Developed Countries

Executive Summary Compared to output, income and net worth, aggregate consumer indebtedness is at the low end of its twenty-first century range. Modest indebtedness and low interest rates have made it easy for households to service their debt and leave them with room to take on more. Low-income households are beginning to show some signs of strain and it appears most of them have used up their pandemic savings. Loans have been underwritten more rigorously since the crisis, however, and borrower quality has been rising, especially since the pandemic began. Loan performance always deteriorates during recessions, but attention-getting claims about credit busts appear to be overheated. Consumer borrowers are on solid footing, and the financial system is not particularly vulnerable to a consumer credit downturn. The White House is reportedly mulling some measure of student loan forgiveness for a targeted set of households at the lower end of the wealth and income distributions. The overall package will have to be small, but it may make a difference for some of the more vulnerable borrowers. Consumers Are Starting From A Good Place Consumers Are Starting From A Good Place Consumers Are Starting From A Good Place Bottom Line: Reports of the American consumer’s demise have been greatly exaggerated. Consumer credit is way down on the list of things to worry about in the current environment, and investors should not be distracted by sensationalized claims about bursting bubbles. Feature Our internal research meeting last Monday, live-streamed and archived in the Live & Unfiltered section of BCA's website, addressed media reports of an increase in auto repossessions. The juiciest report featured the anecdotal observations of Lucky Lopez, YouTuber and owner of Automotive Life, a Las Vegas-based auto-related company with a somewhat ambiguous mission. Lopez’s LinkedIn profile indicates that he has a wide range of experience in the automotive industry as an owner/operator of auto repair shops, an auto body shop, a rental car company and a car dealership, though he is now a consultant and coach for all automotive businesses. Although a cursory Google search indicates that the customer experience at his past businesses has not been uniformly happy, his January YouTube video, “Used Car Market Bubble Popped !!!” has garnered over 300,000 views, raising his profile beyond the bounds of the Internet’s echo chambers. That article also referenced the work of a professor, now at New York’s Cardozo Law School, who has warned that pandemic aid merely delayed the onset of an auto-loan crisis. “The bubble is beginning to show signs of bursting soon,” she said in the column. According to Google Scholar, her 2021 paper, “Bursting the Auto Loan Bubble in the Wake of COVID-19,” has subsequently been cited by three other papers, two of which she co-authored. She and the other people featured in the column pointed to reports of surging repossessions as a cause for alarm, but repo data are hard to come by and delinquency patterns don’t suggest that default rates are headed meaningfully higher. The internal discussion motivated us to look more deeply into consumer creditworthiness. After considering the level and composition of household indebtedness, borrower quality and borrower performance, we conclude that consumer credit is in a good place. It will worsen when the recession arrives, but it will start from a better than usual position and therefore poses less of a threat to financial markets and economic output than it typically would. Our findings reinforce the idea that the economy is not beset by imbalances that increase its vulnerability to an especially nasty recession. Household Indebtedness In contrast to the murky world of auto repos, there are several lengthy data series that allow us to evaluate households’ aggregate financial position. As a share of GDP, household debt is back to the 75% level it first reached 20 years ago (Chart 1), driven by the deleveraging that followed the financial crisis (the pandemic spike was about sudden GDP contraction, not increased borrowing). Adjusted for disposable income, the after-tax cash flowing to consumers to service their obligations, the pattern is the same, as mortgage indebtedness has unwound its crisis excesses while other consumer debt has remained steady (Chart 2). The growth in household borrowing has failed to keep up with appreciating asset values and debt as a share of household net worth fell to multi-decade lows at the end of the first quarter (Chart 3). Chart 1Household Balance Sheets Have Been Strengthening For A Decade Household Balance Sheets Have Been Strengthening For A Decade Household Balance Sheets Have Been Strengthening For A Decade Chart 2A 20-Year Round Trip A 20-Year Round Trip A 20-Year Round Trip Chart 3Debt Is Markedly Lower As A Share Of Net Worth, ... Debt Is Markedly Lower As A Share Of Net Worth, ... Debt Is Markedly Lower As A Share Of Net Worth, ... Chart 4... And Falling Rates Have Made It Especially Easy To Service ... And Falling Rates Have Made It Especially Easy To Service ... And Falling Rates Have Made It Especially Easy To Service Low levels of indebtedness, combined with low interest rates, have eased households’ debt service burden, with the share of their disposable income that goes to interest and principal repayments falling to multi-decade lows (Chart 4). No matter how you slice it, the debt yoke is as light as it has been heading into the last four recessions. From a composition perspective, mortgages maintain the dominant position, accounting for nearly three-fourths of household debt (Chart 5), while student loans (11%), auto loans (8%) and credit cards (6%) comprise nearly all the rest. Although those warning of an auto bubble cite rising auto loan balances as a sign of trouble, they have been mostly steady as a share of disposable income since 2015 and remain well short of their 2002-to-2005 peak.   Chart 5Consumer Credit Has Moved In Step With Disposable Income For The Last 20 Years Consumer Credit Has Moved In Step With Disposable Income For The Last 20 Years Consumer Credit Has Moved In Step With Disposable Income For The Last 20 Years Bottom Line: Household indebtedness is much more manageable now than it was ahead of the last four recessions, thanks to reduced balances relative to income and wealth and lower interest rates. Borrower Quality As household balance sheets strengthen, consumer borrowers become better credits, but loan quality is also a function of lenders’ appetites. Bad loans are made in good times, according to the bank examiner’s mantra, but the corollary is also true. Reluctant lenders make sound loans and banks lost some of their appetite after the crisis while regulators took away much of what was left of it. Basel III standards clipped banks’ wings by applying onerous capital charges to all but the most straightforward lending activity and Fannie Mae’s and Freddie Mac’s aggressive stance on returning defaulted residential mortgages to their originators over an uncompromisingly strict reading of representation and warranty claims have forced banks to scrutinize prospective homeowners’ credentials. Increased scrutiny has shown up in the vastly improved risk profile of mortgage originations (Chart 6), which are now overwhelmingly tilted in favor of prime-plus (FICO score of 720 to 780) and superprime (greater than 780) borrowers and away from near prime (600 to 660) and subprime borrowers (less than 600). It is understandable that investors who lived through the trauma of the financial crisis just over a decade ago remain sensitive to housing market vulnerability, but we think the FICO score data forcefully rebut any lingering concerns about residential mortgages. Chart 6Residential Mortgage Originations By FICO Score How Creditworthy Are American Consumers? How Creditworthy Are American Consumers? The remainder of household debt, detailed in the Fed’s monthly consumer credit reports, is primarily concentrated in student loans, auto loans and credit cards. Student loan balances, adjusted for disposable income, surged in the wake of the financial crisis to surpass declining credit card balances, which slid further in the early stages of the pandemic, and stable auto loans. Student loan borrowers at the lower end of the wealth and income distributions may soon have some of their obligations canceled, which may help consumer credit performance at the margin (Box), though the resumption of paused monthly payments will likely make the net effect a wash. The biggest banks’ customers are beginning to carry slightly higher credit card balances and though the banks have surely eased their standards to make more of their most profitable loans, we do not foresee cards as a systemic vulnerability. BOX Student Loan Debt: Pause, Play Or Erase Student loan borrowers have been able to pause making payments on their loans since the CARES Act took effect in April 2020, but the seventh extension of the temporary pause expires at the end of August and there will not be another. The Biden administration is grappling with whether to make good on a campaign promise to cancel at least some student debt held by the federal government. Washington holds over 80% of outstanding student loans and could wipe out any or all of it via executive order but the political calculus is complicated and perilous: the Democrats would like to appeal to young voters before the midterms, as well as women, who are on the hook for almost 60% of student debt, without alienating less well-off voters who might view cancellation as a giveaway to wealthy elites. Our US Political Strategy service expects that cancellation will be limited and targeted, too small to move the needle on aggregate household finances but perhaps providing the most vulnerable borrowers temporary relief to allow them to better service their other debt and/or maintain their consumption in the face of high food and fuel prices. That leaves auto loans as the swing factor within consumer credit performance. Despite the auto bubble-watchers’ assertions, anonymized Equifax data compiled by the New York Fed for its quarterly Household Debt and Credit Report do not indicate that auto lending standards have been eased: since 2017, the share of auto loan originations made to near-prime and subprime borrowers has steadily declined while the share of prime-plus and superprime originations has risen (Chart 7). Auto lenders did relax their standards in 2013 through 2016, once they got some distance from the crisis, but they reversed the trend in 2017 and tightened the screws even more when the pandemic arrived, as per the moves in a diffusion index calculated by subtracting the share of below-prime originations from the share of above-prime originations (Chart 8). Chart 7Auto Loan Originations By FICO Score How Creditworthy Are American Consumers? How Creditworthy Are American Consumers? Chart 8Tighter Standards On Showroom Floors And Used-Car Lots How Creditworthy Are American Consumers? How Creditworthy Are American Consumers? Chart 9Collateral Values Have Surged Collateral Values Have Surged Collateral Values Have Surged The increase in the value of the collateral securing outstanding auto loans, which have an average term of nearly six years, should help contain lender losses in the event of default (while encouraging borrowers not to default). Per the Manheim Used Vehicle Value Index, used car prices have risen between 150% and 180% since the 2016-2019 vintages of outstanding auto loans were issued (Chart 9). Cars driven for the last five or six years have been depreciating with each mile driven, so they would not bring 150-180% of their initial value if their lenders repossessed and sold them, but the unforeseen price appreciation does mean their loan-to-value ratios (LTVs) must be tiny if borrowers have kept up with their payments. Loans issued after used-car prices exploded higher in late 2020 are vulnerable on an LTV basis and are likely to generate larger-than-normal losses given default once vehicle prices come back to earth, but lenders are well insulated from losses on their older outstanding loans. Bottom Line: Borrower quality is robust relative to history. Mortgage lending standards have tightened considerably since the financial crisis and auto borrower quality has been improving since 2017. The most vulnerable student loan borrowers are likely to get some relief in the form of debt forgiveness and soaring used car prices will help shield auto lenders from losses on the loans they issued before the pandemic. Borrower Performance Monthly delinquencies across consumer borrowing categories support the idea that households are on firmer financial footing than they were before COVID-19. TransUnion’s publicly available data show that 60-day mortgage delinquencies have cratered, spending the last fourteen months at around one-half of their February 2020 level (Chart 10, bottom panel). 90-day credit card delinquencies, after rising from unprecedented lows, have settled over the last six months at about two-thirds of their February 2020 level (Chart 10, second panel). 60-day auto loan delinquencies are back to their pre-pandemic level (Chart 10, top panel), but they are a far cry from what alarmist claims would suggest. As we noted in the previous section, better borrowers and used car appreciation should help insulate lenders from losses on loans that were issued before car prices soared. Chart 10Consumer Delinquencies Remain Well-Behaved How Creditworthy Are American Consumers? How Creditworthy Are American Consumers? The Road Ahead As a SIFI bank CFO put it last week when discussing his company’s second quarter earnings, no cracks in consumer borrower performance have shown up yet. Credit performance frays when growth decelerates and deteriorates when the economy contracts. The coming recession will be no different but what’s different this time is the starting point for consumer credit. Consumers often stretch their credit to the limit by the time output peaks but they are in a comfortably sustainable spot today. This time around, lenders did not abandon their credit standards to maintain market share in an increasingly overheated environment. The borrowing performance rule of thumb is that consumers will pay their debts unless they lose their jobs, get divorced or suffer catastrophic illness. Much therefore depends on employment, and the job market still looks strong. Initial jobless claims are still close to record-low levels, surveys indicate that businesses still have ambitious hiring intentions and plenty of positions need to be filled if the leisure and hospitality industry is going to meet pent-up demand. We will continue to monitor every data series that might lead consumer spending and consumer credit performance. The SIFI banks’ second-quarter earnings releases and calls end today with Bank of America and we will present our July 2022 Big Bank Beige Book report next week. Bank management teams don’t have crystal balls, but they do gain a wealth of insight into consumers’ appetites and businesses’ investment plans, and they often share some of it during their earnings calls with sell-side analysts. The macro backdrop remains fluid and fraught, and consumer credit prospects look a lot like the overall economy – far from perfect, but better than the financial market selloff and persistent gloom would imply. We remain more constructive than the consensus on the twelve-month outlook for financial markets and the economy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

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

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar