Inflation/Deflation

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today ​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’  Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Go Long EUR/CHF Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2  Source: Bureau of Labor Statistics Fractal Trading System Fractal Trades The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary The Fed is in a tough spot. On the one hand, rising long-dated inflation expectations will incentivize it to tighten more quickly. On the other hand, the flat yield curve and poor risky asset performance point to a heightened risk of recession if it tightens too aggressively. The Fed will try to split the difference by lifting rates at a steady pace of 25 bps per meeting, starting this week. Though upside risks have increased, it remains likely that core inflation will peak within the next couple of months. This will allow the Fed to continue tightening at a steady pace, one that is already well discounted in the market. Monthly Core Inflation By Major Component A Soft Landing Is Still Possible A Soft Landing Is Still Possible Bottom Line: Investors should keep portfolio duration close to benchmark and favor yield curve steepeners. Corporate bond spreads will continue to widen in the near-term, but a buying opportunity will soon emerge. A Tough Spot For The Fed A lot has happened since we shifted our portfolio duration recommendation from “below benchmark” to “at benchmark” on February 15. The Russian invasion of Ukraine sent bond yields sharply lower the following week but yields have since recovered and are now close to where they were when we upgraded our duration view (Chart 1). That said, the round-trip in nominal yields masks some significant moves in the real and inflation components. The 10-year TIPS breakeven inflation rate is currently 2.98%, up from 2.45% on February 15, and the 5-year/5-year forward TIPS breakeven inflation rate has moved up to 2.38% from 2.05% (Chart 2). In the past two weeks we’ve also seen a further flattening of the yield curve (Chart 2, panel 3) and widening of credit spreads (Chart 2, bottom panel). Chart 2A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock Chart 1Round-Trip Round-Trip Round-Trip Taken together, recent market moves are consistent with a stagflationary shock. Long-dated inflation expectations are higher, but the yield curve is flatter and risk assets have sold off. This sort of environment is a complicated one for Fed policy. On the one hand, rising long-dated inflation expectations give the Fed a greater incentive to tighten quickly. On the other hand, rapidly tightening financial conditions increase the risk that the Fed may move too aggressively and push the economy into recession. So what’s the Fed to do? For now, it will try to split the difference. In practice, this means that the Fed will start tightening policy this week and proceed with a steady rate hike pace of 25 basis points per meeting. Once this process starts, we see two possible scenarios. The first possible scenario is that the Fed achieves its “soft landing”. A steady hike pace of 25 bps per meeting proves to be slow enough that financial conditions tighten only gradually, the yield curve retains its positive slope and inflation peaks within the next couple of months, halting the upward trend in long-dated inflation expectations. This benign scenario is still more likely than many people appreciate. For starters, the bond market is already priced for close to seven 25 basis point rate hikes this year, the equivalent of one 25 bps hike per meeting (Chart 3). This means a 50 bps hike at some point this year is required for the Fed to deliver a hawkish surprise to near-term expectations. In our view, a 50 bps hike is unlikely unless long-dated inflation expectations continue to move higher and become obviously “un-anchored”. If inflation peaks within the next couple of months, in line with our base case outlook, then so will long-dated expectations. Chart 3Rate Expectations Rate Expectations Rate Expectations The second possible scenario is that we see no near-term relief on the inflation front. Global supply chains remain disrupted by the war in Ukraine and surging COVID cases in China, and commodity prices continue their upward march. This would initially lead to even higher long-dated inflation expectations and an even faster pace of expected Fed tightening. It could even lead to a 50 bps Fed rate hike at some point, though we think it’s more likely that it would lead to an inverted yield curve and a severe tightening of financial conditions (i.e. sell off in equities and credit markets) before the Fed even gets the chance to deliver a 50 bps hike. Investment Implications The “soft landing” scenario remains our base case view. The Fed will start tightening in line with current market expectations and core inflation will peak within the next couple of months, keeping long-dated inflation expectations in check. Related Report  US Investment StrategyQ&A On Ukraine, Financial Markets And The Economy The correct investment strategy for this outcome is to keep portfolio duration close to benchmark and to favor a 2/10 yield curve steepener (buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note). Not only is the front-end of the bond market fully priced for a steady hike pace of 25 bps per meeting, but the 5-year/5-year forward Treasury yield is close to median survey estimates of the long-run neutral fed funds rate. This suggests that the upside in long-dated bond yields is limited (Chart 4). As for the yield curve, assuming that the Fed’s well-discounted steady pace of tightening is unlikely to invert the curve, then it makes sense to grab the extremely attractive yield pick-up available in the 2-year note versus a duration-matched cash/10 barbell (Chart 5). Chart 4Close to Fair Value Close to Fair Value Close to Fair Value Chart 5A Huge Yield Pick-Up In Steepeners A Huge Yield Pick-Up In Steepeners A Huge Yield Pick-Up In Steepeners The investment implications of our second “un-anchored inflation expectations scenario” are more difficult to game out. However, we think the most likely outcome is that bond yields would rise initially, driven by inflation expectations, and then plunge once the yield curve inverts and it becomes clear that the Fed will be forced to tighten the economy into recession. This is not our base case scenario, but investors with a 6-12 month investment horizon who wish to position for this outcome should probably extend portfolio duration rather than shorten it. The 2022 Inflation Outlook A key pillar of the “soft landing” scenario described above is that core inflation peaks within the next couple of months and starts to head lower in H2 2022. Today, we’ll assess the likelihood of that occurring by looking at the three main components of core CPI inflation: goods, shelter, and services (excluding shelter). The first fact to consider is that month-over-month core CPI has printed between 0.5% and 0.6% in each of the past five months, almost matching the extreme inflation readings seen between April and June 2021 (Chart 6). If month-over-month core inflation continues to print at 0.5%, then year-over-year core CPI will drop between March and June before rising again to reach 6.3% by the end of the year (Chart 7). Conversely, if month-over-month core inflation declines to 0.3%, then year-over-year core inflation will fall steadily to 4.2% by the end of 2022. Chart 6Monthly Core Inflation By Major Component A Soft Landing Is Still Possible A Soft Landing Is Still Possible Chart 7Annual Inflation Annual Inflation Annual Inflation These two outcomes likely have different implications for policy and markets. The world where core inflation remains sticky above 6% probably coincides with expectations of rapid Fed tightening, a near-term inversion of the yield curve and rising expectations of recession. Conversely, the world where core inflation falls to 4.2% by the end of 2022 and appears to be on a downward trend probably coincides with well-contained inflation expectations and a steady pace of Fed tightening. We therefore want to know which of these outcomes is more likely. To do that we consider the outlooks for core inflation’s three main components. 1. Core Goods Chart 8Goods Inflation Goods Inflation Goods Inflation Goods have been the main driver of elevated inflation during the past year, especially the new and used car segments (Chart 8). Prior to the pandemic, core goods inflation tended to fluctuate around 0%. Currently, the year-over-year rate is up around 12%. We view a significant decline in core goods inflation as highly likely this year. First off, used car prices – as measured by the Manheim Used Vehicle Index – have already moderated (Chart 8, panel 2), while other measures of supply bottleneck pressures like the ISM manufacturing supplier deliveries and prices paid indexes are rolling over, albeit from high levels (Chart 8, panel 3). Reduced demand should also ease some of the upward pressure on goods prices this year. Consumer spending on goods dramatically overshot its pre-COVID trend during the past two years (Chart 8, bottom panel) as spending on services was often not possible. With US COVID restrictions on the verge of being completely lifted, some spending is likely to shift away from goods and towards services in 2022. The recent news of a surging omicron COVID wave in China and renewed lockdown measures already in place in Shenzhen province may delay the re-normalization of supply chains. As of yet, we think it’s premature for this to alter our view. The omicron experience of other countries suggests that the wave will be quick and that restrictions will not be as severe as in past COVID waves.  2. Shelter Shelter is the largest component of core CPI and it is also the most tightly correlated with the economic cycle. That is, it tends to accelerate when economic growth is trending up and the unemployment rate is falling, and vice-versa. Shelter faces two-way risk in 2022. The upside risk comes from private measures of asking rents and home prices that have already surged. The Zillow Rent Index is up 15% during the past 12 months and the Zillow Home Price Index is up 20% (Chart 9A). Recent research has shown that these private measures tend to feed into core CPI with a lag of about one year.1 The downside risk to shelter inflation this year comes from the economic cycle itself. Chart 9B shows that there is a tight correlation between shelter inflation and the unemployment rate, and between shelter inflation and aggregate weekly payrolls (employment x hours x wages). The unemployment rate’s rapid 2021 decline will not persist this year. The labor market is nearing full employment and last year’s fiscal impulse has faded. Chart 9BShelter Inflation II Shelter Inflation II Shelter Inflation II Chart 9AShelter Inflation I Shelter Inflation I Shelter Inflation I Netting it all out, we think shelter inflation will continue to trend higher for the next few months but will eventually level-off near the end of this year as economic growth slows. 3. Core Services (excluding Shelter) Services inflation printed an extremely strong 0.55% month-over-month in February, though a large portion of that increase was driven by pandemic-related services like airfares and admission to events, increases that will moderate now that the omicron wave has passed. More fundamentally, wage growth is the key driver of services inflation, and it has been extremely strong. The Atlanta Fed’s Wage Growth Tracker is up to 4.3% year-over-year, its highest since 2002, and it is showing signs of broadening out to wage earners of all levels (Chart 10). Though we see wage growth remaining strong, its acceleration is also likely to moderate in the coming months. The Census Bureau’s most recent Household Pulse Survey showed that almost 8 million people were absent from work in February because they were either sick with COVID themselves or caring for someone with COVID symptoms (Chart 11). Near-term wage demands will moderate during the next few months as the pandemic ebbs and these people return to work. Chart 10Wage Growth Is Strong Wage Growth Is Strong Wage Growth Is Strong Chart 11Covid Still Weighing On Labor Supply Covid Still Weighing On Labor Supply Covid Still Weighing On Labor Supply We also must grapple with the possible deflationary fall-out from the recent energy and gasoline price shock. Real household incomes are declining (Chart 12A), and while consumers have ample room to either tap their savings or increase debt to support spending (Chart 12B, top panel), the recent plunge in consumer sentiment suggests that they may behave more cautiously (Chart 12B, bottom panel). Chart 12AReal Incomes Are Falling Real Incomes Are Falling Real Incomes Are Falling Chart 12BConsumer Confidence Is Low Consumer Confidence Is Low Consumer Confidence Is Low Putting It Together We could see core goods inflation falling all the way back to a monthly rate of 0% this year. This would be consistent with its pre-pandemic level, but also wouldn’t incorporate any outright price declines – which are also possible. If we additionally assume some further acceleration in Owner’s Equivalent Rent and Rent of Primary Residence, to 0.6% per month, and a slight pullback in services inflation to a still-strong 0.3% per month, then overall core CPI inflation would hit a monthly rate of 0.34%, consistent with annual core CPI inflation of 4.2%. We think this is a reasonable forecast though we see risks to the upside driven by another bout of supply chain pressures in manufactured goods. In general, we expect year-over-year core CPI inflation to reach a range of 4% to 5% by the end of this year. That would be consistent with the “soft landing” scenario described earlier in this report. Corporate Bonds: Waiting For A Buying Opportunity To Emerge Chart 13Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation Finally, a quick update on our corporate bond allocation. Corporate bonds have sold off sharply versus Treasuries since February 15. The investment grade corporate bond index has underperformed a duration-equivalent position in Treasury securities by 217 bps while High-Yield has underperformed by a less dramatic 120 bps. With economic risks high and the Fed on the cusp of a tightening cycle, we think further spread widening is likely in the near-term. However, if the “soft landing” scenario described earlier in this report pans out, then we will soon see a buying opportunity in corporate bonds. The 12-month quality-adjusted breakeven spread for the investment grade corporate index has risen close to its historical median, from near all-time expensive levels only a few months ago (Chart 13). While a flat yield curve poses a risk to corporate bond returns, wide spreads may soon become too attractive to ignore. Table 1A shows average historical 12-month investment grade corporate bond excess returns given different starting points for the 3-year/10-year Treasury slope and the 12-month corporate breakeven spread. Table 1B shows 90% confidence intervals for those average returns and Table 1C shows the percentage of instances in which excess returns were above 0%. Table 1AAverage 12-Month Future Investment Grade Corporate ##br##Bond Excess Returns* (BPs) A Soft Landing Is Still Possible A Soft Landing Is Still Possible Table 1B90 Percent Confidence Interval Of 12-Month Investment Grade Corporate Bond Excess Returns* (BPs) A Soft Landing Is Still Possible A Soft Landing Is Still Possible Table 1CPercentage Of Episodes With Positive 12-Month Investment Grade Corporate Bond Excess Returns* A Soft Landing Is Still Possible A Soft Landing Is Still Possible At present, the 3-year/10-year Treasury slope is +9 bps and the 12-month breakeven spread is 18 bps. Historically, this sort of environment is consistent with positive excess corporate bond returns 59% of the time, but with a negative average return overall. That said, if the yield curve retains its positive slope, then a further 18 bps of corporate index spread widening would push the 12-month breakeven spread above the 20 bps threshold. The historical record suggests that this would be an unambiguous buy signal. Bottom Line: We are sticking with our recommended 6-12 month corporate bond allocations for now. We are neutral (3 out of 5) on investment grade and overweight (4 out of 5) on high-yield. A yield curve inversion and heightened risk of recession would cause us to turn more cautious, but we think it’s more likely that widening spreads present us with an opportunity to upgrade our corporate bond allocations within the next few months. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.frbsf.org/economic-research/publications/economic-letter/2022/february/will-rising-rents-push-up-future-inflation/ Treasury Index Returns Spread Product Returns Recommended Portfolio Specification A Soft Landing Is Still Possible A Soft Landing Is Still Possible Other Recommendations A Soft Landing Is Still Possible A Soft Landing Is Still Possible

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge... …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts The German Stock Market Is Several Weeks Ahead Of Analysts The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts The US Stock Market Is Several Weeks Ahead Of Analysts The US Stock Market Is Several Weeks Ahead Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... US Profits Multiplied By The 30-Year Bond Price... US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market ...Equals The US Stock Market ...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... German Profits Multiplied By The 7-Year Bond Price... German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market ...Equals The German Stock Market ...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies When Stock Markets Sell Off, The Dollar Rallies When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile The Extreme Rally In Crude Oil Is Fractally Fragile The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound Biotech Is Starting To Reverse Biotech Is Starting To Reverse US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Greece’s Brief Outperformance To End Greece Is Snapping Back Greece Is Snapping Back Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Vladimir Putin has now committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. Assuming he succeeds, and it is far from obvious that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. If Putin concludes that he has no future, the risk is that he will decide that no one else should have a future either. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday Argument. Even if World War III is ultimately averted, markets could experience a freak-out moment over the next few weeks, similar to what happened at the outset of the pandemic. Google searches for nuclear war are already spiking. Despite the risk of nuclear war, it makes sense to stay constructive on stocks over the next 12 months. If an ICBM is heading your way, the size and composition of your portfolio becomes irrelevant. Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective. Bottom Line: The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon. All In on Sanctions In the criminal justice system, there is a reason why the punishment for armed robbery is lower than for murder. If the punishment were the same, an armed robber would have a perverse incentive to kill his victim in order to better conceal his crime. The same logic applies, or at least used to apply, to geopolitics: You do not impose maximum sanctions from the get-go because that removes your ability to influence your enemy with the threat of further sanctions. Following Russia’s invasion of Ukraine, the West chose to go all in on sanctions, levying every type imaginable with the exception of those entailing a big cost to the West (such as cutting off Russian energy exports). Most notably, many Russian banks have been blocked from the SWIFT messaging system while the Russian central bank’s foreign exchange reserves have been frozen. Even FIFA has barred Russia from international competition, just weeks before it was set to participate in the qualifying rounds of the 2022 World Cup. At this point, there is not much more that can be done on the sanctions front. This leaves military intervention as the only avenue available to further pressure Russia. A growing chorus of Western pundits, some of whom could not have picked out Ukraine on a map two weeks ago, have begun clamoring for regime change… this time, in Moscow. As one might imagine, this is not something that sits well with Putin. Last week, he declared that “No matter who tries to stand in our way or … create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history.” To ensure there was no uncertainty about what he was talking about, he proceeded to place Russia’s nuclear forces on “special regime of combat duty.” Yes, It’s Possible The Putin regime has used nuclear weapons of a sort in the past. The FSB likely orchestrated the poisoning of Alexander Litvinenko with polonium-210 in 2006, leaving traces of the radioactive substance scattered in dozens of places across London. As former US presidential advisor and Putin biographer Fiona Hill said in a recent interview with Politico, “Every time you think, “No, he wouldn’t, would he?” Well, yes, he would.” Admittedly, there is a big difference between dropping polonium into a cup of tea at the Millennium hotel in Mayfair and dropping a 10-megaton nuclear bomb on London or any other major Western city. Still, if Putin feels that he has no future, he may try to take everyone down with him. The collapse in the ruble, and what is sure to be a major plunge of living standards across Russia, could foment internal opposition to Putin. A quiet retirement is not an option for him. Based on the latest exchange rates, Russia’s GDP is smaller than Mexico’s and barely higher than that of Illinois (Chart 1). While denying gas to Europe is a very real threat, it has a limited shelf life. Europe will aggressively build out infrastructure to process LNG imports. Chart 1Russia's Economic Power Has Faded Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse In a few years, the one viable weapon that Russia will have at its disposal is its nuclear arsenal. As Dutch historian Jolle Demmers has said, “It is precisely the decline and contraction of Russian power, coupled with the possession of nuclear weapons and a tormented repressive president, that poses great risks.” Some of the world’s most prominent strategic thinkers flagged these risks before the invasion, but with little effect. The Mother of All Risks In simulated war games, it is generally difficult to get participants to cross the nuclear threshold, but once they do, a full-blown nuclear exchange usually ensues.1 The idea of “limited” nuclear war is a mirage.  How high are the odds of such a full-blown war? I must confess that my own feelings on the matter are heavily colored by my writings on existential risk. As I argued in Section XII of my special report, “Life, Death, and Finance in the Cosmic Multiverse,” we are probably greatly understating existential risk, especially when we look prospectively into the future. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday argument (See Box 1). A Paradox for Investors For investors, existential risk represents a paradoxical concept. If an ICBM is heading your way, the question of whether you are overweight or underweight stocks would be pretty far down on your list of priorities. And even if you were inclined to think about your portfolio, how would you alter it? In a full-blown global nuclear war, most stocks would go to zero while governments would probably be forced to default or inflate away their debt. Gold might retain some value – provided that you kept it in your physical possession – but even then, you would still have trouble exchanging it for anything of value if nothing of value were available to purchase. This means that from a purely financial perspective, you should largely ignore existential risk, even if you do care greatly about it from a personal perspective. What, then, can we say about the current market environment? I touched on many of the key issues in Monday’s Special Alert, in which we tactically downgraded global equities from overweight to neutral. I encourage readers to consult that report for our latest market views. In the remainder of today’s report, allow me to elaborate on a couple of key themes. A Freak-Out Moment Is Coming Chart 2Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse The market today reminds me of early 2020. We wrote a report on February 21 of that year entitled “Markets Too Complacent About The Coronavirus,” in which we noted that a full-blown pandemic “could lead to 20 million deaths worldwide,” and that “This would likely trigger a global downturn as deep as the Great Recession of 2008/09, with the only consolation being that the recovery would be much more rapid than the one following the financial crisis.” Many saw that report as alarmist, just as they saw our subsequent decision to upgrade stocks in March as cavalier.  Even if you knew in February 2020 that the S&P 500 would reach an all-time high later that year, you should have still shorted equities aggressively on a tactical basis. I feel the same way about the present. Google searches for nuclear war are spiking (Chart 2). A freak-out moment is coming, which will present a good buying opportunity for investors. Just to be on the safe side, I picked up a couple of bottles of Potassium Iodide earlier this week. When I checked the pharmacy again yesterday, all the bottles were sold out. They are now being hawked on Amazon for ten times the regular price. From Cold War to Hot Economy? The spike in commodity prices – especially energy prices – will have a negative near-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes (Chart 3). In general, inflation expectations and oil prices move together (Chart 4).   Chart 3Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place   Chart 4Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Assuming the geopolitical situation stabilizes in a few months, oil prices should come down. The forward curve for oil is heavily backwardated now: The spot price for Brent is $111/bbl while the December 2022 price is $93/bbl (Chart 5). BCA’s commodity strategists expect the price of Brent oil to fall to $88/bbl by year-end. The decline in energy prices should provide some relief to global growth and risk assets in the back half of the year, which is one reason we are more constructive on equities over a 12-month horizon than a 3-month horizon. Looking out beyond the next year or two, the new cold war will lead to higher, not lower, interest rates. Increased spending on defense and alternative energy sources will prop up aggregate demand, especially in Europe where the need to diversify away from Russian gas is greatest. As Chart 6 shows, capex in the euro area cratered following the euro debt crisis. Capital spending via the Recovery Fund and other sources will rise significantly over the next few years. Chart 5The Brent Curve Is Heavily Backwardated Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Chart 6European Capex Is Poised To Increase European Capex Is Poised To Increase European Capex Is Poised To Increase In addition, the shift to a multipolar world will expedite the retreat from globalization. Rising globalization was an important force restraining inflation – and interest rates – over the past few decades. Lastly, the ever-present danger of war could prompt households to reduce savings. It does not make sense to save for a rainy day if that day never arrives. Lower savings implies a higher equilibrium rate of interest. As we discussed in our recent report entitled “A Two-Stage Fed Tightening Cycle,” after raising rates modesty this year, the Fed will resume hiking rates towards the end of 2023 or in 2024, as it becomes clear that the neutral rate in nominal terms is closer to 3%-to-4% rather than the 2% that the market assumes. The secular bull market in equities will likely end at that point. In summary, equity investors should be somewhat cautious over the next three months, more optimistic over a 12-month horizon, but more cautious again over a longer-term horizon of 2-to-5 years. Box 1The Doomsday Argument In A Nutshell Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1     For example, an article from the Center for Arms Control and Non-Proliferation discusses a Reagan administration war game called “Proud Prophet,” an exercise the Americans hatched to test the theory of limited nuclear strikes. The result of this exercise was that the “Soviet Union perceived even a low-yield nuclear strike as an attack, and responded with a massive missile salvo.” Global Investment Strategy View Matrix Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Special Trade Recommendations Current MacroQuant Model Scores Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Every Shock Is Always Supplanted By A New Shock Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The Economy Is Becoming Less Energy-Intensive The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform When Bond Yields Decline, Banks Underperform When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End The Recent Outperformance Of Banks May Soon End The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Alternative Electricity Is Rebounding From An Oversold Position Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Bitcoin's Support Is Holding Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral The Russian invasion of Ukraine is a stagflationary shock that comes at a difficult time for developed market central banks that have been laying the groundwork for a tightening cycle. We tactically upgraded our recommended duration exposure in the US to neutral last week, as the market was pricing in too much Fed tightening in 2022. We are doing similar upgrades in non-US government bonds this week for the same reason. We are maintaining our cyclical country allocations, however, as those remain in line with interest rate pricing beyond 2022. We are underweight markets where terminal rate expectations remain too low (the US, UK & Canada) and overweight countries where markets are discounting too many rate hikes in 2023/24 (Germany, Japan, Australia). In light of the instability caused by the Russian invasion of Ukraine, we are reducing weightings in our model bond portfolio to credit sectors highly exposed to the war - European high-yield and emerging market hard currency debt. Bottom Line: The Ukraine war comes at a time when global growth momentum was already starting to roll over and with global inflation momentum set to peak soon. Upgrade duration exposure to neutral from underweight in global bond portfolios. Feature Among the tail risks that investors contemplated in their planning for 2022, World War III was likely not ranked too highly on the list. The horrific images of the Russian invasion of Ukraine – and the sharp response of the West to isolate Russia through unprecedented economic and financial sanctions - have shocked global financial markets that had been focused on relatively mundane concerns like the timing of interest rate hikes. BCA sent a short note to all clients late last week that discussed the investment implications of the invasion for several asset classes. In this report, we consider the bond market ramifications of war in Eastern Europe. Our main conclusion is that the Ukraine situation will produce a brief “stagflationary” shock that will boost global inflation and slow global growth, on the margin. High energy prices will be the main driver of that stagflation, given the uncertainties over the availability of Russian oil and natural gas supplies (Chart 1). Tighter financial conditions - beyond what has already occurred so far this year as global equity and credit markets have sold off (Chart 2) – will also contribute to the moderation of the pace of global growth. Chart 1A Mild Inflationary Shock From The Russian Invasion A Mild Inflationary Shock From The Russian Invasion A Mild Inflationary Shock From The Russian Invasion ​​​​​​ Chart 2The Ukraine War Is Adding To 2022 Risk-Off Trends The Ukraine War Is Adding To 2022 Risk-Off Trends The Ukraine War Is Adding To 2022 Risk-Off Trends ​​​​​​ The stagflation shock should be relatively short, perhaps 3-6 months. BCA’s Commodity & Energy Strategy service expects OPEC to eventually supply more oil to the global market – a move that was already likely before the Russian invasion – helping to reduce the Russian supply premium in oil prices. Putin will likely have to be satisfied with claiming eastern Ukraine rather than being stuck in a protracted battle with fierce Ukrainian resistance while Russia suffers under crippling sanctions. BCA’s Geopolitical Strategy service does not expect the conflict to spread beyond Ukraine’s borders, as neither Russia nor NATO have an interest in war with each other (despite the nuclear saber-rattling by Russian President Putin in response to Western sanctions). A mild bout of stagflation will only delay, and not derail, the cyclical move towards tighter global monetary policies in response to elevated inflation and tightening labor markets, particularly in the US. This will take some of the upward pressure off global bond yields as central banks will be less hawkish than expected in 2022, but does not change the outlook for higher bond yields in 2023 and 2024. In terms of changes to our fixed income investment recommendations, and the allocations to our Model Bond Portfolio, we come to the following three conclusions. Upgrade Tactical Non-US Duration Exposure To Neutral We recently upgraded our recommended tactical duration exposure in the US to neutral, with the Fed likely to deliver fewer rate hikes this year than what is discounted by markets. The Ukraine situation makes it even more likely that the Fed will underwhelm expectations. A 50bp rate hike at the March FOMC meeting is now off the table, as the equity and credit market selloffs in response to the conflict have tightened US (and global) financial conditions on the margin. However, the war is not enough of a negative shock to US growth to derail the Fed from starting a gradual tightening process this month with a 25bp hike. Our decision to change our US duration stance was largely predicated on a view that US inflation will soon peak and slow significantly over the rest of 2022. However, there is a strong case to increase non-US duration exposure, as well. Our Global Duration Indicator - comprised of leading cyclical growth indicators and which itself leads the year-over-year change in our “Major Countries” GDP-weighted aggregate of 10-year government bond yields by around six months - peaked back in February 2021 (Chart 3). The Global Duration Indicator is now at a “neutral” level consistent with more stable bond yield momentum. Declines in the ZEW economic expectations survey in the US and Europe, and in our global leading economic indicator, are the main culprits behind the fall in the Global Duration Indicator (Chart 4). Chart 3Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral ​​​​​​ Chart 4Growth Expectations Have Turned Less Bond Bearish ... For Now Growth Expectations Have Turned Less Bond Bearish ... For Now Growth Expectations Have Turned Less Bond Bearish ... For Now ​​​​​ While the ZEW series have rebounded in the first two months of 2022, which could set the stage for a move back to higher yields later this year, the Ukraine situation will likely hurt economic expectations (particularly in Europe) in the near-term. We expect our Global Duration Indicator to continue signaling a more neutral backdrop for global bond yields over the next few months. In our Model Bond Portfolio on pages 13-14, we are expressing our view change by increasing the duration for all countries such that the overall duration of the portfolio is in line with the custom benchmark index (7.5 years). Importantly, we view this as only a tactical view change for the next few months, as developed economy interest rate markets are still discounting too few rate hikes – and in some countries like the UK and US, actual rate cuts – in 2023/24 (Chart 5). Chart 5Priced For Short, Shallow Hiking Cycles Priced For Short, Shallow Hiking Cycles Priced For Short, Shallow Hiking Cycles Maintain Cyclical Government Bond Country Allocations That Favor Lower Inflation Regions Chart 6Oil Is Inflationary Now, Will Be Disinflationary Later Oil Is Inflationary Now, Will Be Disinflationary Later Oil Is Inflationary Now, Will Be Disinflationary Later While we are neutralizing our global duration stance over a tactical time horizon (0-6 months), we are sticking with our current recommended cyclical (6-18 months) government bond country allocations. These are based on underlying inflation trends and the expected monetary policy response over the next couple of years. As noted earlier, BCA’s commodity strategists expect oil prices to fall from current war-elevated levels in response to increased supply from OPEC. The benchmark Brent oil price is forecasted to reach $88/bbl at the end of this year and $87/bbl and the end of 2023. The result will be a sharp decline in the year-over-year growth rate of oil prices that will help bring down headline inflation in all countries (Chart 6). Lower energy inflation, however, will not be the only factor reducing overall inflation across the developed world. Goods price inflation should also slow from current elevated levels over the next 6-12 months, as consumer spending patterns shift away from goods towards services with fewer pandemic-related restrictions on activity. Less goods spending will help ease some of the severe supply chain disruptions that have fueled the surge in global goods price inflation over the past year. That process has likely already begun – indices of global shipping costs have peaked and supplier delivery times have been shortening according to global manufacturing PMI surveys. The shift from less goods spending towards more services spending will lead to trends in overall inflation being determined more by services prices than goods prices. The central banks in countries that have higher underlying inflation, as evidenced by faster services inflation, will be under more pressure to tighten policy over the next couple of years. Therefore, our current cyclical recommended country allocations (and our Model Bond Portfolio weightings) within developed market government bonds reflect the relative trends in services inflation. We are currently recommending underweights in the US, UK and Canada where services inflation is currently close to 4%, well above the central bank 2% inflation targets (Chart 7). At the same time, we are recommending overweights in core Europe (Germany and France) and Australia, where services inflation is around 2.5%, and Japan where services prices are deflating (Chart 8). Chart 7Higher Underlying Inflation In Our Recommended Underweights Higher Underlying Inflation In Our Recommended Underweights Higher Underlying Inflation In Our Recommended Underweights ​​​​​​ Chart 8Lower Underlying Inflation In Our Recommended Overweights Lower Underlying Inflation In Our Recommended Overweights Lower Underlying Inflation In Our Recommended Overweights ​​​​​​ Chart 9Faster Wage Growth In Our Recommended Underweights Faster Wage Growth In Our Recommended Underweights Faster Wage Growth In Our Recommended Underweights The trends in services inflation are also reflected in wage growth in those same groups of countries – much higher in the US, UK and Canada compared to Australia, the euro area and Japan (Chart 9). We expect these relative trends to continue over the next 12-24 months, with higher underlying inflation pressures forcing the Fed, the Bank of England (BoE) and the Bank of Canada (BoC) to be much more hawkish, on a relative basis, than the European Central Bank (ECB), the Reserve Bank of Australia (RBA) and the Bank of Japan (BoJ). Our current bond allocations not only fit with underlying inflation trends, but also with market-based interest rate expectations. In Table 1, we show the pricing of interest rate expectations over the next few years, taken from Overnight Index Swap (OIS) forwards. We show the OIS projection for 1-month interest rates 12 months from now and 24 months from now. We also include 5-year/5-year forward OIS rates as a measure of market expectations of the terminal rate, a.k.a. the peak central bank policy rate over the next tightening cycle. In the table, we also added neutral policy rate estimates taken from central bank sources.1 Table 1Medium-Term Interest Rate Expectations Still Too Low In The US & UK Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World In the US and UK, the OIS rate projections two years out, as well as the 5-year/5-year forward rate, are below the range of neutral rate estimates. This justifies an underweight stance on both US Treasuries and UK Gilts with both the Fed and BoE now in tightening cycles. In Japan and Australia, the OIS projections are already within the range of neutral rate estimates, but the RBA and, especially, the BoJ are not yet signaling a need to begin normalizing the level of policy rates. This justifies an overweight stance on Australian government bonds and Japanese government bonds. In the euro area, OIS projections are below the range of neutral rate estimates, but the ECB is now signaling that any monetary tightening actions will need to be delayed because of the growth uncertainties stemming from the Ukraine conflict and high energy prices. Thus, an overweight stance on core European government debt is still warranted. In Canada, the OIS projections are within the range of neutral rate estimates, but the BoC has been preparing markets for a series of rate hikes. This makes our underweight stance on Canadian government bonds a more “mixed” call, although we remain confident that Canadian bonds will underperform in a global bond portfolio context versus European and Japanese government bonds. In sum, we see our recommended country allocations as the most efficient way to express our cyclical (medium-term) central bank views, given the strong link between forward interest rate expectations and longer-term bond yields (Chart 10). This is why we are not making changes to our country allocation recommendations alongside our move to tactically upgrade our global duration stance to neutral. Chart 10Too Much Tightening Priced Over The Next Year Too Much Tightening Priced Over The Next Year Too Much Tightening Priced Over The Next Year ​​​​​ Chart 11Bond Markets Not Priced For A Relatively More Hawkish Fed Bond Markets Not Priced For A Relatively More Hawkish Fed Bond Markets Not Priced For A Relatively More Hawkish Fed ​​​​​ Given our high-conviction view that markets are underestimating how high the Fed will need to lift interest rates in the upcoming tightening cycle – likely more than any other major developed economy central bank - positioning for US Treasury market underperformance on a 1-2 year horizon still looks like an attractive bet with forward rates priced for little change in US/non-US bond spreads (Chart 11). A wider US Treasury-German Bund spread remains our highest conviction cross-country spread recommendation. Reduce Spread Product Exposure In Europe & Emerging Markets Chart 12Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs The geopolitical uncertainty stemming from the Ukraine war and the stagflationary near-term impact of high energy prices are negatives for all risk assets, on the margin. That leads us to tactically reduce the allocation to spread product to neutral versus government debt in our Model Bond Portfolio. We are implementing this by cutting allocations to riskier fixed income sectors that are most impacted by the Russia/Ukraine conflict – European high-yield corporate debt and emerging market (EM) USD-denominated hard currency debt (Chart 12). We had already been cautious on EM debt before the Russian invasion, with an underweight allocation to both USD-denominated sovereigns and corporates, so the latest moves just increase the size of the underweight. European high-yield, on the other hand, had been one of our highest conviction overweight positions – particularly versus US high-yield - entering 2022. However the Ukraine war is likely to have a bigger negative impact on the European economy than the US economy, thus we are cutting our recommended exposure to European high-yield only. The uncertainty of a war on European soil, combined with the spike in energy prices (especially natural gas), is negative for European growth momentum, reducing 2022 euro area real GDP growth by as much as 0.4 percentage points according to ECB estimates. This raises the hurdle for any ECB monetary tightening this year. An early taper of bond buying in the ECB’s Asset Purchase Program, an outcome that ECB officials claim is a required precursor to rate hikes, is now highly unlikely. Fears of reduced ECB bond buying had weighed on the relative performance of Italian government bonds last month, but a more dovish ECB policy stance should lead to lower Italian yields and a narrowing of the BTP-Bund spread (bottom panel). We continue to recommend a cyclical overweight stance on Italian government debt. A Final Thought We need to reiterate that the recommended changes made in this report – increasing global duration exposure to neutral and cutting EM and European high-yield – are over a tactical time horizon, largely in response to the Ukraine conflict. This is more of a “risk management” exercise, rather than a change in our fundamental cyclical views. We still believe global growth will remain above trend in 2022 and likely 2023, which will prevent a complete unwind of last year’s inflation surge, particularly in the US. We expect global bond yields to begin climbing again later this year and into 2023, and we envision an eventual return to a below-benchmark duration stance.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The sources of the neutral rate estimates are listed in the footnotes of Table 1. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades

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

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing Global Inflation Pressures Easing Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak ​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply ​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions ​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive ​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Tactical Overlay Trades

Executive Summary While inflation has unquestionably surprised to the upside, the US will not enter a self-reinforcing spiral unless an inflation mindset takes hold throughout the economy. The two leading surveys have wildly different takes on consumer confidence. The available evidence sides with the Conference Board’s robust reading rather than the University of Michigan’s dismal one. We are not concerned about housing’s near-term outlook. There is an undersupply of homes in America and mortgage rates have not backed up enough to put a meaningful dent in demand. Financial markets are jumpy and will likely remain hypersensitive to speculation about the Fed’s policy choices. We nonetheless continue to favor risk assets over the next twelve months and will look out for tactical buying opportunities whenever volatility is on the cusp of easing. Consumers Aren't Chasing High Prices And That's A Good Sign Consumers Aren't Chasing High Prices And That's A Good Sign Consumers Aren't Chasing High Prices And That's A Good Sign Bottom Line: The ride is likely to be bumpy for financial markets this year, but we expect it will ultimately be rewarding. Growth will hold up despite recurring fears. Feature Our recent discussions with colleagues and investors indicate that US financial market participants are preoccupied with one of three issues: a potential inflation breakout, a slowdown induced by a consumption shortfall or, worse yet, both. We add to our thoughts on inflation and consumption after digging into some less-watched series, and check in on the housing market following the surge in mortgage rates. Our conclusion remains unchanged: we still expect potent growth in 2022, and we think investors should maintain at least equal weight exposures to risk assets. Amidst elevated volatility brought on by Fed uncertainty, however, investors should be willing to act more opportunistically. Consumers Are Not Adding Fuel To The Fire … We have spoken repeatedly about the inflation mindset, a concept lifted from Japan’s ongoing experience with chronic stagnation. The malaise ailing Japan is in large part attributable to the deflation mindset that has swept consumers, businesses and investors. Economic participants conditioned to expect continuously falling prices change their behavior to adapt to them, so consumers have put off discretionary purchases, anticipating that goods will be cheaper (and better) next year; businesses confronting steadily falling revenue have shunned investment in favor of shrinking their cost bases to preserve profit; and investors have been willing to funnel capital to the lowest-yielding sovereign bonds in the world, content with meager purchasing power accretions. The central theorem of macroeconomics – my spending is your income and your spending is my income – has sentenced the economy to quietly wither in a self-reinforcing loop. Conversely, we believe an inflation mindset in which economic actors expect continually rising prices is a necessary precondition for an upward inflation spiral. The spiral is stoked by a chain reaction of worker and investor demands for increased compensation, wholesale and retail price hikes, and consumers’ rush to maximize their declining purchasing power by buying ahead of the next inevitable increase. Despite all the inflation agita, Treasury investors are untroubled about its long-run prospects, as their 5-year inflation expectations five years from now remain below the bottom end of the Fed’s target range (Chart 1). The hedgers, speculators and market makers who compose the CPI swaps market are also serene (Chart 2). Though all parties see intense price pressures lasting for another year, they expect them to dissipate over time (Table 1). Chart 1Long-Run Inflation Expectations Are Subdued, ... Long-Run Inflation Expectations Are Subdued, ... Long-Run Inflation Expectations Are Subdued, ... Chart 2... Despite Big Near-Term Swings It All Depends On Whom You Ask It All Depends On Whom You Ask Per the University of Michigan’s sentiment survey, consumers also anticipate that near-term inflation pressures will fade in the intermediate term (Chart 3). They are consequently wary about making large purchases at a price they’ll later come to regret. Viewing today’s high prices as temporary, they think it is a historically inopportune time to buy cars, houses and large household durables. Their responses suggest that the inflation mindset has yet to make any headway with consumers; for now, there is no danger that shoppers harbor inflation fears that could become self-fulfilling. Table 1The Inflations Expectations Curve Is Sharply Inverted It All Depends On Whom You Ask It All Depends On Whom You Ask Chart 3Survey Says: Temporary! Survey Says: Temporary! Survey Says: Temporary! The share of respondents citing sticky/rising prices as a reason for buying cars now is at very low levels (Chart 4, top panel) while those citing high prices as a reason not to buy continues to make record highs (Chart 4, middle panel). The spread between the two has never been wider (Chart 4, bottom panel) – a sizable majority of consumers with discretion over when they buy is committed to waiting out the conditions that have sent prices zooming higher. Chart 4Resisting A Spiral Resisting A Spiral Resisting A Spiral Michigan respondents have been on the right side of chronically deflating new car prices, as those who think prices won’t come down have been nearly continuously outnumbered for the last 40 years (Chart 5, bottom panel). Since vehicle buying conditions became a regular survey component, there have been only three stretches when consumers reported a net urgency to buy, all of which coincided with real increases in new car prices (Chart 5, top panel). The chart is silent on the direction of causality, though we would suspect that consumer urgency follows from observed price increases, which it then amplifies and/or extends. Chart 5Just Say No Just Say No Just Say No The Michigan surveyors also ask consumers about the timeliness of buying houses and major household durables. Charts for houses (not shown) and durables (Chart 6) look much like cars, though the Good-Won’t Come Down/Bad-Prices Are High spread for houses is as persistently negative as it is for cars (ex-the 2012 to 2015 recovery from the aftermath of the housing bust). Consumer demand for the biggest-ticket items is apparently more elastic than it is for major appliances. Chart 6Consumers Aren't Chasing Household Durables Prices Higher,Either Consumers Aren't Chasing Household Durables Prices Higher,Either Consumers Aren't Chasing Household Durables Prices Higher,Either Bottom Line: Consumers are disinclined to go along with surging prices on big-ticket items. An inflationary spiral will not take hold while they are committed to putting off major purchases with the expectation that they will get a better deal in the future. … But Could They Be Losing Their Nerve? Consumers’ discipline has positive inflation implications, but the bombed-out vehicle buying conditions chart in the Executive Summary could be sending a worrisome growth signal. Foregone spending is lost income, and if enough buyers defer purchases, a recession could be just around the bend. True enough, but investors should keep in mind that the buying conditions indexes measure demand urgency, not overall demand. Those with discretion over the timing of their purchases may be holding off, but American consumers are not turning Japanese. Surging home and new and used car prices eloquently testify to fierce competition among buyers. We do not therefore see cause for concern in the diverging consumer confidence surveys. Over time, the indexes produced by the Conference Board and the University of Michigan have tended to send similar messages (Chart 7). The relationship has frayed over the last five years, however, and the two series completely diverged last spring. That would be of no more than passing interest if the composite average of both surveys’ expectations component had not formerly been such a reliable coincident indicator of real consumption growth (Chart 8). Chart 7Parting Company Parting Company Parting Company Chart 8The Confidence-Consumption Link Has Been Severed The Confidence-Consumption Link Has Been Severed The Confidence-Consumption Link Has Been Severed Investors may wonder whether consumption will take its lead from the Conference Board’s cheer or Michigan’s gloom. The Conference Board survey consists of just five questions asking respondents to assess current business and employment conditions and offer their six-month expectations about business conditions, employment conditions and their family’s income. The more extensive Michigan survey runs to twelve full pages, touching on business conditions; personal finances; economic policy; unemployment, interest-rate, inflation and home-price expectations; and buying conditions for homes, household durables and motor vehicles. A layperson reading through the Michigan survey might think it was designed to provoke anxiety in unsuspecting respondents – what are the chances your income will keep pace with inflation, that you or your spouse will involuntarily lose a job over the next five years, that you will have enough money for retirement, etc. – but its readings are not uniformly bleak. Since the financial crisis, it has tended to be cheerier than the Conference Board survey when inflation is low or negative while its relative nosedive has coincided with inflation’s breakout (Chart 9). The relationship would logically follow from the Michigan survey’s explicit focus on inflation and one’s personal relation to it. The Conference Board survey is linked much more closely to perceptions of the job market (Chart 10) and it may therefore be expected to lag during disinflationary/deflationary periods but outperform when inflation accelerates. Chart 9The Michigan Survey Is Sensitive To Inflation, ... The Michigan Survey Is Sensitive To Inflation, ... The Michigan Survey Is Sensitive To Inflation, ... Chart 10... While The Conference Board's Tracks Strength In The Labor Market ... While The Conference Board's Tracks Strength In The Labor Market ... While The Conference Board's Tracks Strength In The Labor Market Bottom Line: Given the robust growth outlook, we are inclined to side with the Conference Board’s upbeat consumer confidence reading. We do not expect that flush households with pent-up demand will turn into misers. The 2,400-Square-Foot Gorilla Chart 11Level Trumps Direction Level Trumps Direction Level Trumps Direction The sharp backup in mortgage rates so far this year has many observers concerned about the potential consequences of a housing slowdown. A major slump would idle construction workers, pressure housing industry suppliers, and dampen demand for the furnishings and major appliances that fill homes. We think the concerns are overdone and believe that the housing market will be well supported through the rest of the year. Affordability concerns come back to the level-versus-direction debate that has flared ever since real economic growth began to decelerate from its torrid 6.5% pace in the first half of last year. 3% or 4% is nothing to sneeze at for an economy with a long-run trend growth rate of 1.75 – 2%, however. Deceleration from an extremely high level to a very high level still leaves room for ample corporate earnings gains and risk assets duly delivered chunky excess returns across last year’s second half. 30-year fixed mortgage rates have risen 100 basis points from their pandemic low but remain extremely low relative to history (Chart 11, middle panel). As a result, homes remain quite affordable (Chart 11, top panel), despite the relative increase in median home prices (Chart 11, bottom panel). The horizontal line across the affordability series puts its level into a fuller context. Except for a few years in the early seventies, when the median home price was just two-and-a-half times median household income, affordability never exceeded 140 before the global financial crisis ushered in zero interest rate policy. A supply shortfall will bolster the market. Household formations have outstripped housing starts by a wide margin over the last two years (Chart 12, top panel) and available inventory (Chart 12, middle panel) and vacant units (Chart 12, bottom panel) are at all-time lows. Homebuilder sentiment is firing on all cylinders (Chart 13, top panel), as current sales are strong (Chart 13, second panel), buyer traffic remains elevated (Chart 13, third panel) and future sales expectations are rosy (Chart 13, bottom panel). Chart 12There Isn't Enough Supply ... There Isn't Enough Supply ... There Isn't Enough Supply ... ​​​​​​ Chart 13... And Builders Know It ... And Builders Know It ... And Builders Know It ​​​​​​ Bottom Line: Despite the backup in mortgage rates and twelve months of turbo-charged home price appreciation, housing will do just fine this year. A slump weighing on employment and activity is not in store. Investment Implications 2022 has so far been characterized by the serial emergence of issues that have roiled financial markets. Rising rates/falling tech stocks, impending Fed rate hikes, persistent upside inflation surprises and Ukraine have combined to push the VIX into the 20s and 30s, knock the S&P 500 down 9% and drive losses in Treasuries and spread product. We expect that concerns about Fed policy, growth and inflation will linger throughout the year and across the entirety of the Fed’s rate hiking cycle, waxing and waning with the news and data flow. Our base case is that 2022 growth will be quite strong, boosted by avid consumption and investment underpinned by savings and wealth gains, easy monetary conditions, and a tight job market. We expect that stout macro fundamentals will support earnings gains and that a dearth of alternatives to equities that can be expected to generate positive inflation-adjusted returns will keep earnings multiples elevated. If the mildness of Omicron variant infections points to a future in which COVID-19 becomes no more than a nuisance, global growth will get an additional fillip and some supply-chain pressures should ease, allowing inflation to come off the boil. While we reiterate our constructive view on financial markets and the economy, however, we do not expect a smooth ride to our year-end destination. Most investors lack first-hand experience managing against an inflation backdrop that has not been in place since the early ‘80s and volatility will likely be elevated as they find their footing. We are therefore adopting a more tactical perspective, seeking out opportunities to exploit temporary volatility, and we advise that clients consider shortening timeframes and increasing turnover to the extent their individual mandates will allow it. We do not think that the major inflection point marked by a shift from accommodative to restrictive monetary policy settings will arrive until the second half of 2023 at the earliest, but the run-up to it will likely be bumpy.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com