Developed Countries

Executive Summary Stronger Capex Than Last Decade The fog of war continues, but the worst potential outcome for the market—a freeze of Russian energy exports to Europe—has been avoided. Energy inflation is reaching its apex. Markets will remain volatile in the near term as uncertainty remains elevated in the coming days. Moreover, a transition from a recovery driven by consumer durable goods to services remains a hurdle against near-term European outperformance. Italian bonds and European banks are attractive, but it is not yet prudent to plunge headfirst into the euro. The longer-term consequences of the conflicts point toward greater capex and public deficits in Europe. This will boost the neutral rate of interest and European yields. Industrials and defense stocks are also key structural beneficiaries. Bottom Line: Keep hedges in place for the near term, as uncertainty remains rife. Buy Italian bonds and European banks, which will benefit from ECB support. Industrials still face near-term hurdles but should be a structural overweight position in European equity portfolios, along with financials and defense stocks. Feature The situation in Ukraine is reaching a climax. Following Russia’s recognition of the breakaway Luhansk and Donetsk People’s Republics (LPR and DPR) and its invasion of Ukraine, the S&P 500 entered correction territory. Importantly, the Dow Jones Euro Stoxx 50 is now down 10% since its January 5th high, which validates our repeated call over the past four weeks to hedge risk asset portfolios by selling EUR/CHF and EUR/JPY. An international conflict has begun and a human tragedy is unfolding; but, at the time of writing, it looks like the worst-case scenario for markets will be avoided. Germany is folding Nord Stream 2 indeterminably and Western allies have imposed painful economic sanctions on Russia. However, an expulsion of the SWIFT payment system is not in the cards. This is crucial because it greatly limits the risk that Russia will stop sending natural gas and oil to the EU. Ultimately, neither Russia nor the EU wants this outcome, since it imposes an enormous loss of revenues on the former (which needs hard currency to finance its war) and guarantees a recession for the latter (Chart 1). The war will still cost Europe. European natural gas prices surged again on Thursday, rising by more than 60% intraday. While a spike above EUR200/MWh is unlikely in the absence of an oil embargo, 20% of European natural gas imports pass through Ukraine. The conflict suggests that these flows will remain disrupted for now and that natural gas prices will remain between EUR80/MWh and EUR100/MWh for the next few months. This translates into elevated energy and electricity costs for the EU (Chart 2). Chart 1A European Recession Averted Chart 2Peaking But Elevated Chart 3Ebbing Energy Inflation Oil markets are set to peak soon. The run-up in Brent prices in recent weeks was largely driven by geopolitical concerns. With the odds of an oil embargo declining, the pressure on Brent will also recede. Bob Ryan, BCA’s commodity and energy strategist, believes that Saudi Arabia, the UAE, and Kuwait will increase their own production in coming weeks to burnish their credentials as reliable oil producers, especially if oil experiences more turmoil.  Bob expects crude prices to drop to $85/bbl by the second half of 2022. These dynamics are important because they imply that European headline inflation will soon peak. Yes, the recent spike in natural gas prices will keep energy inflation higher for a few more months, but, ultimately, ebbing base effects will bring down energy CPI. As Chart 3 highlights, even if Brent and natural gas prices stay at today’s levels for the remainder of the year, their year-on-year inflation rates will collapse, which will drive HICP lower. Near-Term Market Dynamics In this context, what to do with European assets? It is probably still too early to abandon our hedges, but we will likely do so next week or soon after. While the market has probably bottomed, prudence remains of prime consideration as a war is taking place and the situation on the ground may deteriorate. Chart 4A Buying Opportunity The clearest near-term investment implication comes for European peripheral bonds. Italian spreads have widened significantly in the wake of the hawkish pivot by the ECB (Chart 4). However, we argued that, when interest rate expectations priced in 50bps of the hike for 2022, the move was excessive and that only one ECB hike in the fourth quarter was likely this year. Now that the Ukrainian crisis is reaching a climax, even some of the ECB’s most hawkish members, such as Robert Holzmann, Governor of the Austrian National Bank, indicate that the removal of liquidity will be slower than originally anticipated. This means that the ECB is likely to continue to backstop the European peripheral bond markets. Italian and Greek bonds, which offer spreads of 165bps and 249bps over German bunds, are appealing in light of this explicit backstop. European financials are another attractive buy. Investors should buy banks outright. As Chart 5 highlights, all the major Eurozone countries’ banking stocks have suffered widespread selloffs. However, the exposure to Russian debt is limited at $67 billion (Chart 6). Additionally, the European yield curve slope is unlikely to flatten significantly from here. The ECB will limit the upside in the German 2-year yields by not hiking until Q4 2022, while the terminal rate proxy in Europe has significant upside from here. A steeper yield curve will boost the appeal of banks, especially in a context in which peripheral spreads are likely to narrow. Chart 5Too Much Of A Dive Chart 6Limited Russian Exposure The outlook for the euro is more complex. Narrower peripheral spreads would boost the euro’s appeal, a cheap currency currently trading at a 17% discount to its PPP fair value. EUR/USD also trades at a 5% discount to the BCA Intermediate-Term Timing Model, which suggests that considerable bad news is already embedded in the exchange rate (Chart 7). The fact that the EUR/USD did not close below its January 27th low in the face of a major war on European soil adds to the notion that the euro already embeds a significant risk premium. However, there are still ample reasons to worry about additional volatility in the coming week or so. The ECB is sounding less hawkish, while the Fed is not changing its tone. Meanwhile, 1-month and 3-month risk reversals are not at levels consistent with a bearish capitulation, which suggests that the euro could suffer one last wave of liquidation (Chart 8). Thus, we are not buying the euro yet and are willing to forego the first few cents of gains for a clearer signal. Chart 7EUR/USD Is Cheap Chart 8Sentiment Could Get More Negative Circling back to the equity front, European equities had become very oversold after the 14-day RSI fell below 30. The diminishing risk of an energy crisis will also help. However, global equities face more risks than just Ukraine. As we wrote earlier this week, the transition away from consumer durable goods as the driver of global growth to services will involve some adjustments for stocks, especially in an environment in which the Fed is allowing global monetary conditions to deteriorate (Chart 9). Thus, the window of volatility in stocks is unlikely to close in the near term. The relative performance of European equities vis-a-vis the US is complex as well. European equities have undone most of the relative gains accrued so far in 2022 (Chart 10). On the one hand, the global growth transition will hurt European equities more than US ones, as a result of their greater exposure to manufacturing activity. Additionally, high energy costs are more of a problem for Europe right now than the US. On the other hand, the continued hawkishness of the Fed is likely to limit the ability of tech stocks to extend the rebound that began last Thursday. As a result, the most likely pattern is for some churning in the relative performance of Europe and the US in the coming week. Chart 10Vanishing Outperformance Chart 9Tightening US Liquidity Conditions For the remainder of the year, we expect the European equity outperformance to re-establish itself in view of the favorable relative profits picture for 2022, a topic that we will explore more deeply in the coming weeks. Bottom Line: The near-term outlook for European assets remains extremely murky. Not only is a war in Ukraine a major threat that can hurt sentiment further, but European assets still have to handle the short-term implications of a change in global growth leadership away from goods consumption. Nonetheless, the dovish message of the ECB in the wake of the Ukrainian invasion suggests that the collapse in Italian bonds and European banks in recent weeks is overdone. European stocks will likely continue to churn against US stocks in the near term but outperform for the remainder of the year. The sell-off in the euro is advanced, but prudence prevents us from buying EUR/USD today. Keep short EUR/CHF and short EUR/JPY hedges in place for now. Longer-Term Implications The crisis in Ukraine heightens Europe’s need to diversify its energy sourcing away from Russia. However, this is not a transition that can be executed on a dime. It will take years. For now, Europe remains dependent on Russian energy, which greatly limits the EU’s options. However, time offers many more possibilities. First, kicking Russia out of SWIFT will become feasible, because it will increase the robustness of the SPFS payment system, allowing Russia to receive funds for its energy, even if it is out of SWIFT. Second, and most importantly, time will allow Europe to find new energy sources. For example, Qatari LNG is often mentioned as a potential replacement for Russian natural gas. Qatar currently does not have the capacity to service Europe extensively, while fulfilling its previous contractual obligations, but the expansion of the production in its North Field East will increase capacity to 126MTPA by 2027. The LNG export capacity of the US may also increase over the coming years. Even if Qatar and the US could send enough LNG to satisfy the hole left by Russia tomorrow, Europe would not be able to accept delivery, as it does not have enough terminals to accommodate these shipments. Thus, investments in that sector will expand. Chart 11The Renewables Envelope Will Expand Chart 12Nuclear Skepticism Remains Most importantly, Europe will accelerate its transition toward renewable energy. Renewables are already a major focus of the NGEU program (Chart 11). However, we expect that, for the remainder of the decade, the NGEU program will be enlarged to allow greater investments in that space. Not only does it fit European green goals, but this policy would also increase the region energy security. More investment in nuclear electricity production is also possible but lacks popular support (Chart 12). The main message of these observations is that European infrastructure spending is likely to remain elevated in the coming years. As a result, industrial stocks may face some near-term headwinds as the global economy transitions away from the consumer goods-buying binge of COVID-19, but they will ultimately benefit greatly from an expansion of the capital stock around the world. Another long-term theme derived from the current crisis is that European defense stocks will fare well on a structural basis. The current crisis will force greater European unity. The presence of a common enemy will incentivize European nations to increase military spending, especially as the US continues to pivot toward Asia. Investors should overweight these stocks. In terms of bond market developments, more military spending and investment in energy infrastructures means that European budget deficits will be wider than if the Ukrainian crisis had not emerged. More accommodative fiscal policy will support aggregate demand, which will feed through greater capex (Chart 13). Thus, the experience of the last decade, whereby aggregate demand was curtailed by unnecessarily stringent European fiscal policy, will not be repeated. This confirms our expectation that the neutral rate of interest will rise in Europe and that Europe will escape an environment of zero rates (Chart 14). Therefore, German bunds yields have upside, the yield curve can steepen, and the outlook for European financials is positive on a long-term basis, not just on a near-term one. Chart 13Stronger Capex Than Last Decade... Chart 14...Means Higher Yields And A steeper Curve Chart 15Ebbing Fixed-Income Outflows? Finally, the picture for the euro is murky. On the one hand, its inexpensiveness is a major advantage while a higher neutral rate of interest will limit the European fixed-income outflows that have plagues the Euro for the past decade (Chart 15). However, if we are correct that European capex will increase and that budget deficits will remain wider than in the last decade, this also means that the European current account surplus will narrow as excess savings recede. This implies that one of the key underpinnings of the euro will dissipate. In the end, productivity will be the long-term arbiter of the exchange rate. Europe still lags behind the US on this front, which augurs poorly for the performance of the euro (Chart 16). Reforms and capex may save the day, but it is too early to make this call. Chart 16The Productivity Handicap​​​​​​​ Bottom Line: The events in Ukraine portend a structural shift in European capex. Europe will need to ween itself off its Russian energy dependency, which will require major investments in LNG facilities and renewable power. Moreover, European defense spending will rise. These will continue to support fiscal and infrastructure spending. As a result, industrials will benefit from a structural tailwind, as will European defense stocks. These same forces will put upward pressure on European risk-free yields, which will benefit beleaguered European financials and banks. The long-term outlook for the euro is murkier. More research must be conducted before making a definitive directional bet.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Dear client, In addition to this weekly report, we sent you a Special Report from our Geopolitical Strategy service, highlighting the risk from the Russo-Ukrainian conflict. Kind regards, Chester Executive Summary The Ukraine crisis will lead to a period of strength for the DXY. Countries requiring foreign capital will be most at risk from an escalation in tensions. Portfolio flows have reaccelerated into the US, on the back of a rise in Treasury yields. This will be sustained in the near term. The euro area on the other hand has already witnessed significant portfolio outflows, on the back of Russo-Ukrainian tensions and an energy crisis. Countries with balance of payment surpluses like Switzerland and Australia are good havens amidst the carnage. Oil-producing countries such as Norway and Canada have also seen an improvement in their balance of payments, on the back of a strong terms-of-trade tailwind. This will be sustained in the near term. Balance Of Payments Across The G10 Bottom Line: The dollar is king in a risk-off environment. That said, the US and the UK sport the worst balance of payments backdrops, while Norway, Switzerland, and Sweden have the best. This underpins our long-term preference for Scandinavian currencies in an FX portfolio. In the near term, we think the DXY will peak near 98-100, but volatility will swamp fundamental biases. Feature Chart 1The US Runs A Sizeable Deficit The Russia-Ukraine conflict continues to dictate near-term FX movements. With Russia’s invasion of Ukraine, the risk of escalation and/or a miscalculation has risen. FX volatility is increasing sharply, and with it, the risk of a further selloff in currencies dependent on foreign capital inflows. As a reserve currency, the dollar has also been strong. It is difficult to ascertain how this imbroglio will end. However, in this week’s report, we look at which currencies are most vulnerable (and likely to stay vulnerable) from a balance of payments standpoint. Chart 1 plots the basic balance – the sum of the current account balance and foreign investment – across G10 countries. It shows that at first blush, Norway, Switzerland, Sweden, and Australia are the most resilient from a funding standpoint, while New Zealand, the UK, and the US are the most vulnerable. In Chart 2, we rank G10 currencies on eight different criteria: The basic balance, which we highlighted above. Real interest rate differentials, using the 10-year tenor and headline inflation. Relative growth fundamentals, as measured by the Markit manufacturing PMI. Three fair value models which we use in-house. The first is our Purchasing Power Parity model, which adjusts consumption basket weights across the G10 to reflect a more apples-to-apples comparison. The second is our long-term fair value model (LTFV), which adjusts for productivity differentials between countries; and the final is our intermediate-term timing model (ITTM), which separates procyclical from safe-haven currencies by including a risk factor such as corporate spreads. All three models are equally weighted in our rankings. The net international investment position (NIIP), which highlights currencies that are most likely to witness either repatriation flows or a positive income balance in the current account. Finally, net speculative positioning, which tells us which currencies have crowded long positions, and which ones sport a consensus sell. Chart 2The Scandinavian Currencies Are Attractive The conclusions from this chart are similar to our basic balance scenario – NOK, SEK, AUD, CHF, and JPY stand out as winners while GBP, NZD, and USD are the least attractive. The US dollar is a special case given its reserve currency status, with a persistent balance of payments deficit. The rise in the greenback amidst market volatility is a case in point. However, portfolio flows into the dollar also tend to be cyclical, so a resolution in the Ukraine/Russia conflict will put a cap on inflows. Equity portfolio flows had dominated financing of the US current account deficit but are relapsing (Chart 3). Bond portfolio flows have rebounded on the back of rising US yields, but US TIPS yields remain very low by historical standards (Chart 4). If they do not improve much further, specifically relative to other developed markets, it will be tough to justify further inflows into US Treasurys. Chart 3Equity Portfolio Flows Into The US Are Relapsing Chart 4Bond Portfolio Flows Into The US Are Strong In this week’s report, we look at the key drivers of balance of payments dynamics across the G10, starting with the US, especially amidst a scenario where the forfeit of foreign capital could come to the fore. United States Chart 5US Balance Of Payments The US trade deficit continues to hit record lows at -$80.7 billion for the month of December. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasurys. A positive net income balance has allowed a slower deterioration in the US current account balance, though at -$214.8 billion for Q3, it remains close to record lows. The overall picture for both the trade and current account balance is more benign as a share of GDP, given robust GDP growth (Chart 5). That said, as a share of GDP, the trade balance stands at -3.5%, the worst in over a decade. Foreign direct investment into the US has been improving of late. This probably reflects an onshoring of manufacturing, triggered by the Covid-19 crisis. That said, despite this improvement, the US still sports a negative net FDI backdrop. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is still deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts worsening.       Euro Area Chart 6Euro Area Balance Of Payments The trade balance in the euro area has significantly deteriorated in recent quarters, on the back of an escalating energy crisis. Russia’s invasion of Ukraine marks the cherry on top. On a rolling 12-month basis, the trade surplus has fallen to 1% of GDP (Chart 6). This is particularly telling since for the month of December, the trade balance came in at €-4.6 billion, the worst since the euro area debt crisis. The current account continues to post a surplus of 2.6% of GDP, on the back of a positive income balance. However, FDI inflows are relapsing. After about two decades of underinvestment in the euro area, FDI inflows were at their highest level, to the tune of about 2% of GDP in 2021. Those have now completely reversed on the back of uncertainty. The combination of an energy crisis and dwindling FDI is crushing the euro area’s basic balance surplus. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Should the deterioration continue, it will undermine our longer-term bullish stance on the euro. It is encouraging that portfolio investments have turned less negative in recent quarters, as bond yields in the euro area are rising. Should this continue, it will be a good offset to the deterioration in FDI.   Japan Chart 7Japan Balance Of Payments Like the euro area, the trade balance in Japan continues to be severely hampered by rising energy imports. The trade deficit in January deteriorated to a near record of ¥2.2 trillion, even though export growth remained very robust. Income receipts from Japan’s large investment positions abroad continue to buffer the current account, but a resolution to the energy crisis will be necessary to stem Japan’s basic balance from deteriorating (Chart 7). The process of offshoring has sharply reversed since the Covid-19 crisis. While FDI is still deteriorating, it now stands at -2.4% of GDP, compared to -4.3% just before the pandemic. Net portfolio investments are also accelerating, especially given the rise in long-term interest rates in Japan, positive real rates, and the value bias of Japanese equities. We are buyers of the yen over the long term, but a further rise in global yields and energy prices are key risks to our view.             United Kingdom Chart 8UK Balance Of Payments The UK has the worst trade balance in the G10, and the picture has not improved much since the pandemic (currently at -6.7% of GDP). Similar to both the euro area and Japan, much of the drag on the trade balance has been due to rising import costs from energy and fuels. This puts the UK at risk of an escalation in the conflict between Ukraine and Russia. Meanwhile, the improvement in the income balance over the last few years has started to deteriorate, as transfer payments under the Brexit withdrawal agreement kick in. As a result, the current account balance is deteriorating anew (Chart 8). Both portfolio and direct investment in the UK were robust in the post-Brexit environment but have started to deteriorate. This is critical since significant foreign investment is necessary to boost productivity in the UK and prevent the pound from adjusting much lower. With bond yields in the UK rising, and the FTSE heavy in cyclical stocks, this should limit further deterioration in the UK’s financial account. A significant drop in the estimated path of settlement payments for Brexit will also boost the income balance. The key for the pound over the coming years remains how fast the UK can improve productivity, which will convince foreign investors that the return on capital for UK assets will increase. Canada Chart 9Canada Balance Of Payments Canada’s domestic economy has been relatively insulated from the geopolitical shock in Europe, but its export sector is benefiting tremendously from it. Rising oil prices are boosting Canadian terms of trade. As a result, the current account has turned into a surplus for the first time since 2009, in part driven by an improving trade balance (Chart 9). Outside of trade, part of the improvement in the Canadian current account balance is specifically driven by income receipts from Canada’s positive net international investment position. At C$1.5 trillion, income receipts are becoming an important component of the current account balance. Foreign direct investment into Canada continues to remain robust, given strong commodity prices. This is boosting our basic balance measure, which today sits at a surplus of 2.4% of GDP and should continue to improve. Finally, because of Canada’s improving balance-of-payments backdrop, it is no longer reliant on foreign capital as it had been in the past, which supports the loonie.         Australia Chart 10Australia Balance Of Payments Australia continues to sport the best improvement in both its trade and current account balances over the last few years. As a result, the basic balance has eclipsed 4% of GDP for the first time since we have been measuring this series (Chart 10). The story for Australia remains improving terms of trade, specifically in the most desirable commodities – copper, high-grade iron ore, liquefied natural gas, and to a certain extent, high-grade coal. Foreign direct investment in Australia has eased significantly. Investment in projects in the resource space are now bearing fruit, easing the external funding constraint. Meanwhile, domestic savings can now be easily recycled for sustaining capital investment. In fact, foreign direct investment turned negative in Q4 2021. This also explains the drop in net portfolio investment since Australians now need to build a positive net international investment position. We have a limit buy on the Aussie dollar at 70 cents, as we are bullish the currency over a medium-term horizon.         New Zealand Chart 11New Zealand Balance Of Payments For the third quarter of 2021, New Zealand’s current account balance hit record lows, despite robust commodity (agricultural) prices. Imports of fertilizers, crude oil, and vaccines have led to a widening trade deficit. A drop in the exports of wood also affected the balance. With a negative net international investment position of about 48% of GDP, the income balance also subtracted from the current account total (Chart 11). From a bigger-picture perspective, New Zealand’s basic balance has been negative for many years, as coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities, have kept the current account in structural deficit. However, as the prices of key agricultural goods head higher, New Zealand can begin to benefit from a terms-of-trade boom that will limit its external funding requirement. In that respect, portfolio investments are also improving. New Zealand has the highest bond yield in the G10, on the back of the highest policy rate so far (the RBNZ raised interest rates again this week). New Zealand’s defensive equity market has also corrected sharply amidst the general market riot. As such, foreign investors could begin to favor this market again based on high yields and a reset in valuations. Going forward, New Zealand should continue to see further improvement in its basic balance relative to the US, supporting the kiwi. Switzerland Chart 12Switzerland Balance Of Payments The Swiss trade balance remains in a structural surplus, with a post Covid-19 boom that has led a new high as a share of   GDP (Chart 12). Global trade has been rather resilient due to high demand for goods. While Switzerland has a large net international investment position, income flows this quarter were hampered by servicing costs for foreign direct investments. The net international investment position did improve by CHF27 billion on a quarter-over-quarter basis in Q3, on the back of a net increase in foreign asset purchases. Currency movements also had little impact on the portfolio in Q3, which is atypical. The SNB will always have to contend with a structural trade surplus that puts upward pressure on the currency. This will keep the Swiss franc well bid, especially in times of crisis when the positive balance-of-payments backdrop makes the CHF a safe haven.             Norway Chart 13Norway Balance Of Payments Q3 2021 saw a strong recovery in Norway’s trade account that is likely to carry over to this year. A recovery in crude oil and natural gas prices was a welcome boon. The lack of tourism also boosted the services account (Norwegians travel and spend less abroad than foreigners visiting Norway). The ongoing electricity crisis in Europe was also an opportune export channel for Norway, which for the first time, opened its 450-mile-long, 1400-megawatt North Sea cable link to the UK. Positive income flows also benefit the current account and the krone (Chart 13). With one of the largest NIIPs in the world heavily skewed towards equity dividends, the NOK benefits when yields rise, even though the domestic fixed-income market is highly illiquid. While a resolution of the Russian-Ukrainian crisis could sap the geopolitical risk premium from oil, the reopening of the global economy will benefit Norwegian exports of oil and gas. Tepid investment in global oil and gas exploration will also ensure Norway’s terms of trade remain robust.       Sweden Chart 14Sweden Balance Of Payments The Swedish current account balance has deteriorated slightly in the last few quarters, on the back of supply-side bottlenecks. Particularly, exports of cars have been hampered amidst a semiconductor shortage. That said, the primary income surplus remains a key pillar of the current account, keeping the basic balance at a healthy surplus of about 6% of GDP (Chart 14). Portfolio inflows into Sweden have dwindled, like most other European economies. If this has been due to geopolitical tensions in Europe, it will eventually prove to be fleeting. That said, the Riksbank remains one of the most dovish in the G10 and the OMX is also one of the most cyclical stock markets, which may have spooked short-term foreign investments. The Swedish krona has been the weakest G10 currency year-to-date. Given that we expect most of the headwinds to be temporary, and the basic balance backdrop remains solid, we will go long SEK versus both the euro and the US dollar.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Bank Credit Analyst

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

Bank Credit Analyst

Highlights The Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that equities and other risk assets will ultimately recover. We continue to expect above-trend growth and above-target inflation in the US and other developed economies this year. Q1 growth in the US is likely to be closer to 4% after removing the effect of changing inventories, and incoming information still points to the view that the pandemic will continue to recede in importance over the coming several months. Given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has recently occurred. There are legitimate arguments in favor of a very aggressive pace of Fed tightening. Still, our view is that seven rate hikes from the Fed over the coming 12 months is likely too aggressive: A peak in headline inflation over the coming months will help restrain longer-term household inflation expectations, the surge in wage growth continues to reflect pandemic-driven labor market distortions that could unwind, and a significant further flattening of the yield curve – despite likely being a false signal of a recession – would probably cause a temporary period of tighter financial conditions that the Fed would respond to. We believe it is likely that the Fed will initially seek to raise interest rates at a pace that is in line with current market pricing, but that it will likely slow the pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. The case for aggressive ECB hikes was weak even before Russia’s invasion of Ukraine. European core inflation is nowhere near as strong as it is in the US, and nominal output in the euro area has not yet recovered to its pre-pandemic trend (in heavy contrast to the US). Russia’s invasion has caused a disruption of natural gas flows that will keep European gas prices at elevated levels, and aggressive tightening in response risks repeating the mistakes the ECB made in 2008 and 2011 when it raised rates in the face of an ultimately deflationary supply shock. On a 6-12 month time horizon, we are only likely to recommend downgrading global stocks once 5-year/5-year forward US Treasury yields break above 2.5%, barring a more severe shock to global economic activity from the Ukrainian crisis than currently appears likely. On Russia’s Invasion Of Ukraine Yesterday, BCA Research published a Special Alert in response to Russia’s invasion of Ukraine.1 In the report, we outlined Russia’s motivation for invading, and noted that it will not withdraw troops until it has changed the government and seized key territories – such as coastal regions to ensure the long-term ability to blockade the country. Crucially, we noted that while the US and EU will levy sweeping sanctions against Russia, that the EU would not halt Russian energy exports. We regard the decision to maintain Russia’s access to the SWIFT system as consistent with that view. Given this, we believe that the Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that growth, inflation, and monetary policy will ultimately return as the drivers of equities and other risk assets over the coming weeks and months. Beyond Ukraine: Growth, Inflation, And Monetary Policy In The DM World Chart I-1Recent US Data Has Looked Smoewhat Stagflationary BCA Research presented three possible growth and inflation scenarios for this year in our 2022 Annual Outlook report. Our base case scenario, to which we assigned 60% odds, was one of above-trend growth and above-target inflation. We assigned 30% odds to a “stagflation-lite” scenario of above-target inflation with below-trend growth, and a 10% chance of a recession. Since we published our Annual Outlook, we raised the odds of the second, stagflation-lite scenario – mostly due to the impact that the Omicron variant of COVID-19 could have on the Chinese supply chain. But until recently, US economic data was also looking somewhat stagflationary: US real GDP only grew at a 2.3% annualized basis in Q3, and the strong Q4 number was mostly boosted by inventories. Real goods spending has slowed over the past few months without a major increase in services spending, and US auto production continues to be restrained by semiconductor shortages (Chart I-1). Supply-side constraints on production and spending have occurred against the backdrop of a significant acceleration in US consumer prices, the combination of which seemingly points more to the second growth and inflation scenario that we outlined, rather than our base case. However, our view is that above-trend growth in the US and other developed economies remains the most likely outcome this year, even given ongoing supply-side constraints and Russia’s invasion of Ukraine. In addition to the sizeable amount of excess savings that have been accumulated during the pandemic and the enormous increase in household net worth that has occurred over the past two years, two other factors point to above-trend DM growth. In the US, following the release of the January retail sales report, the Atlanta Fed GDPNow model is forecasting below-trend growth for Q1, but with a -2.3% contribution from the change in private inventories. Chart I-2 highlights that the Atlanta Fed’s model is projecting 3.6% annualized growth in Q1 of final sales of domestic product, a measure of GDP that excludes the effect of changing inventories (whose contribution to growth averages to zero over time). This would be above the trend rate of real GDP growth, and would represent an acceleration relative to the past few quarters. Beyond the next few months, the other factor pointing to above-trend growth is the indication that the pandemic will indeed continue to recede in importance over the course of the year, in line with what we laid out in our Annual Outlook. Chart I-3 highlights that the Omicron-driven surge in hospitalizations in G7 countries has been short-lived, and Chart I-4 highlights that deliveries of Pfizer’s anti-viral treatment Paxlovid, while still in their early stages, have begun. Chart I-2Q1 US Economic Growth Likely To Be Above-Trend Chart I-3Hospitalizations Are Falling Sharply In a recent study, Paxlovid was found to have an 89% efficacy in preventing COVID hospitalizations and deaths, with less serious adverse events or discontinuations than the placebo group.2 Its high effectiveness against all SARS-CoV-2 variants suggests that its increased deployment over the course of the year should significantly reduce the impact of COVID-19 on the medical system as well as lower the fear of the disease amongst consumers, even as new variants of the virus emerge and spread around the world. Consequently, it is likely that the output gap in advanced economies will turn positive this year despite ongoing supply-side constraints unless Russian energy exports to the EU are ceased, triggered either by a European boycott or a Russian embargo. Prior to Russia’s invasion, consensus growth expectations implied above-trend growth for this year (Chart I-5), which we see as consistent with the base case growth and inflation view that we presented in our Annual Outlook if Russian energy exports continue. However, given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has occurred over the past 2 months. Chart I-5We Agree With Consensus Expectations For Growth This Year Chart I-4US Paxlovid Deliveries Are Creeping Higher   The Case For, And Against, Aggressive Fed Tightening Just since the beginning of the year, investors have moved to price in an additional 100 basis points of rate hikes from the Fed (Chart I-6). Earlier this month, comments by St. Louis Fed President James Bullard signaling his desire for a full percentage point of interest rate hikes by July had a sizeable effect on US Treasury yields, with market participants still pricing in meaningful odds of a 50 basis point rate hike in March despite recent pushback from key Fed officials and Russia’s invasion of Ukraine. Chart I-6The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction Last year, The Bank Credit Analyst service warned on several occasions that a return to maximum employment was likely to occur faster than investors expected, and that a hawkish shift from the Fed was probable. We noted in our July report that the cumulative odds of a rate hike by some point in Q2 2022 were close to 40%,3 and in our September Special Report we reinforced the view that a mid-2022 rate hike was likely.4 Still, even relative to our (then) comparatively hawkish expectations, the monetary policy outlook has shifted very aggressively towards more and earlier rate hikes. This shift has partially occurred due to the labor market dynamics that we projected last year, but also due to a significant broadening of inflation over the past four months. Chart I-7 highlights that the 6-month rate of change in US core CPI excluding cars and COVID-impacted services was not meaningfully different in October than it was in the latter half of late-2019, in heavy contrast to overall headline and core inflation. However, over the past four months this measure has accelerated by 175 basis points, highlighting that inflationary pressures are becoming broader – and that an earlier and more forceful response from the Fed may be warranted. Chart I-7US Inflation Has Broadened, And Quickly So Does the broadening in US inflationary pressure that has occurred over the past few months justify the seven rate hikes currently expected by investors over the coming year? We present the detailed case for and against that view below, and conclude that seven rate hikes over the coming 12 months is likely too aggressive. The Case For Aggressive Tightening The most prominent argument in favor of aggressive Fed rate hikes is not just to slow the pace of inflation, but to address the fact that broadening inflationary pressures risk unanchoring inflation expectations. As we discussed in our January 2021 Special Report,5 inflation is determined not just by the output gap, but as well by inflation expectations. Economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to cyclically fluctuate, but those fluctuations are relative to a level that is determined by inflation expectations – not the Fed’s inflation target. It is only if inflation expectations are consistent with the Fed’s target that actual inflation will equal that target, abstracting from the business cycle and other distorting events. A deeply negative output gap for several years following the global financial crisis caused inflation expectations to be vulnerable to shocks, and the collapse in oil prices in 2014 served as a large enough surprise that expectations unanchored to the downside. This event ultimately motivated the Fed’s introduction of its average inflation targeting policy, but Chart I-8 highlights that inflation expectations are no longer chronically low and that they may unanchor to the upside without meaningfully tighter monetary policy. A temporary period of higher food prices stemming from Russia’s invasion of Ukraine also raises the risk of unanchored inflation expectations among households. The second argument in favor of aggressive Fed rate hikes is that the unemployment rate has essentially fallen back to its pre-pandemic level, and median wage growth has already risen to its strongest level in 20 years (Chart I-9). Given that a large amount of excess savings and a very significant wealth effect are likely to continue to support aggregate demand, the inference is that overall wage growth may accelerate significantly further as the unemployment rate continues to fall. Chart I-8Inflation Expectations Are No Longer Depressed Chart I-9Wage Growth Has Risen Very Significantly The third argument in favor of rapid tightening is that the natural/neutral rate of interest is likely higher than both investors and the Federal reserve believe, meaning that monetary policy is even easier today than is generally recognized. We have written about this issue at length: in March 2020 we explained why the most cited measure of “R-star” was wrong,6 and noted in our April 2021 Special Report why we no longer believe that a gap between interest rates and trend rates of economic growth are justified. This perspective also suggests that investors should look past the quasi-recessionary signal currently being flagged by the 2/10 yield curve, as curve inversion is likely to be a false signal of a recession – as it was in 2019 (see Box I-1). BOX I-1 The Sino-US Trade War, The Yield Curve, And The COVID-19 Pandemic The US yield curve has historically provided a highly reliable signal of the likelihood of a recession. Investors have taken an inverted yield curve as a sign that short-term interest rates have risen to a level that is not likely to be sustained over the longer term, meaning that monetary policy has become tight. An inverted yield curve has indeed preceded several US recessions, although its track record at predicting contractions globally has been less reliable. While it is a counterfactual assertion, we believe that the yield curve provided a false signal when it inverted in 2019. Clearly the inversion did not predict the COVID-19 pandemic; the question is whether the US would have experienced a recession had the pandemic not occurred. In our view, the evidence does not point to that conclusion. Charts I-B1 and I-B2 highlight that the yield curve responded to an economic slowdown that was mostly caused by the Sino-US trade war, as well as an ongoing slowdown in Chinese credit growth and economic activity. It does not appear to have occurred due to interest rates having risen to a level that would be unsustainable absent these non-monetary shocks. Chart I-B1The Yield Curve Inverted Well After The Trade War Hit… Chart I-B2…And The Economy Started Improving After The Inversion In addition, the signal from the yield curve lagged that of the equity market: Chart I-B1 highlights that the US equity market fell just shy of 20% eleven months before the yield curve inverted. In fact, stock prices were rising sharply just prior to the emergence of the pandemic in response to expectations of monetary easing and the Phase I US trade deal, and the US Markit manufacturing and services PMIs were also turning up. None of these signs point to the likelihood of a contraction in US output had the COVID-19 pandemic not emerged. The key point for investors is that an inversion of the yield curve, were it to occur over the coming 12-18 months, would not necessarily signal a recession unless it were coupled with a major non-monetary shock. It would, however, be significant from a strategy standpoint, as the Fed would likely take it as a sign of tightening financial conditions. The Case Against Aggressive Fed Action Chart I-10Inflation Expectations Have Risen, But Are Not Out Of Control There are several counterpoints to the arguments noted above, as well as a few additional reasons to suggest that 7 rate hikes over the coming year is too aggressive. First, on the issue of inflation expectations, while it is true that expectations are no longer chronically low, longer-term expectations have not yet exceeded their pre-global financial crisis (GFC) range (Chart I-10). In addition, despite the temporary spike in energy and food prices stemming from Russia’s invasion of Ukraine, headline inflation is likely to peak at some point over the coming months, which will act to restrain longer-term household inflation expectations. Importantly, inflation is likely to peak even without any Fed tightening. A comparison of the recent pace of advance in both headline and core CPI suggests that the former has up to 200 basis points of downside if crude oil prices remain at $100/bbl. Our Commodity & Energy Strategy team expects that Russia’s invasion of Ukraine will prompt increased production from core OPEC producers to reduce the elevated risk premium and allow refiners to boost inventories. We now expect Brent oil to average $85/bbl in the second half of 2022, implying eventual deflation from energy prices and a slowdown in the pace of advance in headline CPI over the coming months – potentially below that of core. That would represent a very significant easing in headline inflation relative to current levels, and we do not expect that long-term household expectations for inflation would rise much further in such a scenario. The easing in the prices paid component of the ISM manufacturing index also points to an imminent peak in headline inflation and, by extension, household inflation expectations (Chart I-11). Second, while it is true that overall wage growth has recently accelerated quite significantly, it is still the case that this is being driven by the lowest-paid workers. Chart I-12 highlights that 1st and 2nd quartile wage growth are between 0.4-1.2% higher than they were prior to the pandemic, but that 3rd and 4th quartile wage growth is either the same or lower. Chart I-12Lower-Pay Wage Inflation Is Due To The Pandemic... Chart I-11The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation   This surge in wages for low-paid workers largely reflects pandemic-driven labor market distortions, rather than excess demand. Chart I-13 highlights that real US services spending remains close to 5% below its pre-pandemic trend, and Table I-1 highlights that the leisure & hospitality industry now accounts for the vast majority of the jobs gap relative to pre-pandemic levels. Chart I-14 also highlights that while the leisure & hospitality jobs gap is smaller in red states than in blue states (which may be disproportionately affected by lost services jobs in central business districts due to work-from-home policies), it is still larger today that it was during the depths of the 2008/2009 recession. Chart I-13...Not Excessive Services Demand The key takeaway from Table I-1 and Charts I-13 and I-14 is that rising 1st and 2nd quartile wage growth is being caused by labor scarcity in low paying industries, which we attribute to the fact that working conditions in these jobs became more difficult during the pandemic and the fact that many of these positions involve close contact with customers. And clearly, raising interest rates will not hasten the return of leisure & hospitality workers to the labor market.   Table I-1Leisure & Hospitality And Education Now Make Up Almost All Of The US Jobs Gap Chart I-14The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends Third, even though we think the natural/neutral rate of interest is higher than both investors and the Federal reserve believe and that the yield curve provided a false signal of a recession in 2019, a significant further flattening of the yield curve would probably cause a tightening in financial conditions, at least for a time. The Fed is unlikely to be dissuaded from raising rates due to a valuation-driven decline in equity prices, but it is likely to respond to market-based signals of a material slowdown in economic activity – even if those signals ultimately prove to be false. The yield curve is an important reflection of how far bond investors believe the economic cycle has progressed (Chart I-15), and an increase in short-term interest rates at the pace that investors are currently expecting would flatten the 2/10 yield curve very close to (or into) negative territory. It seems likely that a rapid flattening in the curve would precipitate a growth scare in financial markets for a time, leading to falling equity prices (due to concerns about earnings, not just valuation), a rising US dollar, and a widening in corporate credit spreads. Chart I-15For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession To conclude on this point, the Fed will feel that it is justified in hiking rates aggressively while inflation is well above its target levels and the unemployment rate is low and falling, but it is likely to change this assessment if financial markets begin to behave in a way that signals a rising risk of a significant slowdown in jobs growth. That would lead to a tactical period of weakness for risky asset prices, but it would ultimately be cyclically positive if the Fed revises its pace of tightening to a rate that is slower than investors currently expect. Our View Netting out the arguments presented above, the Fed may initially seek to raise interest rates at a pace that is in line with current market pricing, but it will likely slow that pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. Our view also has important implications for the euro area interest rate outlook, given the significantly weaker case for aggressive ECB action that existed even before Russia’s invasion of Ukraine. A Flimsy Case For Aggressive ECB Rate Hikes, Even Before Russia’s Invasion Chart I-16The European Inflation Situation Is Not As Bad As In The US At the early-February ECB meeting, President Christine Lagarde signaled a more hawkish outlook for euro area monetary policy than investors had been expecting. Since the beginning of the year, the OIS market has moved to price-in roughly 70 bps of hikes over the coming 12 months, German 2-year bund yields have risen 20 basis points, and 10-year yields have risen back into positive territory. Italian and Greek 10-year yield spreads (relative to Bunds) have risen by 35 and 90 basis points, respectively. From our perspective, investors are pricing a too-aggressive path for the ECB policy rate, and we would probably characterize an ECB decision to raise rates in line with current market expectations as a policy mistake. As highlighted in a recent report by my colleague Mathieu Savary, BCA’s Chief European Strategist, several arguments support this view. First, Chart I-16 highlights that euro area core inflation is running at a considerably slower rate than headline inflation or core inflation in the US, and that our core inflation diffusion index for the euro area has peaked. It is true that core inflation is much higher in Germany than in other key euro area economies, and it is also true that aggregate euro area core inflation is above the ECB’s 2% target. But high German core inflation is seemingly driven by particularly acute passthrough effects from high natural gas prices, and recent IMF research underscores that over half of the increase in German manufacturing price inflation has occurred due to supply shocks rather than demand (Chart I-17). Chart I-18 shows that expectations for euro area inflation and actual wage growth do not, in any way, suggest that the ECB’s 2% target is under threat, underscoring that aggressive tightening over the coming several months risks repeating the mistakes the ECB made in 2008 and 2011 when it tightened policy in the face of an ultimately deflationary supply shock. Chart I-17German Core Inflation Is Being Disproportionately Driven By Supply Shocks The second argument is that nominal output in the euro area has not yet recovered to its pre-pandemic trend, in heavy contrast to the US (Chart I-19). This is particularly true for Italy and Spain, and reflects the nature of the euro area fiscal response to the COVID-19 pandemic. Chart I-20 highlights that the cumulative growth in euro area disposable income has been lower than what would have been expected absent the pandemic, unlike what occurred in the US and Canada – two countries that provided sizeable direct transfers to households as part of their fiscal response. Chart I-19Key Euro Area Economies Have Recovered Far Less Than The US Has Chart I-18Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat     Third, Russia’s invasion has caused a disruption of natural gas flows via Ukraine that will keep European gas prices at elevated levels even beyond the winter period, which will have a negative impact on the euro area economy. Chart I-21 highlights that European natural gas prices are now seven times as high as they were at the beginning of 2021. Unlike the prior rise in European natural gas prices, which was somewhat related to global demand for goods, the post-invasion surge is a pure supply shock – echoing our point about the ECB’s previous policy mistakes. Chart I-20Euro Area Disposable Income Is Lower Than Its Pre-Pandemic Trend, In Contrast To The US Chart I-21Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock The fact that Italy’s nominal economic recovery has been comparatively weak has helped explain the rise in its 10-year government bond yield relative to 10-year German Bunds. Allowing for a further economic recovery in those countries before raising rates would let the ECB ultimately increase rates further down the road – and thus exit more cleanly from negative policy rates in Europe. Our European Strategy Team continues to expect that the ECB is on track to raise interest rates only once in Q4 2022, to be then followed by more aggressive hikes in 2023. Investment Conclusions For fixed-income investors, the investment implications of policy rates moving higher over the coming year at a pace that is less rapid than currently expected would normally imply that an at or above-benchmark duration stance is warranted. However, Chart I-22 highlights that there is still upside for 10-year US Treasury yields even in a scenario where the Fed raises rates at a pace of 100 basis points per year. As such, we continue to recommend that investors remain short duration on a 6-12 month time horizon, although we agree with BCA’s fixed-income team’s recommendation to tactically raise duration to neutral given the potential for the European energy crisis to worsen further and the fact that 10-year US Treasury yields do not have as much upside on a cyclical basis as they did when we published our Annual Outlook.7 For equities, we do not find the case for a tactical downgrade to be compelling at current levels, given that global stocks have already fallen 10% from their mid-November highs. Over the near term, we expect the continued underperformance of euro area equities, be we doubt that the negative economic impact of higher natural gas and oil prices would persist beyond a 0-3 month time horizon. On a 6-12 month time horizon, our expectation that monetary policy will tighten at a less aggressive pace than investors expect suggests that the earnings risk to global stocks is not substantial, underscoring that a meaningful contraction in equity multiples would likely be required for stocks to register negative 12-month returns from current levels. In the US, business surveys suggest that sales growth is set to slow to a still-healthy level, and that profit margins are likely to be flat over the coming year (Chart I-23). This is in line with the view that we presented in our Annual Outlook, namely that US earnings growth in 2022 would be driven mainly by top-line growth. Chart I-22Investors Should Still Be Cyclically Short Duration Chart I-23Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Chart I-24Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Similarly, the risk of a serious interest rate-driven contraction in equity multiples over the coming year does not appear to be elevated. Investors are far more inclined to use long-maturity bond yields to discount future cash flows than short-term interest rates, and we have noted that the rise in long-maturity bond yields is necessarily self-limiting unless investor expectations about the natural/neutral rate of interest change. Chart I-24 highlights that despite an extremely rapid shift in monetary policy outlook amid the highest US headline inflation in 40 years, 5-year/5-year forward US Treasury yields remain only fractionally above 2%. This underscores that fixed-income investors will need to see evidence that a progressively higher Fed funds rate is not disrupting economic activity before they are likely to abandon the secular stagnation narrative. While the equity risk premium will remain elevated over the near term due to the situation in Ukraine, the bond market’s continued belief in secular stagnation will likely support equity multiples – at least for the remainder of the year. As such, we recommend that investors position in favor of the following over the coming 6-12 months: Overweight equities versus long-maturity government bonds Overweight value versus growth stocks Short duration within a fixed-income portfolio, with a neutral tactical overlay Overweight speculative-grade corporate bonds with a credit portfolio Overweight non-resource cyclicals versus defensives and small caps versus large Short the US dollar versus major currencies Jonathan LaBerge, CFA Vice President The Bank Credit Analyst February 25, 2022 Next Report: March 31, 2022 II. Canada: How High Can Rates Rise? The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.8 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,9 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off and Russia’s invasion of Ukraine, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1     Please see BCA Special Alert "Russia Takes Ukraine: What Next?," dated February 24, 2022, available at bca.bcaresearch.com 2    Jennifer Hammond et al. “Oral Nirmatrelvir for High-Risk, Nonhospitalized Adults with Covid-19.” The New England Journal of Medicine, February 16, 2022. 3    Please see The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 4   Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 6    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 7    BCA Webcast Positioning For A Rate Hike Cycle, February 15, 2022. 8   For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 9    Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Executive Summary Risk Premium Abates, But Does Not Disappear The risk premium in crude oil and natural gas prices is abating, and we expect that to continue. In the immediate aftermath of Russia's invasion, Brent crude oil traded close to $105/bbl on Thursday. At the urging of China's Xi Jinping, Russian President Vladimir Putin suggested he is prepared to enter negotiations with Ukraine in Minsk to discuss the latter's neutrality. Whether Ukraine is amenable to negotiations framed in this manner remains to be seen. Nothing has changed in supply-demand balances for oil or natgas. Markets are tight, and more supply is needed. In this highly fluid situation, we project Brent crude oil will average $100.00/bbl in 1Q22; $90.30/bbl in 2Q22; $85.00/bbl in 3Q22; and $85.00/bbl in 4Q22 (see Chart). Our estimate for 2023 Brent averages $85.00/bbl. Upside risk dominates in the near term. We expect the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait, the only members of OPEC 2.0 with the capacity to increase and sustain higher production, to lift output by 1.75mm b/d. The Iran nuclear deal likely gets a boost from the Russian invasion, which will hasten the return of ~ 1.0mm b/d of production in 2H22, perhaps sooner. We also expect the US, and possibly the OECD, to release strategic petroleum reserves, but, as typically is the case, this will have a fleeting impact on markets and pricing. These supply increases will return prices closer to our base case forecast, which we raise slightly to $85/bbl from 2H22 to end-2023. If we fail to see an increase in core-OPEC production, or the US shales, or if Iranian barrels are not returned to export markets, oil prices have a good chance of moving to $140/bbl, as can be seen in the accompanying Chart. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF.