Economic Growth

Executive Summary Summarizing Our Main Investment Themes In One Chart Summarizing Our Main Investment Themes In One Chart Summarizing Our Main Investment Themes In One Chart Our current strategic recommendations are centered around four key themes: global inflation will slow over the rest of 2022, Europe remains too weak to handle significantly higher interest rates, corporate default risk in the US and Europe is relatively low, and the fundamental backdrop for emerging markets is poor. If we are going to be proven wrong on any of those themes, it will most likely be because global inflation remains high for longer due to resilient commodity prices and lingering supply chain disruptions. A sluggish economy will handcuff the ECB’s ability to raise rates as fast as markets are discounting over the next year. The state of corporate balance sheet health in the developed world is not problematic, on average, even with some sectors taking on more leverage in response to the 2020 COVID downturn. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. Bottom Line: We remain comfortable with our main fixed income investment recommendations: maintaining neutral global portfolio duration, overweighting core European bonds versus US Treasuries, favoring high-yield corporates over investment grade (both in the US and Europe), and underweighting EM hard currency debt. Feature One of the foundations of a sound medium-term investment process is to allocate capital towards highest conviction views, while constantly assessing - and reassessing - if those views are unfolding as expected. Trades that are not going according to plan may need to be reconstructed, if not exited entirely, to avoid losses. We feel the same way about the investment recommendations highlighted in the pages of our reports, which represent our portfolio, as it were. With this in mind, in this report we identify the four most critical themes underpinning our current main investment recommendations and evaluate the potential risks that our views will not turn out as expected. Theme #1: Global Inflation Will Decline In The Latter Half Of 2022 Our biggest theme for the rest of this year is that global inflation will cool off after the massive acceleration over the past year. Many of our current fixed income investment recommendations across the developed markets – maintaining neutral overall global duration exposure, underweighting global inflation-linked bonds versus nominal government debt, betting against additional yield curve flattening (especially in the US) – are predicated on reduced inflationary pressure on interest rates. Related Report  Global Fixed Income StrategyA Crude Awakening For Bond Investors The expectation of lower inflation is based on some easing of the forces that first caused the current inflationary overshoot – booming commodity prices and rapidly accelerating goods prices due to supply-chain disruptions. Already, the commodity price factor is starting to fade, on an annual rate-of-change basis that matters for overall inflation, thanks to more favorable comparisons to the commodity surge in 2021 (Chart 1). The year-over-year growth rate of the CRB index has decelerated from a peak of 54.4% in June 2021 to 19.3% today, even with many commodity prices seeing big increases in response to the Russia/Ukraine war. This is because the increases in commodity prices were even larger one year ago when much of the global economy reopened from COVID-related economic restrictions. Favorable base effect comparisons are not the only reason why commodity inflation has slowed. Commodities are priced in US dollars, and the steady appreciation of the greenback, with the trade-weighted dollar up 5% on an year-over-year basis, has also helped to slow commodity price momentum (Chart 2). Slower global growth, coming off the overheated pace of 2021, has also acted as a drag on overall commodity price inflation (middle panel). Beyond the commodity space, some easing of global supply chain tensions has resulted in indicators of shipping costs seeing meaningful declines even with supplier delivery times still elevated (bottom panel). Chart 1Our Main Strategic Theme: Decelerating Global Inflation Our Main Strategic Theme: Decelerating Global Inflation Our Main Strategic Theme: Decelerating Global Inflation ​​​​​​ Chart 2Disinflationary Momentum From Commodities Already Underway Disinflationary Momentum From Commodities Already Underway Disinflationary Momentum From Commodities Already Underway ​​​​​ A more fundamental factor that should help moderate global inflation momentum this year beyond the commodity/supply chain effects relates to a lack of broad-based global "excess demand", even as the world economy continues to recover from the massive pandemic shock in 2020. The IMF’s latest projections on output gaps – estimates of the amount of spare economic capacity – show that few major developed or emerging market economies are expected to have positive output gaps over 2022 and 2023 (Chart 3). The US is the most notable exception, with an output gap projected to average +1.6% this year and next. Most other developed market countries are projected to have an output gap close to zero. This suggests that the US is facing the most inflationary pressure from an overheating economy, which is why we continue to see the Fed as being the most hawkish major developed market central bank over the next couple of years. Chart 3Few Countries Expected To Have Inflationary Output Gaps In 2022/23 Assessing The Risks To Our Main Views Assessing The Risks To Our Main Views Yet even with so much of the macro backdrop supporting our call for slower global inflation in the coming months, there are several potential risks to that view. Chart 4A Risk To Our Lower Inflation View: Resilient Oil Prices A Risk To Our Lower Inflation View: Resilient Oil Prices A Risk To Our Lower Inflation View: Resilient Oil Prices Another war-related upleg in global oil prices Our commodity strategists continue to see oil prices settling down to the low $90s by year-end. Yet oil has seen tremendous volatility since the Ukraine war began as prices had to factor in the potential loss of Russian oil supplies in an already tight crude market. The benchmark Brent oil price briefly hit $140 in the immediate aftermath of the Russian invasion. A similar move sustained over the latter half of 2022 would trigger a reacceleration of oil momentum, putting upward pressure on overall global inflation rates. A renewed bout of energy-induced inflation would push global interest rate expectations, and bond yields, even higher from current levels – a challenge to both our neutral duration stance and underweight bias on global inflation-linked bonds (Chart 4). More supply-chain disruption from China Chinese authorities are clamping down hard on the current COVID wave sweeping across China. The current lockdowns in major cities like Shanghai could shave as much as one percentage point off Chinese real GDP growth for 2022, according to our China strategists. Those same lockdowns in a major transportation and shipping hub like Shanghai are already causing supply chain disruption within China. Supplier delivery times saw big increases in the March PMI data (Chart 5), while the number of cargo ships stuck outside Shanghai has soared. The longer this lasts, the greater the risk that supply chains beyond China would be disrupted, erasing the improvements in global supplier delivery times seen over the past few months. That could keep goods price inflation elevated for longer. Stubbornly resilient services inflation A big part of our lower inflation view is related to a rebalancing of consumer demand in the developed world away from goods towards services as economies move away from COVID restrictions. This implies an easing of the excess demand pressures that have triggered supply shortages for cars and other big-ticket consumer goods. The result would be a sharp slowing of goods price inflation, with the result that overall inflation rates in the major economies would gravitate towards the slower rate of services inflation. The latter, however, is accelerating in the US, UK and Europe (Chart 6) – largely because of soaring housing costs – which raises the risk that overall inflation will fall to a higher floor in 2022 as goods inflation slows. Chart 5Another Risk To Our Lower Inflation View: China Lockdowns Another Risk To Our Lower Inflation View: China Lockdowns Another Risk To Our Lower Inflation View: China Lockdowns ​​​​​ Chart 6One More Risk To Our Lower Inflation View: Sticky Service Prices One More Risk To Our Lower Inflation View: Sticky Service Prices One More Risk To Our Lower Inflation View: Sticky Service Prices In the end, we see the balance of risks still tilted towards much slower global inflation this year. However, if we are going to be proven wrong on any of our major investment themes in 2022, it will most likely be because global inflation remains resilient for longer. Theme #2: Europe’s Economy Is Too Fragile To Handle Higher Interest Rates Beyond the global inflation call, our next highest conviction view right now is that markets are overestimating the ECB’s ability to tighten euro area monetary policy. Markets are now pricing in 85bps of ECB rate hikes by the end of 2022, according to the euro area overnight index swap (OIS) curve, which would take policy rates back to levels last seen before the 2008 financial crisis. The war has put the ECB in a difficult spot vis-à-vis its next policy move. High euro area inflation, with annual headline HICP inflation climbing to 7.4% in March and core HICP inflation reaching 2.9%, the highest level of the ECB era dating back to 1996, would justify a move to begin hiking policy interest rates as soon as possible.   However, European growth momentum has slowed significantly so far in 2022. Initially this was due to the spread of the Omicron COVID variant that resulted in a wave of economic restrictions. That was followed by the shock of the Russian invasion of Ukraine, that has hit European economic confidence and raised fears that Europe would lose access to Russian energy supplies. Our diffusion indices of individual country leading economic indicators and inflation rates within the euro area highlight the pickle the ECB finds itself in (Chart 7). All countries have headline and core inflation rates above the ECB’s 2% target, yet only 60% of euro area countries have an OECD leading economic indicator that is higher than year ago levels. In the three previous tightening cycles of the “ECB era” since the inception of the euro in 1998, the diffusion indices for both growth and inflation reached 100% - in other words, every euro area economy was seeing faster growth and above-target inflation. Chart 7The ECB Will Have Difficulty Hiking As Much As Expected The ECB Will Have Difficulty Hiking As Much As Expected The ECB Will Have Difficulty Hiking As Much As Expected Chart 8Warning Signs On European Growth Warning Signs On European Growth Warning Signs On European Growth Other economic data are also sending worrying messages. The euro area manufacturing PMI fell to the lowest level since January 2021 in March, while the European Commission consumer confidence index and the ZEW expectations index have plunged to levels last seen during the depths of the 2020 COVID recession (Chart 8). Euro area export growth has also decelerated sharply, with exports to China contracting on a year-over-year basis. Simply put, these are not the kind of growth data consistent with a central bank that needs to begin tightening policy aggressively. The inflation data also does not paint a clean picture for the ECB. ECB President Christine Lagarde has repeatedly noted that the central bank is on the lookout for any “second round effects” from the current commodity-fueled surge in European inflation on more lasting inflationary measures like wages. On that front, European wage growth remains stunningly subdued. European annual wage growth was only 1.6% in Q4/2021, despite the unemployment rate for the whole euro area falling below the OECD’s full employment NAIRU estimate of 7.7% (Chart 9). Unit labor costs only grew at an 1.5% annual rate at the end of 2021, suggesting little underlying pressure on European inflation from wages. Chart 9No Inflationary Pressures From Wages In Europe No Inflationary Pressures From Wages In Europe No Inflationary Pressures From Wages In Europe ​​​​​ Chart 10European Bond Yields Discount Too Much ECB Hawkishness European Bond Yields Discount Too Much ECB Hawkishness European Bond Yields Discount Too Much ECB Hawkishness Without a bigger inflation boost from labor costs, the ECB will feel less pressured to begin tightening monetary policy as rapidly and aggressively as markets are discounting – especially if global goods/commodity inflation slows as we expect. We remain comfortable with our overweight recommendation on core European government bonds (Germany and France), both within a global bond portfolio but especially versus the US. The Fed is far more likely to deliver the aggressive rate hikes discounted in money markets compared to the ECB (Chart 10). Theme #3: Corporate Default Risk In The US And Europe Is Relatively Low Another of our main investment themes relates to corporate credit risk. Specifically, we see high-yield debt in the US and Europe as being relatively more attractive than investment grade credit, even in a typically credit-unfriendly environment of tightening global monetary policy and slowing global growth momentum. Our Corporate Health Monitors are highlighting that corporate finances are in relatively good shape on either side of the Atlantic (Chart 11). This is primarily related to strong readings on interest coverage, free cash flow generation and profit margins, all of which are helping to service higher levels of corporate leverage. Defaults are expected to rise over the next year in response to slowing growth momentum, but the increase is projected to be moderate. Moody’s is forecasting the US and European high-yield default rates to be virtually identical, climbing to 3.1% and 2.6%, respectively, by February 2023. Those relatively low default rates, however, are for the aggregate of all high-yield borrowers. Default risks may be higher for some companies and industries that were more severely impacted by the pandemic. Chart 11US/Europe Default Risk Remains Relatively Modest US/Europe Default Risk Remains Relatively Modest US/Europe Default Risk Remains Relatively Modest ​​​​​ Chart 12The IMF Sees Fewer Financially Vulnerable Firms The IMF Sees Fewer Financially Vulnerable Firms The IMF Sees Fewer Financially Vulnerable Firms ​​​​​​ Chart 13Default-Adjusted HY Spreads Still Offer Some Value Default-Adjusted HY Spreads Still Offer Some Value Default-Adjusted HY Spreads Still Offer Some Value An analysis of global private sector debt included in the latest IMF World Economic Report highlighted that companies that suffered the most significant declines in revenues in 2020 also took on greater amounts of debt than companies whose businesses were least impacted by the 2020 growth shock (Chart 12). Industries that were “worst-hit” by COVID also saw significant worsening of debt servicing capability, described by the IMF analysts as the percentage of firms among the “worst-hit” that had interest coverage ratios less than one (middle panel). Importantly, the IMF report noted that the “worst-hit” industries have seen significant improvements in interest coverage since 2020, reducing the number of financially vulnerable firms (those with high debt-to-assets ratios and interest coverage less than one). The IMF analysis uses corporate data from a whopping 71 countries, but the conclusions are like those from our Corporate Health Monitors for the US and Europe – corporate credit quality has improved, on the margin, since the dark days of the 2020 COVID recession for an increasing number of borrowers. Default-adjusted spreads for high-yield bonds in the US and Europe, which subtract expected default losses from high-yield index spread levels, show that high-yield bonds currently offer decent compensation for expected credit losses (Chart 13). This is especially true for European high-yield, where the default-adjusted spread is just below the average level since 2000. This fits with our current recommendation to maintain neutral allocations to both US and European high-yield. We have a bias to favor the latter, however, due to better valuation metrics and a more dovish outlook on ECB monetary policy compared to the Fed. Theme #4: The Fundamental Backdrop For Emerging Markets Is Poor Chart 14The Backdrop Remains Challenging For EM The Backdrop Remains Challenging For EM The Backdrop Remains Challenging For EM We have been negative on emerging market (EM) credit dating back to the latter months of 2021. Specifically, we are now underweight EM USD-denominated debt, both sovereigns and corporates. This is a high-conviction view and one that remains fundamentally supported. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China policy stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. While we expect the latter to occur in the coming months, there are meaningful risks to that view, as described earlier. Meanwhile, the situation in Ukraine appears to be worsening with Russia pushing the offensive and showing no desire for reengaging talks with Ukraine. Chinese policymakers are starting to respond to slowing Chinese growth, made worse by the COVID lockdowns, with some easing measures on monetary policy. Credit growth has also started to pick up, but the credit impulse remains too weak to warrant a more positive view on Chinese growth and import demand from EM countries (Chart 14). Finally, the US dollar remains well supported by a hawkish Fed and widening US/non-US interest rate differentials. This may be the most critical variable to watch before turning more positive on EM credit, given the strong historical correlation between the US dollar and EM hard currency spreads (bottom panel). For now, the trend of the US dollar remains EM-negative. Concluding Thoughts Chart 15Summarizing Our Main Investment Themes In One Chart Summarizing Our Main Investment Themes In One Chart Summarizing Our Main Investment Themes In One Chart Our four main investment themes, and associated recommendations, are summarized in Chart 15. The credit-related themes – underweighting high-yield bonds in the US and Europe versus investment grade equivalents, and underweighting EM USD-denominated debt – are already performing as expected. The interest rate related themes – slower global inflation and fading European rate hike expectations – should unfold in favor of our recommendations over the balance of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Assessing The Risks To Our Main Views Assessing The Risks To Our Main Views The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Assessing The Risks To Our Main Views Assessing The Risks To Our Main Views Tactical Overlay Trades

Executive Summary Everything the banks see indicates that their household customers are in fantastic shape, with overstuffed checking accounts and unusually low outstanding credit card balances. Despite low confidence measures, they are spending with vigor, showering revenue on pandemic-squeezed businesses. Inflation in the price of necessities like food and gasoline most harms households at the low end of the wealth and income distributions, but the banks report that they are bearing up remarkably well so far. Credit quality remains exceptionally good and delinquencies and other leading indicators are still flashing the all-clear sign. Growing deposits demonstrate that the world is still awash in liquidity and credit stresses are not at hand, but highlight the challenges the Fed faces in trying to cool the economy. The banks expressed little to no appetite for deploying their idle cash into securities. It appears that another constituency will have to step up to replace the Fed’s QE purchases of Treasuries and agencies. A Blessing And A Curse A Blessing And A Curse A Blessing And A Curse Bottom Line: The biggest banks’ observations support a rosy near-term outlook – the consumer is firing on all cylinders, businesses are well positioned and there is no credit distress on the horizon. The Fed will have its hands full slowing an economy that has so much momentum, however, and there is little chance that volatility will not be elevated over the rest of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing Easter weekend. Their results were ho-hum – it remains our view that the banks lack a fundamental catalyst to drive relative outperformance – and mainly illustrated that higher interest rates, despite boosting net interest income, are far from the industry cure-all they’re cracked up to be. The SIFIs have languished over the last three months after consistently outperforming the overall market since late 2020, often by wide margins, and now find themselves modestly leading since the first effective COVID vaccines were developed in November 2020 (Chart 1). Chart 1An Incomplete Comeback An Incomplete Comeback An Incomplete Comeback We do not compile the Big Bank Beige Book every quarter to assess the banks’ relative investment merits, however. The S&P 500 Diversified Banks have a uniquely privileged vantage point into activity across the economy and we are simply trying to look over their shoulders. The banks’ earnings releases and analyst calls offer insight into the broad macro backdrop via borrower performance, lender willingness, financial system liquidity and the actions, intentions and financial capabilities of households and businesses. The following is what we heard and how it informs our take on financial markets and the economy. Households Are Still Flush … Related Report  US Investment StrategyThe Big Bank Beige Book, January 2022 Bank of America consumers spent at the highest-ever [first quarter] level, … [a] double-digit percentage increase over 2021, … despite the stimulus bonus [boosting the year-ago numbers]. (Moynihan, BAC CEO) [C]ombined credit and debit [card] spend was up 21% year-on-year, with growth stronger in credit as we see a continued pickup in travel and dining. And as the quarter progressed, we saw robust reacceleration of T[ravel] and E[ntertainment] spend, up 64%. (Barnum, JPM CFO) Consumer credit card spend remained strong, up 33% from a year ago. All spending categories were up (Chart 2) with the highest growth in travel, entertainment, fuel and dining. … Discretionary [debit card] spending remained strong with entertainment up 39% and travel up 29% from a year ago. (Scharf, WFC CEO) Chart 2Making Up For Lost Time Making Up For Lost Time Making Up For Lost Time In the first quarter …, credit and debit card travel volumes exceeded pre-pandemic levels. March airline volume was flat compared to March 2019, the first … [monthly] recovery to pre-pandemic levels. Although corporate T&E-related volumes … are still below pre-pandemic levels, they continue their upward trajectory … [and were] 75% of their pre-pandemic level in March. (Dolan, USB CFO) We’re still seeing quite a bit of excess liquidity sitting there in the back pocket of our consumers and very healthy balance sheets (Chart 3). I think [credit card payment rates] have peaked … and I think that’s good, because it should be the return this year to more healthy behavior. The spend is obviously … quite remarkable, … up in the mid-20s%. [It’s] also great to see the experience side, and … services coming back in again. We’ve been seeing it in travel, we’ve been seeing it in apparel. People like getting dressed up to go to dinner again in their [favorite] restaurant. (Fraser, C CEO) Chart 3Up, Up And Away Up, Up And Away Up, Up And Away … Even The Ones In Higher Inflation’s Crosshairs [Today’s] very strong underlying growth will go on. It’s not stoppable. The consumer has money. They pay down credit card debt. Confidence isn’t high, but the fact that they have money, they’re spending their money. They have $2 trillion still in their savings and checking accounts. Businesses are in good shape. Home prices are up. Credit is extraordinarily good. … That’s going to continue in the second quarter, third quarter. After that, it’s hard to predict. (Dimon, JPM CEO) Q: Are you seeing any signs of pullbacks and shifts in the type of [consumer] spend[ing] that could point to some softening there? A1: What we are continuing to see [across the board] … is good, strong, both [in terms of] year-over-year growth and comparisons back to 2019. … I would expect that there’s probably going to be a shift to some extent from … durable goods … to more service-oriented sorts of activities, but in terms of the overall level of spend, I feel like that will continue at least for some period of time. (Dolan, USB) A2: Consumer credit card spend is up 35% versus pre-pandemic. … [W]e’re not seeing any negative trends thus far and it continues to be very strong. (Cecere, USB CEO) March was the eighth straight month in which inflation outpaced income, with lower-income consumers being most impacted by rising energy and food prices. That said, higher deposit balances and rising wages have thus far allowed consumers to weather these headwinds. (Scharf, WFC) Our data show continued growth in average deposit balance[s] across all customer levels … , suggest[ing] … strong spending [can] continue. On an aggregated basis, average deposit balances were up 47% from pre-pandemic levels … and the momentum continued through the first quarter, particularly in the low-balance accounts. [C]ustomers who had $1,000 to $2,000 of balances [pre-pandemic], with an average $1,400 balance … now have $7,400. [T]hose with $2,000 to $5,000 [and a pre-pandemic average of $3,250] today have an average … of $12,500. … Consumers are sitting on lots of cash. (Moynihan, BAC) Q: Are you starting to see any drawdown [of consumer deposits] because of inflation? A: It’s actually the opposite; they grew faster from February to March. That [jump is] probably because of tax refunds, but … beginning around May of last year, they pretty consistently grew 1-2% per month, [with the most growth in] lower-end balances. [The only exception was] November, [when] we saw a slight downdraft in lower-end balances and [then it] picked back up in December. … It grew [every] month this quarter and March had the strongest growth. We haven’t seen the data for April yet, but [deposits are still growing very strongly] all the way up into the people who carried balances of $10,000 – 20,000 pre-pandemic. We’re not seeing that deteriorate at all yet. (Moynihan, BAC) Some Business Loan Demand Is Returning (Chart 4) Chart 4No Thanks For The Loan; We Issued Bonds Instead No Thanks For The Loan; We Issued Bonds Instead No Thanks For The Loan; We Issued Bonds Instead C[ommercial]&I[ndustrial] loans were up 3% sequentially, ex-PPP [Paycheck Protection Plan loans], reflecting higher revolver utilization and originations across middle market and in corporate client banking. (Barnum, JPM) We do see pretty nice loan growth in the commercial bank. There’s a bunch of different factors there, it could be [some pent-up capex,] some inventory effects and so on. (Barnum, JPM) The economy is returning more towards normal and our line utilization is, … too. That’s part of what’s driving our loan growth. Revolver utilization in commercial banking now is 31.7%; pre-pandemic, our normal was around 35%. (Borthwick, BAC CFO) I think that most businesses have been kind of holding back … on capex [over the last couple of years] and so I think there’s a bit of an increase in that spend related to it. And then as companies see more and more inflationary pressure, they’re going to look to automation as a way of offsetting some of the [cost] pressure they see [when they try to hire]. At least in the near term, our expectation is that capex will continue to be reasonably strong. And our utilization rates support that. We’ve been running [around] 19%, plus or minus, for a number of quarters and we saw an increase, certainly not to normal levels, but up to 22-23% in the last few months. (Dolan and Cecere, USB) Revolver utilization rates have increased, but are still well below historical levels. Loan demand has been driven by larger clients who are increasing borrowing due to the impact of inflation on material and transportation costs as well as to support inventory growth. We’re also seeing new demand from some clients who are catching up from underinvestment in projects and capex over the past couple of years. (Santomassimo, WFC CFO) No Credit Warning Signals Yet Q: Are you seeing any stresses in the levered parts of the debt markets, … levered loan, high yield, CLO, private credit? A: Obviously, in this environment, everyone’s looking very closely everywhere for any risks and trying to see around the corner. But as of right now, we’re really not seeing anything of concern in the … spot metrics. (Barnum, JPM) Q: Are there any [household] income buckets where you’re seeing early-stage delinquencies picking up? A: In short, no. It’s an interesting question as you look across our customer base, particularly in card, that heavily debated question of real income growth and gas prices and what’s that doing to consumer balance sheets. And so we’re watching that, especially in the kind of LMI [lower-to-middle-income] segment of our customer base. But right now, we’re not actually seeing anything that gives us reason to worry. (Barnum, JPM) Consumers remain in good shape. … The average card balances of our credit card customers [with whom we have] deposit relationships are 8% lower than they were pre-pandemic. … These [card and deposit] customers have built significant additional savings and their average deposit balances are up 39%. … The small low-FICO-score subset of our customer base was even stronger [in terms of higher] cash balances and lower debt levels. We believe this is not a [BAC-specific] phenomenon, as … debt service levels are hovering near historic lows (Chart 5) and household deposit and cash levels are $3 trillion higher than when we entered the crisis. (Moynihan, BAC) Chart 5Debt Service Is Easy For Households Debt Service Is Easy For Households Debt Service Is Easy For Households We continue to see strong credit performance across our [U.S.] portfolio as clients’ balance sheets remain healthy. (Mason, C CFO) Credit is still exceptionally good, and certainly will be into the next quarter based on everything that we see and possibly beyond (Chart 6), even though at one point [charge-offs] will go up. (Scharf, WFC) Chart 6Consumer Credit Leading Indicators Are Healthy The Big Bank Beige Book, April 2022 The Big Bank Beige Book, April 2022 Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio will remain lower than historical levels, but continue to normalize over time. (Dolan, USB) The Banks Aren’t Eager To Buy Securities Deposits continued to grow in the first quarter and despite a pickup in loan growth, the largest banks continue to hold a great deal of cash (Chart 7). The sharp rise in interest rates affords them an opportunity to put that cash to work, potentially driving a big increase in net interest income (NII). Every bank that raised its NII guidance, however, stated that the increased guidance was independent of any growth in the aggregate size of its loan and securities portfolios. The banks’ priority is to lend to household and business customers (Chart 8) and if demand for loans continues to rise, their commentary implied that securities holdings may well shrink. Chart 7Demand For Loans Is Still Lagging ... Demand For Loans Is Still Lagging ... Demand For Loans Is Still Lagging ... Chart 8... Banks' Willingness To Make Them ... Banks' Willingness To Make Them ... Banks' Willingness To Make Them Q: Any appetite to deploy the excess liquidity? A: No, don’t expect that. (Dimon, JPM) Guys, we were just talking about interest rates going up maybe more than 3%. Convexity is going up. [Mark-to-market loss on available-for-sale securities] is going up. There are all these various reasons not to [move cash into securities]. We’re not going to do it just to give you a little bit more NII next quarter. (Dimon, JPM) When it comes to deploying liquidity, it’s going to be loans first. … And then based on what we see there, we will decide if we’re going to grow the securities portfolio. (Santomassimo, WFC) At the end of the day, the reason why we have securities investments is because we have $2 trillion of deposits and $1 trillion of loans, and we got to do something with the money. (Moynihan, BAC) We’re not interest rate traders, we’re interest rate managers through a cycle. (Borthwick, BAC) What Ails The Banks’ Stocks? We did not join the chorus of investors and strategists at the beginning of the year who were singing the praises of bank stocks in a rising rate environment. We loved the SIFIs back in 2020 when they built up enormous loan-loss reserves in the first two quarters of the pandemic because we believed they would not be needed given monetary and fiscal efforts to shield the economy from COVID disruptions. Those reserves were eventually released back into earnings, pumping the banks' per-share book values above expectations, but once the truing up of actual versus expected credit losses was complete, the stocks had no apparent outperformance catalyst. Rising rates didn’t do much to entice us because we believe investors dramatically overestimate banks’ earnings sensitivity to interest rates and the slope of the yield curve. Higher rates help boost net interest income, but they are not an unmitigated positive, as first-quarter results and management commentary indicated. Every bank suffered hits to its accumulated other comprehensive income (AOCI) from the decrease in the value of the securities it holds in the available-for-sale bucket. AOCI is not an income statement item, but it does reduce equity and thereby undermines the banks’ regulatory capital positions and makes regulatory constraints more binding. Rising rates also entice depositors to shift some money away from banks and raise the cost of retaining deposits and every call featured analyst questions about the sensitivity of bank deposit pricing to changes in interest rates (deposit betas). Rising rates might also lead to pressure on non-interest income, which is nearly equal to the SIFIs' net interest income. As WFC CEO Charlie Scharf put it, “The mortgage origination market experienced one of its largest quarterly declines that I can remember, and it will take time for the industry to reduce excess capacity.” Volumes will fall as that capacity is reduced and so will gain-on-sale margins as the banks shed their remaining inventory. The bottom line is that somewhat higher rates are a net positive but much higher rates will be a drag on bank earnings, just as they will on the overall economy, and investors right now seem to be skipping to the end of the rate hike story and ignoring the benign chapters along the way. Finally, it appears that the extraordinary volume of bond issuance over the last two years displaced some of the need for C&I loans. Given that any CFO or corporate treasurer who didn’t term out company debt in 2020-21 ought to have his or her head examined, the shortfall in credit line utilization and sharply below trend C&I loans outstanding may extend well into the intermediate term. Investment Implications The banks’ calls reinforced our take that the economy has a lot of momentum in the form of flush consumers and amply funded businesses. Credit performance is tremendously strong and net charge-off rates will remain subdued for the foreseeable future. Low delinquency rates will not suddenly spike when business and consumer deposit balances are extremely high and still growing. The Fed’s response to uncomfortably high inflation was a shadow looming over all the calls, just as it was over equities at the end of last week, but it will take a steady diet of rate hikes to rein in a galloping economy. While there is no shortage of concerns, our view remains that they will not be realized in 2022 and that it is therefore too soon to take evasive action in individual portfolios or at the broad asset allocation level. We still recommend that investors with a six-to-twelve-month timeframe remain at least equal weight equities in a multi-asset portfolio, though we are more confident about the next six months than we are about the next twelve and believe it is appropriate to manage portfolios more tactically. We wholeheartedly agree with JPM CEO Jamie Dimon’s assessment and think investors would do well to try to manage in accordance with it. I cannot foresee any scenario at all where you’re not going to have a lot of volatility in markets going forward. We’ve … spoken about the enormous strength of the economy, QT, inflation, war, commodity prices – there’s almost no chance that you won’t have volatile markets … and I think people should be prepared for that. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Real Wages Are Declining Real Wages Are Declining Chart 2Consumer Confidence Has Soured Consumer Confidence Has Soured Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories Here Comes Goldilocks Here Comes Goldilocks The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Here Comes Goldilocks Here Comes Goldilocks Chart 6The Clogged-Up Port Of Shanghai Here Comes Goldilocks Here Comes Goldilocks Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Here Comes Goldilocks Here Comes Goldilocks Special Trade Recommendations Current MacroQuant Model Scores Here Comes Goldilocks Here Comes Goldilocks

Executive Summary The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 3India And China Both Depend On Middle East For Oil Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 4China’s Naval Power Pales Versus US Allies In Asia Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 7America Can Provide Military Heft To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 8US Is A Key Trading Partner For India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 10India Offers US Firms Access To High Growth Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 11India Is A Key Market For American Big Tech Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 17China & Pakistan: Iron Brothers? Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 18Indians View China And Pakistan Negatively Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis?   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary After having overspent on goods ex-autos over the past two years and experiencing contracting incomes in real terms, US and European households will reduce their purchases of goods ex-autos. Risks to global growth stemming from China remain to the downside. Leading indicators from Asia and global financial markets are signaling a contraction in global trade. Yet, US core inflation will not drop below 4% for the rest of this year. Consequently, the Fed will likely end up hiking rates and sounding hawkish amidst a major global trade slump. This will give rise to stagflation anxiety among investors and will be negative for global risk assets in general and EM equities, currencies and credit markets in particular. The yuan is breaking down versus the US dollar. A weaker RMB will pull down Emerging Asian as well as other EM currencies. Does This Divergence From A Historic Correlation Signify Stagflation? Does This Divergence From A Historic Correlation Signify Stagflation? Does This Divergence From A Historic Correlation Signify Stagflation? Bottom Line: Global equity and credit portfolios should remain defensive and continue underweighting EM. Currency investors should be positioned for another upleg in the US dollar and a downleg in EM currencies. Feature The volume of global trade is about to contract. Meantime, US inflation will remain well above the Fed’s target. This combination will produce stagflation anxiety among investors. It is impossible to know whether stagflation will be a long-lasting phenomenon in the real economy. In our view, the stagflation narrative will dominate global financial markets in the coming months. This heralds a cautious stance on global and EM risk assets. The slowdown in global manufacturing and trade will be pervasive and broad-based but will exclude auto production. The latter will in fact recover as chip/input shortages ease. The main drivers of the slowdown are (1) a mean reversion in US and European demand for goods ex-autos; (2) China’s economic woes and (3) moribund domestic demand in mainstream EM. Shrinking DM Household Demand For Goods ex-Autos Chart 1DM Household Demand For Goods ex-Autos Will Experience Mean Reversion DM Household Demand For Goods ex-Autos Will Experience Mean Reversion DM Household Demand For Goods ex-Autos Will Experience Mean Reversion After having overspent on goods ex-autos over the past two years and experiencing contracting income in real terms (after adjusting for inflation), US and European households will reduce their purchases of goods ex-autos. US and European consumption of goods ex-autos exploded at the onset of the pandemic two years ago and has stayed robust until now. Chart 1 illustrates that since mid-2020, the consumption of goods ex-autos was running well above its trend, which signifies excessive demand over the past two years. Such excessive demand has led to bottlenecks and shortages, giving producers an opportunity to hike prices. In a nutshell, inflation in tradable goods in the past 18 months was primarily driven by demand, not supply constraints. A portion of future goods consumption has been pulled forward, which implies that household demand for these goods has become saturated. Moreover, as the pandemic subsides, consumers are shifting their spending from goods to services. These dynamics could create an air pocket in the demand for certain goods. Chart 2DM Household Real Incomes Are Contracting DM Household Real Incomes Are Contracting DM Household Real Incomes Are Contracting Critically, US and European household income is contracting in real terms (Chart 2). Wage growth has not kept up with the surge in inflation. Due to shrinking disposable real income, consumers in advanced economies will curtail their consumption of discretionary items, primarily goods ex autos on which they have overspent during the past two years. Bottom Line: Demand for goods ex-autos will shrink in advanced economies in the next 6-12 months. This will weigh on global merchandise trade. China’s Trilemma Chinese authorities are facing an “impossible trinity” in their attempts to simultaneously achieve three objectives: (1) pursuing the dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. We do not think all three objectives can be achieved. China’s economy was struggling prior to the recent lockdowns. The COVID-related restrictions have only made matters worse and have weighed heavily on economic activities and household income. Domestic orders for industrial enterprises plunged below 50, i.e., they are in contraction territory (Chart 3). These surveys, released on March 30-31, were not affected by the Shanghai lockdowns, which have proliferated since March 28. Exports orders are also contracting (Chart 4). Chart 3China: Domestic Orders Were Plunging Prior To Lockdowns China: Domestic Orders Were Plunging Prior To Lockdowns China: Domestic Orders Were Plunging Prior To Lockdowns Chart 4China: Exports Are Set To Contract China: Exports Are Set To Contract China: Exports Are Set To Contract   Further, China’s import and export volumes were contracting in January – prior to the Ukraine war and the recent lockdowns. Notably, Chart 5 highlights that prior to the recent lockdowns, import weakness was broad-based, including commodities, machinery and semiconductors. In particular, total imports in USD are flat in March compared to a year ago. With commodity prices up significantly, it is clear that import volumes in March have shrunken substantially. National disposable income per capita was growing at about 6% in nominal terms before the lockdowns (Chart 6, top panel). Household mortgage growth had decelerated considerably before lockdowns became widespread (Chart 6, bottom panel). Chart 5Chinese Imports Were Shrinking Before Lockdowns Chinese Imports Were Shrinking Before Lockdowns Chinese Imports Were Shrinking Before Lockdowns Chart 6China: Household Income And Mortgage Borrowing China: Household Income And Mortgage Borrowing China: Household Income And Mortgage Borrowing ​​​​​​​​​​​​​​​​​​​​​   As the lockdowns wreak havoc on the economy and household income, and with the government not providing direct transfers to the population, household consumption will be severely affected in the months ahead. The property market remains in the doldrums and is unlikely to recover soon. As we have highlighted in previous reports, structural headwinds, continue to weigh down on the property market. Since 2009, there has been no business cycle recovery in China without the real estate market playing the leading role. Residential floor space sold was down by 20% in Q1 from a year ago (Chart 7, top panel). House prices have begun deflating in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Critically, the plunge in property developers’ financing entails shrinkage in housing completion (construction work) (Chart 7, bottom panel). The latter has so far held up as authorities have been forcing developers to use their limited financing to complete projects that they had already started. The massive issuance of local government bonds will spur an acceleration in infrastructure spending. China’s government gave the green light already this year to infrastructure projects worth nearly 70% of what was allowed for the whole of last year. Yet, this might be insufficient to produce a rapid business cycle recovery in an environment of rolling lockdowns and with other segments of the economy facing challenges. Related Report  Emerging Markets StrategyGlobal Semi Stocks: More Downside Given these negative forces, the Chinese economy requires massive government stimulus in the form of direct transfers to households and SMEs – as the US offered in the spring of 2020. Yet, it does not seem that the government is rushing to provide such direct and significant stimulus. In our opinion, the policy stimulus measures announced so far by the government fall short of what is required to lift the economy. Policymakers are neither ready to abandon the dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. With these two constraints, economic growth in China is set to underwhelm. Bottom Line: Risks to global growth stemming from China remain to the downside. In EM ex-China, ongoing fiscal tightening, monetary tightening in LATAM and feeble household income growth in India and ASEAN will all cap consumer spending and business investment (Chart 8). Chart 7China: Property Construction Is Set To Shrink China: Property Construction Is Set To Shrink China: Property Construction Is Set To Shrink Chart 8EM ex-China: Domestic Demand Will Remain Sluggish EM ex-China: Domestic Demand Will Remain Sluggish EM ex-China: Domestic Demand Will Remain Sluggish Signs Of A Global Trade Contraction There is already evidence to suggest that a major relapse in global manufacturing and trade is beginning: Taiwanese shipments to China are dipping into negative territory, and they lead global exports (Chart 9). Taiwanese exports to China are a good leading indicator of global trade dynamics because mainland producers order inputs from Taiwan first before they produce final goods for export. When producers located in China order less inputs, they evidently expect less in the way of production and shipments. Korea’s business survey of exporting companies indicates a substantial deterioration in their business conditions in April (Chart 10). This points to a major slump in the nation’s exports and, hence, global trade. Chart 9Global Trade Is Set To Contract Global Trade Is Set To Contract Global Trade Is Set To Contract Chart 10Korean Exporters Are Downgrading Their Expectations Korean Exporters Are Downgrading Their Expectations Korean Exporters Are Downgrading Their Expectations Korean and Japanese non-financial share prices have plunged despite considerable currency depreciation, which is typically positive for their competitiveness. As many of these non-financial companies are major exporters, this development points to a major downtrend in global trade. Global cyclicals have been underperforming global defensives. This dynamic has historically been a good leading indicator for the global industrial downturn (Chart 11). Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives (Chart 12). This also points to a slowdown in US growth. Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Chart 12Beware Of A Relapse in US Early Cyclical Stocks Beware Of A Relapse in US Early Cyclical Stocks Beware Of A Relapse in US Early Cyclical Stocks   Bottom Line: Leading indicators from Asian economies and global financial markets are signaling that global trade will experience a contraction and global growth will slow. Inflation Amid A Global Trade Contraction? Chart 13US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms A natural question is why worry about inflation when global trade volumes will be contracting? The primary source of anxiety in this context is US inflation and the Fed’s tightening. A decline in global trade will not be enough to bring down US core inflation substantially. By contrast, China and Asia do not face an inflation problem. US inflation worries will persist, and the Fed will likely continue to hike rates and sound hawkish for the following reasons: First, US capital expenditures by companies and household spending on services will remain robust. US services make up a larger share of the American economy and employment than do goods-producing sectors. Hence, we do not expect a broad-based recession in the US this year. Second, as we have previously noted, the US has a genuine inflation problem. American wages are accelerating, and a tight labor market will push up wage growth above 5-6% (Chart 13, top panel). Importantly, real wages in the US have contracted (Chart 13, bottom panel). Faced with a decline in purchasing power, employees will demand higher wages. The tight labor market raises the odds that companies will likely accommodate higher wages. Chart 14Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Given that US productivity growth is no more than 1.5-2%, wage growth over 5-6% means that unit labor costs will be rising by more than 3-4%. This will prevent core inflation from falling a lot. Unit labor costs have historically been the main driver of core inflation in the US (Chart 14). Finally, inflation is a lagging and inert phenomenon. It takes a long time (more than six to nine months) of sub-par growth for inflation to subside. Odds are that even though global trade volumes will be contracting, the Fed will continue hiking rates and sounding hawkish because US inflationary pressures will remain acute. Bottom Line: Annual core CPI inflation will drop in the US due to the base effect and a drop in some goods prices. Yet, we expect core CPI and PCE to remain above 4% for the rest of this year. Underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be reduced meaningfully without bringing economic growth down below potential growth and weakening the labor market for a few quarters. Investment Implications Shrinking global trade volumes and a hawkish Fed are bearish for global risk assets in general and EM equities, currencies and credit markets in particular. Contracting exports and a hawkish Fed are negative for the Chinese yuan and other Asian currencies. The CNY/USD exchange rate has broken below its 200-day moving average and odds are that it will depreciate further (Chart 15). Our target for CNY/USD is 6.7. The broad trade-weighted US dollar has more upside and EM currencies will depreciate. Chart 16 illustrates that investors’ net long positions in ZAR, BRL and MXN are high. Chart 15The RMB Is Breaking Down The RMB Is Breaking Down The RMB Is Breaking Down Chart 16Investors Are Long EM Commodity Currencies Investors Are Long EM Commodity Currencies Investors Are Long EM Commodity Currencies   Our recommended currency shorts for now are ZAR, PHP, IDR, COP, HUF, PEN and PLN. Global equity and credit portfolios should continue underweighting EM. Notably, global defensive equity sectors have been outperforming non-TMT stocks despite rising US/global bond yields (Chart 17). This is a major departure from the historical relationship and likely signifies a period of slower global growth ahead but continuous Fed tightening. Global equity managers should favor defensive stocks. Chart 17Does This Divergence From A Historic Correlation Signify Stagflation? Does This Divergence From A Historic Correlation Signify Stagflation? Does This Divergence From A Historic Correlation Signify Stagflation? For EM equity managers, we also recommend favoring defensive sectors like consumer staples. Presently, our country overweights are Korea, Singapore, Chinese A-shares, Mexico and Brazil. Our underweights are India, Central Europe, Indonesia, Turkey, South Africa, Colombia and Peru. In local rates, we continue recommending receiving Chinese and Malaysian 10-year swap rates, a long position in Brazilian 10-year bonds, betting on yield curve flattening in Mexico and paying Polish 10-year swap rates while receiving Czech 10-year swap rates. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com​​​​​​​ A Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation?

Executive Summary China’s Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing wave of local Omicron infections and city lockdowns pose the largest macro risk in China post Q1 2020. The current lockdowns in major cities - including Shanghai - may shave one percentage point from China’s 2022 GDP growth. Restrictions on activity and travel in Shanghai and surrounding areas in the Yangtze River Delta have led to severe supply-chain disruptions, created by both port and highway transportation congestion and manufacturing plant shutdowns. Unlike in 2H20, chances are lower for a quick and strong post-lockdown recovery in China’s economy and stock prices because the nation’s policy easing will be less aggressive and is less effective than two years ago. The scale of China’s monetary easing will be smaller than in H1 2020 given the Fed is rising interest rates. The country’s fiscal balance sheet is also in worse shape than in 2020, particularly at the local level.  Bottom Line: The wave of lockdowns in China’s major cities will pose substantial risks to China’s economy this year. The post-lockdown recovery will likely be more muted than in 2H20 because there is limited room for the country to stimulate its economy and policy easing measures will likely be less effective than two years ago.   Chart 1China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present China's Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing lockdowns linked to the spike in Omicron and China’s zero tolerance towards COVID are exacting a heavy toll on China’s economy. While the situation is fluid and official data is lagging, China’s economy faces the largest macro risk since early 2020. In the past four months, China has imposed more lockdowns, with full and partial mobility restrictions, than in the past two years combined (Chart 1). In particular, this round of citywide shutdowns occurred in some of China’s largest and most prosperous cities, such as Shanghai and Shenzhen, and several manufacturing hubs including Jilin province and cities in the Yangtze River Delta region. Furthermore, the post-lockdown recovery this year will likely be more muted than two years ago. Beijing has less room to ease policy and stimulate the economy than in early 2020. In addition, policy easing measures will be less effective in boosting domestic demand, given that private sector sentiment was already downbeat prior to the lockdowns and the country’s zero-COVID policy may lead to more stringent confinement measures in the rest of the year. Serious Economic Implications China’s aggregate economy is suffering significant damage from the current round of city- and province-wide lockdowns in some of China’s most populous and prosperous regions. Chart 2The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Economic data following the shutdown of Hubei province in early 2020 can serve as a roadmap to illustrate what to expect from lockdowns in Shanghai, which accounts for 4% of China’s GDP and is the same size as Hubei. During a 60-day lockdown in Q1 2020, Hubei’s retail sales growth nose-dived by 43 percentage points (ppt) and fixed-asset investment growth tumbled by 83ppt in Q1 2020 compared with the previous three months (Chart 2). The aggregate economy in Hubei shrank by 40% in Q1 2020 from a year ago and the decline likely reduced Chinese GDP growth by 1.5% in that quarter alone (Chart 3). The lockdown also dragged Hubei’s government revenues, tourism income and corporate profits into a deep contraction for 2020 (Chart 4). Chart 3The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Chart 4The Economic Impact From Hubei Lockdown In Q1 2020 The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy A recent study estimating the economic impact of lockdowns by analyzing the flow of intercity trucking found that freight traffic would plummet by 54% under a full lockdown for a month, versus a 20% drop under a partial lockdown. In addition, the ripple effect of a lockdown would be felt by surrounding cities. According to the article, if the four most important economic centers of the country - Beijing, Shanghai, Guangzhou and Shenzhen - are shut down for one month at the same time, then their real income in that month would decrease by a whopping 61%. Meanwhile, the national real income in the same period would shrink by 8.6%, which translates into a 1ppt decline in China’s annual GDP growth. The scenario that China’s four major cities would be locked down was inconceivable before the onset of Omicron. However, as of April 15, it is estimated that local cities that have experienced full or partial lockdowns account for about 40% of China’s GDP, affecting more than 250 million residents. As such, the aggregate economic losses from the current round of lockdowns could reach 1ppt of China’s 2022 GDP growth. Bottom Line: The economic impact from the current lockdowns has the potential to reduce China’s GDP growth by 1ppt in 2022. Supply Chain Disruptions Shanghai’s lockdown has had economic repercussions on the Yangtze River Delta region, an important manufacturing hub and key supplier in the automobile and electronic equipment industries. Cross-regional travel restrictions have led to supply-chain disruptions through transportation blockades and manufacturing plant shutdowns. These obstacles include: Table 1Top Ten Ports In China The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Increased port congestion. The Ports of Shanghai and its nearby Ningbo handle nearly 30% of China’s total ocean shipping volume and are key barometers of China’s foreign trade and logistics chain (Table 1). Data from VesselsValue shows an almost fivefold increase in the number of ships waiting to load or discharge at Shanghai in the second half of March (Chart 5). Port congestion worsened in April after the Shanghai lockdown began on March 28. Chart 5Ships Waiting To Load Or Discharge At Shanghai Port The Cost Of China’s Zero-COVID Strategy The Cost Of China’s Zero-COVID Strategy Chart 6Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Road transport blockades. Road traffic in the Yangtze River Delta has been restricted, causing significant delays in suppliers’ delivery times (Chart 6). By April 7, nationwide vehicle logistics freight flow fell by 32% from a year ago and plunged more than 80% in the Shanghai area. Highway traffic mobility tracked by Gaode dipped to the same level as in early 2020. Production suspensions. A significant number of businesses from automakers Tesla and Volkswagen to notebook manufacturer Quanta Computer Inc. reportedly suspended operations at their Shanghai plants to comply with government restrictions for virus control. ​​​​​​​The city, together with Jilin and Guangdong provinces, account for more than 30% of China’s auto production. Even if employees at auto and chip makers in Shanghai can return to production plants and work through a “closed-loop” system whereby they live on-site and test regularly, a more serious challenge would be how manufacturers can secure trucks to get materials and products delivered on time.1 Supply-chain disruptions are starting to impact China’s trade. The country’s import growth in nominal value in March dropped sharply to a 0.1% contraction (on a year-on-year basis) (Chart 7). Even though China’s exports in March expanded by 14.7% from a year ago, exports are below that of its Asian manufacturing neighbors, such as South Korea and Vietnam (Chart 8). Chart 7Chinese Import Growth Fell Into Contraction In March Chinese Import Growth Fell Into Contraction In March Chinese Import Growth Fell Into Contraction In March Chart 8China's Export Growth Has Dropped Below That Of Vietnam And South Korea China's Export Growth Has Dropped Below That Of Vietnam And South Korea China's Export Growth Has Dropped Below That Of Vietnam And South Korea Bottom Line: The Shanghai lockdown is having spillover effects on the Yangzte River Delta region through supply-chain disruptions. Strong Post-Lockdown Rebound? Chart 9China Will Need A Stimulus That Is Comparable To 2020 China Will Need A Stimulus That Is Comparable To 2020 China Will Need A Stimulus That Is Comparable To 2020 China’s economic growth and stock prices will unlikely repeat the quick and strong recovery registered following the early 2020 lockdown. Beijing has stepped up policy supports, but the challenges from both domestic conditions and the external environment are greater than in 2020. Thus, the country’s stimulus (measured by credit growth including local government bond issuance) will need to at least be similar to that of two years ago to shore up the economy (Chart 9). We are skeptical about both the magnitude and effectiveness of the stimulus in 2022, despite policymakers’ mounting efforts to support the economy. Therefore, we maintain a cautious view on Chinese risk assets (in both onshore and offshore markets).  Our view is based on the following: There may be more frequent shutdowns of business activity as China continues upholding its zero-COVID approach.  Even as we go to press, a few cities that recently recovered from COVID outbreaks have failed to resume their business and social activities. A flareup of COVID cases in the low double digits has dragged cities back to either mass COVID testing or partial city lockdowns. China’s COVID-containment measures escalated when the country’s business activity was already weak which was vastly different from prior to Q1 2020 when the economy was improving (Chart 10). Sentiment among the corporate and household sectors has been beaten down following two years of struggling with COVID, and the sectors’ propensities to invest or spend have been further dampened from last year’s harsh regulatory crackdowns (Chart 11).  Chart 10Business Cycle Was On A Downtrend When Omicron Hit... Business Cycle Was On A Downtrend When Omicron Hit... Business Cycle Was On A Downtrend When Omicron Hit... Chart 11...Sentiment Among Private Sector Has Been Downbeat ...Sentiment Among Private Sector Has Been Downbeat ...Sentiment Among Private Sector Has Been Downbeat Input costs are much higher now than two years ago, while demand is weaker (Chart 12). Global energy and commodity prices will remain elevated this year, while external demand for Chinese manufactured goods will dwindle (Chart 13). China’s exports as a share of the global total peaked in July last year; a strong RMB and frequent supply-chain disruptions will likely reduce competitiveness of Chinese exports. Chart 12Elevated Input Costs, Subdued Domestic Demand Elevated Input Costs, Subdued Domestic Demand Elevated Input Costs, Subdued Domestic Demand Chart 13Demand For Chinese Export Goods Will Likely Dwindle This Year Demand For Chinese Export Goods Will Likely Dwindle This Year Demand For Chinese Export Goods Will Likely Dwindle This Year Granted the Fed’s tightening, unless China is willing to tolerate meaningful currency depreciation, the PBoC has limited room to cut interest rates. The US Federal Reserve is expected to raise interest rates by 270bps over the coming 12 months, which will further tighten US dollar liquidity conditions and may exacerbate capital flows out of emerging economies. China’s 10-year government bond yield in nominal terms dropped below that of the US for the first time in a decade, prompting global investors to offload Chinese bonds at a record pace (Chart 14). The PBoC refrained from a policy rate cut last week. The move underwhelmed investors and was a sign that the central bank may be cautious in adopting a monetary policy stance that further diverges from the Fed.  Chart 14A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year Chart 15Growth In Gov Revenue From Land Sales In Deep Contraction Growth In Gov Revenue From Land Sales In Deep Contraction Growth In Gov Revenue From Land Sales In Deep Contraction The room for further fiscal expansion is also more limited than two years ago as local governments are more constrained by funding. An expansionary fiscal policy in the past two years has pushed local governments’ debt ratios2 up by more than 20 percentage points to above the international standard of 100%, while the property market slump has led to a deep contraction in local government revenues from land sales (Chart 15). ​​​​​​​ Bottom Line: Business activity will likely rebound when restrictions are eventually lifted, and the existing and/or forthcoming stimulus will work their way into the economy. However, the above mentioned hurdles suggest that China has limited room to further loosen its monetary and fiscal policies compared with two years ago, and the effectiveness of policy easing on the economy will be more muted. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1     Recently the consumer and auto division head of Huawei Technologies warned that “If Shanghai cannot resume production by May, all of the tech and industrial players that have supply chains in the area will come to a complete halt, especially the automotive industry.” "China’s Auto Industry May Grind to a Halt Amid Shanghai Lockdown", Caixin Global 2     Measured by local governments’ total debt including general and special-purpose bonds, divided by their overall fiscal balance. ​​​​​​​ Strategic Themes Cyclical Recommendations

Executive Summary A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 Global Bond Yields Take A Breather Global Bond Yields Take A Breather In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking ​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish ​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US Global Bond Yields Take A Breather Global Bond Yields Take A Breather The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out ​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation? A Peak In US Core Inflation? A Peak In US Core Inflation? ​​​​​ Chart 9Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures Global Bond Yields Take A Breather Global Bond Yields Take A Breather The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking ​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing ​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Global Bond Yields Take A Breather Global Bond Yields Take A Breather Chart 17Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Global Bond Yields Take A Breather Global Bond Yields Take A Breather The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Global Bond Yields Take A Breather Global Bond Yields Take A Breather Tactical Overlay Trades

Listen to a short summary of this report.     Executive Summary The Currency And Interest Rates: On A Collision Course? The Currency And Interest Rates: On A Collision Course? The Currency And Interest Rates: On A Collision Course? The dip in the Swedish krona has priced in a recession in the domestic economy. If a contraction does indeed occur, the impact on the currency is already a fait accompli. If it does not, the currency is poised for a coiled spring rebound. Fundamentally, the krona is cheap, and there is a dearth of SEK bulls, which is positive from a contrarian perspective. The Riksbank’s mandate is price stability. Given inflationary pressures and a weak currency, the Riksbank will have no choice but to turn more hawkish or lose credibility (Feature chart). There is potential for a brewing demand boom in Sweden – via refugees from Ukraine and Russia – that would increase government outlays and strengthen the need for higher rates. Admittedly, catalysts for SEK weakness remain in place – geopolitical tensions, rising energy costs and a stampede into safe-haven assets, including the dollar. Our strategy therefore is to buy on dips. We could be on the precipice of a capitulation phase that will present investors with an opportunity to accumulate the SEK at a fire-sale price. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/sek 10.15 2022-04-14 0.27 Bottom Line: Sweden is a small, open economy, very sensitive to global economic conditions. A recession is already priced by weakness in the SEK. Investors willing to tolerate volatility should buy the SEK on any further weakness. Feature Chart 1The SEK Tracks The DXY The SEK Tracks The DXY The SEK Tracks The DXY The Riksbank has been one of the more dovish central banks, both within the G10 and globally. Policy rates in Sweden are still at the zero bound, while they are rising in many other countries. In the Riksbank’s latest monetary policy report, domestic inflationary pressures were characterized as transitory. As such, the repo rate would not be raised until the second half of 2024.  The consequence of the Riksbank’s dovishness has been weakness in the Swedish krona, and a steep rise in inflation expectations. Most central banks are admitting that emergency policy settings are no longer appropriate in the current environment, especially after unprecedented monetary and fiscal stimulus. Yet, Sweden remains in the dovish camp. In this report, we argue that the Riksbank will have to raise rates sooner rather than later to maintain credibility and fend off inflationary pressures. The result of the Riksbank’s easy monetary policy has been the proliferation of massive carry trades, as investors sell the SEK and buy the dollar and/or other higher yielding currencies (Chart 1). As a small open economy, this could potentially unanchor longer-term inflation expectations, via a weak currency. Why Should The Riksbank Hike Rates? Chart 2The SEK Has Priced A Swedish Recession The SEK Has Priced A Swedish Recession The SEK Has Priced A Swedish Recession Sweden is likely to experience a technical recession in the coming quarters. The new orders-to-inventories ratio has contracted sharply, underscoring that the manufacturing sector will deflate (Chart 2). As a small, open economy, the manufacturing sector holds the key to the business cycle. Despite this, our bias is that the Riksbank will overlook the temporary dip in economic activity for the following reasons: The currency has already acted as a relief valve, which should cushion further downside in manufacturing activity (Chart 3). This is especially beneficial in a world where purchasing managers’ indices are declining everywhere. By the same token, the incentive for a central bank to raise rates when inflation is rising and the currency is more compelling, compared to a regime where a stronger currency tightens monetary conditions. Chart 4 shows that is weak is krona has been a fluid conduit for higher inflation in Sweden. A stronger krona will cap rising inflation expectations. Chart 3SEK Weakness Has Been A Welcome Relief Valve SEK Weakness Has Been A Welcome Relief Valve SEK Weakness Has Been A Welcome Relief Valve Chart 4SEK Weakness = High Imported Inflation SEK Weakness Equals High Imported Inflation SEK Weakness Equals High Imported Inflation It is remarkable that the traditional relationship between the SEK and oil prices (which is positive) has broken down (Chart 5). This is because rising oil prices usually reflect strong global demand, which benefits Sweden. This time around, a weak SEK is a tax on the economy as energy prices soar. Chart 5The Energy Shock To Sweden Has Been Unusual The Energy Shock To Sweden Has Been Unusual The Energy Shock To Sweden Has Been Unusual The Chinese credit impulse has bottomed, which is historically a good sign that Swedish central bankers can tolerate a stronger currency (Chart 6). Sweden’s biggest trade surplus is with the US, which in turn has the biggest trade deficit with China (Chart 7). As such, the relationship between the Swedish krona and the Chinese credit impulse is tightly knit. China’s zero COVID-19 policy is generating huge supply bottlenecks that are affecting inter-oceanic supply chains, but the pent-up demand once that ends could be tectonic. Chart 6The SEK Tracks The Chinese Credit Impulse The SEK Tracks The Chinese Credit Impulse The SEK Tracks The Chinese Credit Impulse Chart 7Sweden Needs The US And China Sweden Needs The US And China Sweden Needs The US And China The Riksbank’s mandate is to manage inflation expectations. Inflation is at 6%. The Riksbank’s own measure of resource utilization is at a level that has typically been associated with a much higher repo rate. The output gap is closing, raising the risk of a wage inflation spiral (Chart 8). Simply put, the Riksbank would have to raise interest rates or engender a crisis of confidence in monetary policy. Chart 8A Taylor Rule Approach Suggests Interest Rates Are Too Low A Taylor Rule Approach Suggests Interest Rates Are Too Low A Taylor Rule Approach Suggests Interest Rates Are Too Low Finally, house prices are surging to record highs, on the back of very low mortgage rates and extremely accommodative monetary policy (Chart 9). Chart 9Low Rates Have Led To A Debt Binge And Housing Boom Low Rates Have Led To A Debt Binge And Housing Boom Low Rates Have Led To A Debt Binge And Housing Boom A Potential Demand Boom The unemployment rate in Sweden remains above pre-pandemic levels. More importantly, it might rise in the coming quarters, but that would not be particularly worrisome. The reason is a potential increase in the labor dividend in Sweden, as new entrants increase the size of the labor force. First, the employment component of the manufacturing PMI index suggests employment growth should remain around 2% or so. There has been a tight correlation between employment growth in Sweden and the purchasing managers’ survey of the employment outlook (Chart 10). In our view, there is good reason to expect employment growth to remain resilient and in turn, stimulate demand. Related Report  Foreign Exchange StrategyThe Unsung Case For The Euro Sweden has a long history of openness towards immigration compared to many other European countries. If we go back to the Syrian crisis several years ago, the number of asylum seekers skyrocketed to over 160,000 or circa 1.5% of the total population (Chart 11). This was a huge labor dividend. This time around, migrants from both Ukraine and Russia will add to the skilled pool of domestic workers. Some estimates suggest there could be as many as 200,000 immigrants, just from the current crisis. This said, it will also increase frictional unemployment, as new migrants integrate into the labor force and adopt a new language. Chart 10Employment Is Holding Up In Sweden Employment Is Holding Up In Sweden Employment Is Holding Up In Sweden Chart 11There Is Potential For A Huge Labor Dividend There Is Potential For A Huge Labor Dividend There Is Potential For A Huge Labor Dividend Foreign-born workers have been rising as a share of the Swedish labor force and now constitute about 20% of the total population (Chart 12). This growth dividend will be reaped for years to come. With the Social Democrats in power, upside surprises to immigration numbers are within a reasonable confidence interval of outcomes. In a nutshell, Sweden enjoys a relatively positive demographic outlook (Chart 13). Chart 12Foreign Workers Are Important Foreign Workers Are Important Foreign Workers Are Important Chart 13Sweden Has A Demographic Dividend Sweden Has A Demographic Dividend Sweden Has A Demographic Dividend The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase of lower-paying jobs, there is still upward pressure on housing and consumption, notwithstanding a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 16.2%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. The difference this time is that inflation is surging, and the potential for cost-push pressures to translate into demand-pull inflation (via higher wages) is rising in Sweden. In our view, Governor Stefan Ingves will renormalize policy as quickly as possible, given that he is managing a small open economy with one of the cheapest currencies in the G10 universe, with a large footprint of imported inflation. Trading Strategy Chart 14The Riksbank Will Have To Raise Rates The Riksbank Will Have To Raise Rates The Riksbank Will Have To Raise Rates Our currency strategy is to buy the SEK on weakness. The recent dovish path by the ECB will mean that the Riksbank will tread very carefully in sounding too hawkish. However, every real-time indicator of its mandate suggests emergency policy settings are no longer necessary. Real rates are falling in Sweden relative to both the US and the euro area. As such, the SEK has not yet priced a shift in the Riksbank's policy setting. (Chart 14). This suggests that while the carry cost is high from being long the SEK at current levels, a capitulation phase will present investors with an opportunity to accumulate the SEK at a fire-sale price. As for Long EUR/SEK, the cross could overshoot, but will head lower on a 12–18-month horizon. Long SEK/CHF positions are also attractive.   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

Executive Summary The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Is A Recession Inevitable? Is A Recession Inevitable? Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones Is A Recession Inevitable? Is A Recession Inevitable? To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Is A Recession Inevitable? Is A Recession Inevitable? Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years The Fed's Estimate Of The Terminal Rate Has FalLen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Is A Recession Inevitable? Is A Recession Inevitable? Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Image Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) The Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) The Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Is A Recession Inevitable? Is A Recession Inevitable? Special Trade Recommendations Current MacroQuant Model Scores Is A Recession Inevitable? Is A Recession Inevitable?

Executive Summary Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Supply-chain disruptions arising from Russia's invasion of Ukraine and demand hits from lockdowns in Shanghai are increasing the odds of a global recession, which can be seen in the WTO's latest economic forecast. Cyclical base-metals demand, particularly copper's, will slow in a recession. Still, markets will remain physically short and well bid, as incremental demand from the global renewable-energy and defense buildouts gathers strength. Global GDP growth will return to trend in 2024. Renewables and defense-related demand will continue to power ahead. Physical deficits will persist. Copper-supply growth increasingly is tied to local political risk – e.g., Chile's government sued miners over water-use disputes this month. Miners now are seeking assurances investment will be protected before committing to higher capex. The environmental stain arising from the global competition for metals will redound to the benefit oil and gas E+Ps involved in natural gas and hydrogen production. Bottom Line: A higher likelihood of a global recession will not diminish the drive to secure base metals critical to renewables and defense, particularly copper. This will keep metals bid and inventories strained. Stagflation likely ensues. We remain long commodity-index exposure expecting longer-term backwardation, and ETFs with exposures to the equity of miners. We continue to expect copper prices to average $5/lb on the COMEX this year, and $6/lb in 2023. Feature The World Trade Organization (WTO) released a sharply lower expectation for global growth this week – from a robust 5.7% rate in 2021 to 2.8% this year and 3.2% next year.1 This effectively translates into a global recession arriving this year. The WTO forecast also calls for global merchandise trade volume to grow 3.0% in 2022 and 3.4% in 2023, which also will dampen cyclical aluminium demand. Related Report  Commodity & Energy StrategyCopper Will Grind Higher The WTO's forecast is one of the first among major agencies to incorporate the impact of the Ukraine war and supply-chain disruptions arising from lockdowns in Shanghai. If the WTO's forecast is realized, cyclical copper and base metals demand will slow, but markets will remain physically short – i.e., in deficit – and well bid, in our view (Chart 1). Incremental demand from the global renewable-energy and defense buildouts in the Big 3 military-industrial blocs – the EU, US and China – will gather strength and keep metals markets tight over the course of this decade (Chart 2). Chart 1Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Chart 2Copper Inventories Will Remain Tight Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Global refined copper demand is highly sensitive to GDP growth: While not exactly a 1-for-1 correspondence, a 1% increase in global GDP translates into a 0.76% increase in refined copper demand. A 1% increase in EM GDP translates into a 0.54% increase in refined copper demand in these economies (Chart 3). Interestingly, our modeling finds DM GDP growth has had little if any effect on global refined copper demand, most likely because, historically, DM economies were not building infrastructure to the extent EM economies, particularly China and the Asian Tigers, has been building over past decades. Chart 3World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand Estimating New Incremental Copper Demand The DM base metals demand profile – particularly for copper – is set to change dramatically following the Russian invasion of Ukraine. Russian aggression prompted the EU to double-down on its renewable energy build-out, and to restore a credible military to protect its borders and the safety of its citizens. Both of these efforts will be funded by new bond-issuance programs from the EU. Practically, this means the EU will join the US and Chinese military-industrial complexes in the global competition for critical materials required for the renewable-energy and defense buildouts. The EU and China already were active on the renewables side; it is the US that will be joining that race on a larger scale following the passage of legislation by the Biden administration to fund and incentivize renewables.2 The US and China have been in an intense competition to build military capacities; now the EU joins that race. None of these military-industrial complexes will provide actual spending estimates for these buildouts, which means markets have to continually revise their supply-demand estimates for base metals as data becomes available. Copper markets provide the best data for such an exercise – it is the bellwether market for base metals, with useful data to estimate supply and demand. As a starting point for our estimation of copper balances going forward, we assume global cyclical demand will remain a function of global GDP; EM demand also can be modelled using EM GDP as an explanatory variable. We also assume that the 10 years ending in 2030 will require refined copper production to double in order to meet demand for renewable-energy and from the military-industrial complex globally. We make some reasonable first approximations of what this will look like initially, and then will iterate as actual data becomes available. Chart 1 shows the evolution we expect for global consumption as a function of cyclical and incremental demand. On the supply side, we use estimated annual production for refined copper production from the Australian government's Department of Industry, Science, Energy and Resources, and the World Bureau of Metals Statistics. We note there are a few noteworthy projects due to come on line – e.g., Canada (Kena Gold-Copper project; Blue Cove Copper Project); Congo (Kamoa-Kakula project ramping up); Peru (Quellaveco) and Chile (Pampa Norte). We again note that copper supply in critically important states accounting for huge shares of global production – e.g., Chile (30% of global mining output) and Peru (10%) – increasingly is vulnerable to local political risks.3 Chile, in particular, is facing environmental and political challenges on the mining side: It is in the 13th year of a drought, which forced the government to institute water rationing in the capital Santiago this week. In addition, last week the federal government sued major mining companies over water-rights disputes. Our price view will evolve as we get data on cyclical and incremental demand, and supply additions.We would note in this regard major miners already are sounding the alarm on how difficult it will be to lift supply over the next 10 years given the likely demand markets will be pricing in. For now, we are maintaining our expectation COMEX copper prices will average $5/lb this year and $6/lb next year, and that markets will remain backwardated with inventories remaining under pressure (Chart 2).4 Investment Implications Base metals markets – copper included – are facing a moment of reckoning in terms of being able to support the global push for renewable energy. While the odds of a global recession in the wake of Russia's invasion of Ukraine and China's lockdowns to address the COVID-19 outbreak in Shanghai are higher – which ordinarily would point to inventory accumulation, all else equal – we believe markets will remain tight. A recession will cause cyclical demand to soften, which, along with marginal new supply, will keep the COMEX forward curve relatively flat over the short term (3-9 months). However, over the next two years and beyond, supply will not be coming on fast enough to offset cyclical and incremental demand from the global renewables and defense buildouts (Chart 3). This will keep copper markets in physical-deficit conditions, and inventories will have to draw to meet demand (Chart 4). We expect this will translate into renewed backwardation in the COMEX forward curve. Chart 4Global Inventories Will Continue To Draw Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 5Backwardation Will Re-emerge Backwardation Will Re-emerge Backwardation Will Re-emerge We remain bullish copper over the medium and longer terms, and remain long commodity index exposure expecting a return of backwardation in COMEX copper, and the XME ETF, which gives us exposure to base metals miners (Chart 5).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish US LNG exports hit record highs again in March, continuing a streak that began in December 2021. Exports averaged 11.9 Bcf/d for the month, on the back of new liquefaction capacity coming on line at the beginning of March. The US EIA is expecting LNG exports to average 12.2 Bcf/d this year, which would represent a 25% increase in shipments abroad. This US is accounting for the bulk of European LNG exports at present. European storage ended March at 26% of capacity, vs. a five-year average capacity of 34% at end-March. Separately, China became the largest importer of LNG in the world in 2021, displacing Japan for the top spot. According to the EIA, China’s LNG imports averaged 10.5 Bcf/d last year, which was close to 20% above 2020 levels. China's LNG imports exceeded Japan's , a 1.7 Bcf/d (19%) increase over its 2020 average, and 0.8 Bcf/d more than Japan’s imports. Base Metals: Bullish The Fraser Institute released a report assessing states’ and countries’ mining investment attractiveness for 2021. Investment attractiveness is measured by accounting for the mineral availability in the region and the effect of government policy on exploration investment. Western Australia topped the charts, while the copper-rich nations of Chile and Peru ranked 38th and 49th. This is telling of the policy adversity and uncertainty towards mining in these two countries and resonates with a BHP executive’s remarks a few weeks ago. Last week, the Chilean government sued mines operated by BHP, Albemarle, and Antofagasta over alleged environmental damage. One of the mines sued is BHP’s Escondida, the world’s largest copper mine. Precious Metals: Bullish According to Impala Platinum, palladium and rhodium prices are expected to rally for the next four-to-five years on tight market fundamentals. Low palladium supply coupled with an increase in the metal’s demand for catalytic converters, as pollution control regulations tighten, are causing the supply squeeze. On April 8 London’s Platinum and Palladium Market suspended Russian refiners from minting platinum and palladium for the London market, boosting the price of both metals (Charts 6 and 7). Russia supplies 10% and 40% of global mined platinum and palladium respectively. Depending on the period of the suspension, Europe may need to substitute Russian imports of the metals from South Africa. Chart 6 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 7 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession       Footnotes   1     Please see the WTO's "TRADE STATISTICS AND OUTLOOK: Russia-Ukraine conflict puts fragile global trade recovery at risk," released by the WTO on April 12, 2022. Revisions are subject to the evolution of the war in Ukraine following Russia's invasion in February 2022. 2     Worthwhile noting here the Biden Administration in the US invoked the Defense Production Act (DPA) to "to support the production and processing of minerals and materials used for large capacity batteries – such as lithium, nickel, cobalt, graphite, and manganese." In addition, the US Department of Defense will be tasked in implementing this authority. Lastly, the White House readout notes, "The President is also reviewing potential further uses of DPA – in addition to minerals and materials – to secure safer, cleaner, and more resilient energy for America." Practically, the US and China are treating access to critical materials as a defense issue. The EU likely joins this club in the very near future. 3    Please see our report from February 24, 2022 entitled Copper Will Grind Higher for additional discussion. It is available at ces.bcaresearch.com. 4    Please see, e.g., Bigger investment in mining needed to meet climate goals, says LGIM, published by ft.com on  April 5, 2022. The article summarizes a study done by Legal & General Investment and BHP, which notes that without a significant increase in mining activity – which is itself a hydrocarbon-intensive undertaking – there will not be sufficient supplies to achieve the IEA's 2050 net-zero goals.     Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image