tame inflation. More specifically, there is a growing sense among some market participants that the US economy will soon fall into recession and that recessions are usually accompanied by Fed rate cuts. However, the magnitude of the increase in the unemployment rate that is shown in our alternative scenario would almost certainly be classified as a recession, but an optimal control perspective tells us that the Fed shouldn’t back away from tightening if that were to occur. The bottom line is that while we could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, we caution against turning overly bullish on bonds even if you anticipate a recession within the next 6-12 months. Given where inflation is today, there are strong odds that the Fed would respond to a rising unemployment rate by simply tempering its pace of rate hikes or perhaps temporarily pausing. Optimal control tells us that we would need to see an extremely large employment shock for the Fed to consider reversing course and cutting rates. Investors should stick with ‘at benchmark’ portfolio duration for the time being. A Quick Note On Real Yields   Chart 4Short 2-Year TIPS The 2-year real yield has risen to -0.70% from a 2021 low of -3.05%, but we have high conviction that it has further to run (Chart 4). At the press conference following the June FOMC meeting, Fed Chair Powell hinted that he viewed positive real yields across the entire Treasury curve as a reasonable intermediate-term goal. He then made similar claims when testifying before the Senate last week: It’s really only the very short end of the curve where our rates are still in negative territory from a real perspective. If you look further out, real rates are positive right across the curve and that’s really what you’re trying to achieve in a situation like this where we have 40 year highs in inflation.3 One way or another, we think it is highly likely that the Fed will achieve its goal of positive real yields across the entire curve. This could happen in a benign scenario where falling inflation expectations push short-maturity real yields higher. Or, it could happen in a more dramatic fashion where inflation expectations remain elevated but that only quickens the pace of Fed tightening. In that scenario, rising short-maturity nominal yields would drag real yields with them. Either way, investors should continue to hold outright short positions in 2-year TIPS. Corporate Health Check-Up In prior reports we noted the extremely good condition of corporate balance sheets, while also suggesting that balance sheet health would deteriorate going forward.4  An updated read on the status of corporate balance sheets suggests that conditions are still favorable, but much less so than even a few months ago. We begin with our Corporate Health Monitor (CHM), a composite indicator of six financial ratios calculated from the US National Accounts data for the nonfinancial corporate sector. This indicator was deep in “improving health” territory at the end of 2021, but it moved close to neutral in 2022 Q1 (Chart 5). Ratings trends, meanwhile, send a similar message. Through the end of May, upgrades continued to dramatically outpace downgrades in the investment grade space (Chart 5, panel 2), but the rate of net upgrades slowed somewhat in high-yield (Chart 5, bottom panel). Digging deeper, we find that the main culprit behind the CHM’s recent jump is a large drop in the ratio of Free Cash Flow to Total Debt (Chart 6). This drop occurred because after-tax cash flows held roughly flat in Q1 but capital expenditures surged, causing free cash flow to dip (Chart 6, panel 2). Chart 5Corporate Health Monitor Chart 6Capex Surged In Q1 This trend is confirmed by another important indicator of corporate balance sheet health, the financing gap. The financing gap is the difference between capital expenditures and retained earnings. A positive financing gap means that retained earnings are insufficient to cover capital expenditures and firms therefore have an incentive to tap debt markets. We see that the financing gap jumped sharply in Q1, from deeply negative into positive territory (Chart 7). Chart 7The Financing Gap Is Positive A positive financing gap on its own does not send a negative signal for corporate defaults. However, when a positive financing gap coincides with tightening lending standards, then an increase in the default rate becomes likely. For now, lending standards are close to unchanged (Chart 7, bottom panel), but there is a strong chance that continued Fed hiking will push them into ‘net tightening’ territory in the months ahead. Investment Implications Chart 8Attractive Value In HY Corporate balance sheet health isn’t quite flashing red, but it is certainly trending in the wrong direction. With continued Fed tightening likely to weigh on lending standards and interest coverage going forward, a defensive posture toward corporate bonds is warranted. We continue to recommend an underweight allocation (2 out of 5) to investment grade corporate bonds in US fixed income portfolios. We maintain a somewhat higher neutral (3 out of 5) allocation to high-yield bonds for the time being. This is because high-yield valuation is quite attractive, and we see potential for some near-term spread tightening as inflation rolls over (Chart 8). That said, the sector’s long-term return prospects are not good, and we will consider turning more defensive should the average high-yield spread narrow to its 2017-19 average or should core inflation move closer to our 4% target.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 2 https://www.stlouisfed.org/from-the-president/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/bullardowensborokychamberofcommerce17july2014final.pdf   3 https://www.c-span.org/video/?521106-1/federal-reserve-chair-jerome-powell-testifies-inflation-economy 4 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 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