Inflation/Deflation

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… The Business Cycle Drives Earnings... The Business Cycle Drives Earnings... Chart 2…Earnings In Turn Drive Stock Prices… ...Earnings In Turn Drive Stock Prices... ...Earnings In Turn Drive Stock Prices... An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party A Long House Party A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock The Aging Capital Stock The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright Chart 19Need More Houses Need More Houses Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Mo' Debt Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market Special Trade Recommendations Current MacroQuant Model Scores The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US A Growth Rotation Away From The US A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar US Dollar US Dollar Chart 5BUS Dollar US Dollar US Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Euro Euro Chart 6BEuro Euro Euro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Japanese Yen Japanese Yen Chart 7BJapanese Yen Japanese Yen Japanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound British Pound British Pound Chart 8BBritish Pound British Pound British Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Australian Dollar Australian Dollar Chart 9BAustralian Dollar Australian Dollar Australian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 10BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Canadian Dollar Canadian Dollar Chart 11BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Swiss Franc Swiss Franc Chart 12BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Norwegian Krone Norwegian Krone Chart 13BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Swedish Krona Swedish Krona Chart 14BSwedish Krona Swedish Krona Swedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Risk Premium In EU Gas Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase ​​ Regardless of whether Russia invades all, part of or none of Ukraine again, its current standoff with the West will force the EU to reconfigure its gas markets to assure reliability of supplies, and remove geopolitical supply disruptions. We expect the EU's renewable energy taxonomy scheduled for release Wednesday will include natgas as a sustainable fuel, which will help build more diversified sources of supply and deeper spot and term markets.  Success here will increase market share of natgas in EU power generation. In the short run (1-2 years), neither the EU nor Russia can afford Gazprom's pipeline supplies to be significantly curtailed. Over the medium term (3-5 years), alternative supplies from US and Qatari LNG exports will be required to deepen EU gas-market liquidity and supply. Longer term (i.e., beyond 2025), EU energy markets will remain volatile as the renewable-energy transition progresses. High and volatile natgas prices will translate into persistent EU inflation – particularly food prices, because of higher fertilizer costs, and base metals' prices.  Shortages in these markets will slow the energy transition, and raise its price tag. Bottom Line: The Russian standoff with the West over Ukraine puts a higher risk premium in EU gas prices.  We remain long commodity-index exposure (S&P GSCI, and COMT ETF), and the XME ETF.  We are getting long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) at tonight's close. Feature We expect the EU's financial taxonomy for renewable energy scheduled for release Wednesday will include natgas as a sustainable fuel. This will help in building out more diversified sources of supply and deeper spot and term markets. Success here will increase the market share of natgas in the EU's power generation (Chart of the Week). This coincides with natural gas supply uncertainty, arising from geopolitical tensions. On the back of already-low inventory levels, European natural gas markets are forced to handicap the odds of a major curtailment of Russian pipeline gas supplies resulting from another invasion of Ukraine (Chart 2).  This is keeping a significantly increased risk premium embedded in natgas prices: Russian exports to the EU account for 40% of total gas supplies.  Germany is particularly exposed, as  ~65% of its gas comes from Russia (Chart 3). Chart of the WeekEU Natgas Generation Will Rise In Energy Transition Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase BCA’s Geopolitical Strategy desk upgraded the odds of Russia invading Ukraine to 75% from 50% in its latest research report.1  Our colleagues, however, keep the probability of Russia invading all of Ukraine low.  Their analysis concludes Russia will only invade a part of Ukraine, so as to argue for lighter sanctions being imposed on it by the West, as opposed to having to incur the full wrath of US and EU sanctions.  The other 25% of the probability space includes a diplomatic settlement between the West and Russia. Chart 2Risk Premium In EU Gas Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase While Russia has been trying to diversify its customer base – by increasing natgas exports to China, e.g. – data from the BP Statistical Review of World Energy shows ~ 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020.2  Chart 3EU Highly Dependent On Russian Gas Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase In light of the fact that Russia likely will face watered-down sanctions, and the EU’s gargantuan share of total Russian exports, we do not believe Europe’s largest natural gas exporter will stop all supply to the EU now or in the near future. In case Russia does go through with its invasion, it likely will cut off natural gas supply to Ukraine, implying Europe will loose slightly more than 6% of total natgas imports as opposed to 40% in the event of a halt to all natgas exports to Europe (Chart 4).  Gas consumption of the EU-27 in 2021 was ~ 500 Bcm, according to the Oxford Institute For Energy Studies (OIES).  Some 85% of EU gas consumption was met by imports. Chart 4Imports Cover Most EU Gas Consumption Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Can The EU Mitigate The Loss Of Russian Gas? The EU and the US have entered discussions with other countries to plug the potential 6% reduction in imports from Russia.  While in theory, there is enough spare pipeline capacity to import natural gas from existing and new sources (Chart 5), practical limitations may prevent this from occurring.3 The US is working with the EU to ensure energy supply security in case Russia cuts off natural gas supply. However, as can be seen in Chart 6, Panel 1, the US currently is and likely will continue to export nearly at capacity until end-2023. Panel 2 shows global liquefaction also is nearly at capacity. Chart 5EU Gas Import Capacity Exists, But Filling It Will Be Problematic Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Chart 6US LNG Export Capacity Maxed Out Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase While an increase in gas production at the earthquake-prone Groningen field in the Netherlands is theoretically viable, it will induce a public backlash, as was evidenced when the Dutch government announced plans to double output from the field earlier this year. In the short run, facing few sources of alternate gas supply, the EU will need to focus on curtailing demand. Fossil fuels will need to be considered as an alternative for electricity and heating, since nuclear is not used in all EU countries.  The depth of this crisis and the Dutch TTF price rise will be capped by the fact that we expect the EU to lose a relatively small fraction of total imports.  Further, while we expect Dutch TTF prices to be volatile and face upward pressure, any price increases also will be capped by the fact that the colder-than-expected Northern Hemisphere winter has not yet materialized, and the warmer Spring and Summer months will be approaching soon. Medium-, Long-Term EU Gas Supply On the supply side, over the medium- and long-term, the EU will need to deepen and stabilize its gas supply, so that firms and households can rationally forecast and allocate spending and investment.  This would include finding back-up or alternative supplies to Russian imports, which carry with them uncertain geopolitical risk.  If Brussels includes natural gas as a sustainable fuel in its energy taxonomy, over the medium term (3-5 years), alternative supplies from US and Qatari LNG exports will be required to deepen EU gas-market liquidity and supply.  Longer term (i.e., beyond 2025), EU energy markets will remain volatile as the renewable-energy transition progresses.  Natgas will be a critical component of this transition, until utility-scale battery storage is able to support renewable generation and grid stability.  We believe over the remainder of this decade, high and volatile natgas prices will translate into persistent EU inflation, as pricing pressures spill into oil and coal markets at the margin, as happened over the course of last year.  This will work in the other direction as well – e.g., higher coal prices will spill over into gas and oil markets as price pressures incentivize fuel switching at the margin. Food prices will be right in the inflationary cross-hairs, given the fertilizer required to produce the grains and beans consumed globally consists mostly of natgas in urea and ammonia fertilizers (Chart 7).  This will feed into higher food prices (Chart 8). Chart 7High Natgas Prices Will Show Up In High Fertilizer Prices High Natgas Prices Will Show Up In High Fertilizer Prices High Natgas Prices Will Show Up In High Fertilizer Prices Chart 8… And Higher Food Prices Long-Term EU Gas Volatility Will Increase Long-Term EU Gas Volatility Will Increase Base metals' prices also will be upwardly biased as natgas price volatility remains elevated.  Supply shortages in natgas markets will, at the margin, slow the energy transition by reducing reliable energy supplies in the EU, forcing states to compete for back-up and replacement supply in the global LNG markets.  Fuel-switching into oil, gas and coal will transmit EU gas volatility to markets globally. Tight energy and base metals markets also will feed directly into higher inflation and inflation expectations (Chart 9). Chart 9Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher   Investment Implications The standoff between the West and Russia over the latter's amassing of troops on the Ukraine border, plus the marked increase in the tempo of Russian naval operations, will keep the risk premium in EU natgas prices high.  This is not a sustainable equilibrium over the medium- to long-term.  We expect little if any curtailment of Russian natgas exports over the short term; however, prudence suggests EU member states will be forced to find back-up and alternative gas supplies over the medium- to longer-term, as the global renewable-energy transition gains traction. The knock-on effects from the current European geopolitical standoff are keeping EU natgas prices elevated via a higher risk premium to cover possible supply losses.  This will feed into other markets – particularly metals and ags – which will feed directly into inflation and inflation expectations. We remain long commodity index exposure – the S&P GSCI and the COMT ETF – and metals producers via the XME ETF.  At tonight's close, we will be getting long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0's decision to stay with its policy of returning 400k b/d every month appeared to be a foregone conclusion in the markets.  In our January 2022 balances and price forecasts, we anticipated a larger increase, given the producer coalition led by Saudi Arabia and Russia has fallen significantly behind its goal of returning 400k b/d to the market monthly due to declining production among OPEC 2.0 member states ex-Gulf GCC member states, chiefly KSA, UAE and Kuwait (Iraq's exports fell in December and January; production data have not been released).  In the past, KSA has said it will not make up for production shortfalls of OPEC 2.0 member states, and would abide by its production allocation. The upside risk to prices remains, in our estimation, and we continue to expect KSA and its GCC allies to increase output if production from the price-taking cohort led by the US shale-oil producers fails to materialize in over the coming months.  Failure to cover production shortfalls among OPEC 2.0 member states would lift Brent prices by $6/bbl above our baseline forecast, which assumed higher production from the GCC states would be forthcoming at Wednesday's OPEC 2.0 meeting (Chart 10, brown curve). Base Metals: Bullish An environmental committee in Chile's Senate voted out a proposed bill that would, among other things, reportedly make it easier for the government to seize mines developed and operated by private companies.  The proposed legislation still has a long road ahead of it, but copper prices rallied earlier in the week as this news broke.  Even if the odds of the bill's passage are slim, a watered down version of the proposed legislation would markedly change the economic proposition of developing and maintaining copper mines in Chile (Chart 11).  We continue to follow this closely.   Chart 10 Brent Forecast Restored To $80/bbl For 2022 Brent Forecast Restored To $80/bbl For 2022 Chart 11 Bullish For Copper Prices Bullish For Copper Prices     Footnotes 1     Please see All Bets Are Off ... Well, Some (A GeoRisk Update), published by BCA Research's Geopolitical Strategy service 27 January 2022.  It is available at gps.bcaresearch.com. 2     Please see bp's Statistical Review of World Energy 2021 | 70th edition. 3    Norway, the EU’s second largest gas exporter after Russia stated that its natural gas production is at the limit. Apart from the issue of production, current LNG flows will need to be redirected from Asia and the Americas. Defaulting on long-term contracts to redirect fuel to Europe could mire exporters’ relationships with importing countries. Finally,  infrastructure in the Eastern and Central section of the EU may not be equipped to receive supplies from the West, thus increasing costs and time associated with putting these systems in place.    Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast series ‘Where Is The Groupthink Wrong?' I do hope you can join. Executive Summary Spending on goods is in freefall while spending on services is struggling to regain its pre-pandemic trend.  If spending on goods crashes to below its previous trend, then there will be a substantial shortfall in demand. The good news is that the freefall in goods spending is leading inflation. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year. Underweight the goods-dominated consumer discretionary sector, and underweight semiconductors versus the broader technology sector. Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Overbought base metals are particularly vulnerable. Fractal trading watchlist: We focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Bottom Line: As spending on goods crashes back to earth, so will inflation, consumer discretionary stocks, semiconductors, and overbought commodities. Feature The pandemic has unleashed a great experiment in our spending behaviour. After a binge on consumer goods, will there be a massive hangover? We are about to find out. The pandemic binge on consumer goods, peaking in the US at a 26 percent overspend, is unprecedented in modern economic history. Hence, we cannot be certain what happens next, but there are three possibilities: We sustain the binge on goods, at least partly. Spending on goods falls back to its pre-pandemic trend. There is a hangover, in which spending on goods crashes to below its previous trend. The answer to this question will have a huge bearing on growth and inflation in 2022-23. After The Binge Comes The Hangover… The pandemic’s constraints on socialising, movement, and in-person contact caused a slump in spending on many services: recreation, hospitality, travel, in-person shopping, and in-person healthcare. Nevertheless, with incomes propped up by massive stimulus, we displaced our spending to items that could be enjoyed within the pandemic’s confines; namely, goods – on which, we binged (Chart I-1). Chart I-1Spending On Goods Is In Freefall Spending On Goods Is In Freefall Spending On Goods Is In Freefall Gradually, we learned to live with SARS-CoV-2, and spending on services bounced back. At the same time, we made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping. Additionally, a significant minority of people changed their behaviour, shunning activities that require close contact with strangers – going to the cinema or to amusement parks, using public transport, or going to the dentist or in-person doctors’ appointments. The result is that spending on services is levelling off well short of its pre-pandemic trend (Charts I-2-Chart I-5). Chart I-2Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Chart I-3Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Chart I-4Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Chart I-5Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Arithmetically therefore, to keep overall demand on trend, spending on goods must stay above its pre-pandemic trend. Yet spending on goods is crashing back to earth. The simple reason is that durables, by their very definition, are durable. Even nondurables such as clothes and shoes are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can binge on before reaching saturation. Indeed, to the extent that our bingeing has brought forward future purchases, the big risk is a period of underspending on goods. Countering The Counterarguments Let’s address some counterarguments to the hangover thesis. One counterargument is that some goods are a substitute for services: for example, eating-in (food at home) substitutes for eating-out; and recreational goods substitute for recreational services. So, if there is a shortfall in services spending, there will be an automatic substitution into goods spending. The problem is that the substitutes are not mirror-image substitutes. Spending on eating-in tends to be much less than on eating-out. And once you have bought your recreational goods, you don’t keep buying them! A second counterargument is that provided the savings rate does not rise, there will be no shortfall in spending. Yet this is a tautology. The savings rate is simply the residual of income less spending. So, to the extent that there is a structural shortfall in services spending combined with a hangover in goods spending, the savings rate must rise – as it has in the past two months. A third counterargument is that the war chest of savings accumulated during the pandemic will unleash a tsunami of spending. Well, it hasn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-6). Chart I-6Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending The explanation comes from a theory known as Mental Accounting Bias. This points out that we segment our money into different ‘mental accounts’. And that the main factor that establishes whether we spend our money is which mental account it resides in. The moment we move money from our ‘income’ account into our ‘wealth’ account, our propensity to spend it collapses. Specifically, we will spend most of the money in our ‘income’ mental account, but we will spend little of the money in our ‘wealth’ mental account. Hence, the moment we move money from our income account into our wealth account, our propensity to spend it collapses. Still, this brings us to a fourth counterargument, which claims that even though the ‘wealth effect’ is small, it isn’t zero. Therefore, the recent boom in household wealth will bolster growth. Yet as we explained in The Wealth Impulse Has Peaked, the impact of your wealth on your spending growth does not come from your wealth change. It comes from your wealth impulse, which is fading fast (Chart I-7). Chart I-7The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked Analogous to the more widely-used credit impulse, the wealth impulse compares your capital gain in any year with your capital gain in the preceding year. It is this change in your capital gain – and not the capital gain per se – that establishes the growth in your ‘wealth effect’ spending. Unfortunately, the wealth impulse has peaked, meaning its impact on spending growth will not be a tailwind. It will be a headwind. As Spending On Goods Crashes Back To Earth, So Will Inflation, Consumer Discretionary Stocks, And Overbought Commodities In the fourth quarter of 2021, US consumer spending dipped to below its pre-pandemic trend and the savings rate increased. Begging the question, how did the US economy manage to grow at a stellar 6.7 percent (annualised) rate? The simple answer is that inventory restocking contributed almost 5 percent to the 6.7 percent growth rate. In fact, removing inventory restocking, US final demand came to a virtual standstill in the second half of 2021, growing at just a 1 percent (annualised) rate. Growth that is dependent on inventory restocking is a concern because inventory restocking averages to zero in the long run, and after a massive positive contribution there tends to come a symmetrical negative contribution. If, as we expect, spending on services fails to catch up to its pre-pandemic trend while spending on goods falls back to its pre-pandemic trend, then there will be a demand shortfall. And if there is a hangover, in which spending on goods crashes to below its previous trend, then the demand shortfall could be substantial. As inflation crashes back to earth, so will overbought commodities. The good news is that the freefall in durable goods spending is leading inflation. In this regard, you might be surprised to learn that the US core (6-month) inflation rate has already been declining for five consecutive months. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year (Chart I-8). Chart I-8As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Given that the level (rather than the inflation) of commodity prices is irrationally tracking the inflation rate, the likely explanation is that investors have piled into commodities as a hedge against inflation. Hence, as inflation crashes back to earth, so will overbought commodities (Chart I-9). Overbought base metals are particularly vulnerable. Chart I-9Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Fractal Trading Watchlist This week we focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. To reiterate, overbought base metals are vulnerable, and the 70 percent outperformance of nickel versus silver through the past year has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2016, 2018, and 2020 (Chart I-10). Accordingly, this week’s recommended trade is to go short nickel versus silver, setting the profit target and symmetrical stop-loss at 20 percent.  Chart I-10Short Nickel Versus Silver Short Nickel Versus Silver Short Nickel Versus Silver A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell EUR/CZK At A Bottom EUR/CZK At A Bottom EUR/CZK At A Bottom Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... 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      

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Asian Inflation Has Diverged From US Emerging Asia: Domestic Bond Strategy Emerging Asia: Domestic Bond Strategy Inflation has been largely subdued in emerging Asia and will remain so for now. This argues for the outperformance of emerging Asian local bonds versus their EM peers, as well as DM/US bonds.   The most important macro driver of Asian domestic bond yields is inflation. Rising inflation usually also hurts local currencies – creating a toxic cocktail for bonds’ total returns in US dollar terms. Diverging currency dynamics in emerging Asia is what will determine the relative performances of individual bond markets. Chinese, Indian, and Malaysian currencies have a better outlook than currencies in Indonesia, Thailand and the Philippines. Book profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021. Recommendation   Initiation Date Return to Date Short KRW / Long USD 2021-03-25 5.2% Bottom Line: Regional fixed income managers should overweight China, Korea, India and Malaysia, and underweight Indonesia, Thailand and the Philippines within an emerging Asian bond portfolio. In an overall EM domestic bond portfolio however, Thailand and the Philippines should be accorded a neutral allocation, given their better inflation outlook compared to their peers in EMEA and Latin America. Feature US Treasury yields will likely go up further. If history is any guide, EM Asian bond yields should also rise in tandem (Chart 1). The basis is that business cycles in Asia and the US usually move together. Yet, in this cycle, inflation in emerging Asia has diverged considerably from that of the US. US core consumer price inflation has surged while in Asia, core inflation remains largely contained (Chart 2). How should bond investors position themselves in Asian domestic bond markets? Chart 1Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Asian Bond Yields Usually Move In Line With US Treasury Yields... Chart 2...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds ...But Diverging Inflation Means Asian Bonds Will Outperform US Bonds Chart 3Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets Relative Domestic Bond Performances In Asian Markets In this report, we will discuss some of the common factors that drive Emerging Asian bond markets. We will also highlight each individual market’s idiosyncrasies to explain our recommended allocation across local currency bond markets in emerging Asia for the coming year.     Our recommended allocation is as follows: China, Korea, India and Malaysia merit an overweight stance in an emerging Asia domestic bond portfolio, while Indonesia, Thailand, and the Philippines warrant an underweight allocation (Chart 3). That said, given a much more benign inflation outlook in Asia than elsewhere in EM, we recommend that Thailand and the Philippines be accorded a neutral allocation in an overall EM domestic bond portfolio. The Two Drivers For international investors in local bonds, total returns are predicated on two main drivers: (1) the direction and magnitude of change in bond yields; and (2) currency performance. In all Asian countries, the most potent macro factor that drives local bond yields is the country’s inflation. Rising inflation is usually a harbinger of higher bond yields (and hence, worsening bond performance); and falling inflation is an indicator of lower yields (Charts 4 and 5). Chart 4Inflation Is The Most Important Macro Driver … Inflation Is The Most Important Macro Driver... Inflation Is The Most Important Macro Driver... Chart 5… Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia ... Of Bond Yields In Emerging Asia What’s more, rising inflation in a country is also often associated with a depreciating currency. Currencies in countries with higher/rising inflation in general do worse than in countries with lower/falling inflation. This aspect is especially important when doing a cross-country comparison. The fact that higher inflation negatively impacts both the drivers of bond performance – it pushes up yields and weakens the currency – can indeed be seen happening in Asian financial markets. Rising inflation leads to poor performance of domestic bonds’ total return in dollar terms; and falling inflation leads to a better performance. The upshot is that the potential inflation trajectory is key to any country’s domestic bond performance in both absolute and relative terms. Inflation In Asia Is Benign Most of the Asian countries have their core and trimmed mean consumer price inflation running at or well below their central banks’ targets (Charts 6 and 7). Their inflation outlook also remains largely benign.1 As such, bond yields in these countries are unlikely to rise materially in the near future. Chart 6Inflation Is Running At Or Below … Inflation Is Running At Or Below... Inflation Is Running At Or Below... Chart 7… Central Banks’ Target in Asia ... Central Banks' Target in Asia ... Central Banks' Target in Asia Notably, even the recent surge in US yields did not spook Asian bond yields. The yield differentials between individual Asian domestic and US yields have remained flattish in the past few months. All this implies that Asian domestic bonds, in general, would likely fare better relative to the rest of the EM and the US – where inflation is high and well above their central banks’ targets. Currency Is A Key Differentiator Given inflation, and therefore the bond yield trajectories among Asian economies are unlikely to deviate significantly from one another, the key differentiator of their bond market performance (on a total return basis) will be their exchange rates. In fact, Asian currencies do vary considerably in their outlooks as their fundamentals differ.  For instance, in China and Korea, higher bond yields are usually associated with an appreciating currency (Chart 8, top and middle panels). The key driver of bond yields in these economies is the business cycle. Accelerating growth often pushes up both the currency as well as interest rates. The opposite is also true: decelerating growth usually leads to a weaker currency and falling bond yields.  The consequence is that in these countries, bond performance is tempered by two opposing forces. For example, the effect of falling yields (which is a positive for total return) is often mitigated by the effect of a falling currency (which is a negative for total return), or the other way around. In contrast to China and Korea, ASEAN countries usually experience rising bond yields accompanied by a depreciating currency (Chart 9). A crucial reason for this is significantly higher foreign ownership of their domestic bonds. In periods of stress, when foreigners exit their bond holdings, this leads to both higher yields and a falling currency. During risk-on periods, foreigners’ purchases do the opposite. Chart 8Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Higher Bond Yields Coincide With A Stronger Currency In China And Korea Chart 9Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN Higher Bond Yields Coincide With A Weaker Currency In ASEAN In this context, foreign ownership of domestic bonds in ASEAN countries has fallen in the past few years, but remains non-trivial: 19% in Indonesia, 24.2% in Malaysia, 19.9% in the Philippines, and 11.3% in Thailand. Hence, the currency view on ASEAN countries is crucial to get the outlook right for their domestic bond performance. Incidentally, Thailand, the Philippines and Indonesia have a weak currency outlook, while Malaysia’s is neutral. We discuss the individual currency outlooks in more detail in the respective country sections below. But in summary, this warrants a more positive stance on Malaysian domestic bonds compared to Indonesian, Thai and Filipino bonds. Finally, in case of India, bond yields and the rupee have little correlation (Chart 8, bottom panel). The main reasons for that are near absence of foreign investors in Indian government bond markets, and large captive domestic bond investors (its commercial banks). Yet, unlike China and Korea, India also has higher inflation and a persistent current account deficit. All these make the correlation of bond yields with the exchange rate different in India from both ASEAN as well as China and Korea. In the sections below, we discuss each country’s currency and overall bond outlook in more detail. We also explain the reasons behind our relative bond strategy. China: Overweight Chart 10Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More Chinese Bond Yields Will Likely Fall More China’s economy will remain weak in the coming months. The hit to the economy from slowing property construction is material. Besides, COVID-induced rotational lockdowns are hurting consumption, income and investment in the service sector. The latest round of stimulus has so far not been sufficient to produce an immediate recovery. We expect growth to revive only in H2 2022. For now, the PBOC will reduce its policy rate further. This and the fact that the yield curve is positively slopped heralds more downside in Chinese government bond yields (Chart 10). Concerning the exchange rate, the ongoing US dollar rally could eventually cause a short period of yuan weakness. However, the latter will be small and short lived. In brief, Chinese domestic bonds will outperform both their Asian and EM peers in the coming months. Korea: Overweight The following factors argue for overweighting Korean bonds within both emerging Asian and EM domestic bond portfolios: Chart 11Korea Has No Genuine Inflation Korea Has No Genuine Inflation Korea Has No Genuine Inflation The Korean won has already depreciated quite a bit against the US dollar. While further downside is possible in the very near term, the medium-term outlook is positive. Even though headline and core inflation have exceeded the central bank’s target of 2%, trimmed mean consumer price inflation has not yet exceeded 2% (Chart 4, middle panel) and services CPI, excluding housing, seems to have rolled over. Importantly, no wage inflation spiral is evident. Unit labor costs have been falling in both the manufacturing and service sectors (Chart 11). Hence, there is little pressure for companies to hike prices. India: Overweight Indian bonds should continue to outperform other EM domestic bonds (Chart 3, middle panel). The combination of prudent fiscal policy, a benign inflation outlook and a cheap currency makes Indian bonds attractive to foreign investors. Even though yields will go up somewhat given a recovering economy, the rise will be capped as the inflation outlook remains benign. The reason for a soft inflation outlook is wages and expectations thereof are quite low (Chart 12). Global commodity prices will also likely soften in the months ahead. That will ease price pressures in India. The Indian rupee is cheap – it is now trading 12% below its fair value versus the US dollar (Chart 13). The rupee will likely be one of the best performers among EM currencies in the year ahead. Chart 12Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Low Urban And Rural Wages Will Keep A Lid on Indian Inflation Chart 13Indian Rupee Is Cheap Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies Indian Rupee Is Quite Cheap And Will Likely Outperform Many EM Currencies   The spread of India’s 10-year bonds over that of GBI-EM Broad index is 190 basis points. The currency performance will likely offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Stay overweight. Indonesia: Underweight Indonesian relative bond yields versus both EM and the US have already fallen massively and at multi-year lows (Chart 14). The currently low yield differential between Indonesia and the aggregate EM local bonds as well as US Treasury yields is a negative for Indonesia’s relative performance going forward. Chart 15 shows that the rupiah is also vulnerable over the next several months as the Chinese credit and fiscal impulse has fallen to its previous lows while the rupiah has not yet depreciated. We believe raw material prices will correct in the coming months, weighing on the rupiah. Hence, the country’s local bonds’ relative performance is facing a currency headwind too. Chart 14Indonesian Relative Bond Yields Are Quite Low Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Indonesian Bond Yields Are Quite Low Relative To Their EM And US Counterparts Chart 15Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable Indonesian Rupiah Is Vulnerable   Notably, a weaker currency by itself could cause bond yields to rise – because that may prompt foreign bond holders to exit this market. For now, investors would do well to underweight this domestic bond market in an emerging Asian or global EM portfolio. Malaysia: Overweight Chart 16Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian Yield Curve Is Too Steep Given The Deflationary Macro Backdrop Malaysian domestic bonds will likely fare well as the nation’s economy is still working through credit excesses of the previous decade. Domestic demand weakness has been exacerbated by a constrained fiscal policy. All of this has paved the way for a strong disinflationary backdrop.   The job market has not recovered either: the unemployment rate is hovering at a high level. That in turn has put downward pressures on wages. Average manufacturing wages are weak. Dwindling wages have contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 16). Considering the economic backdrop, Malaysia’s yield curve is far too steep (Chart 16, bottom panel). Odds are that the curve will flatten going forward – yields at the long end of the curve are likely heading lower. At a minimum, they will rise less than most other EM countries. Notably, the ringgit is quite cheap, and is unlikely to depreciate much versus the US dollar. Hence, it will outperform many other Asian/EM currencies. That calls for an overweight position in Malaysian local bonds within an Asian/EM universe.  Thailand: Underweight To Neutral Given the high correlation between Thai bond yields and the baht (rising yields coincide with a weakening currency), the total return of Thai bonds in USD terms is highly dependent on the baht’s performance. (Chart 17). The baht outlook remains weak, as the two main drivers of the currency, exports and tourism revenues, remain sluggish and absent, respectively. As such, absolute return investors in Thai domestic bonds should continue to avoid this market. Asset allocators should underweight Thai domestic bonds in an emerging Asia basket. In an overall EM domestic bond portfolio, however, Thai bonds warrant a neutral allocation. That’s because Thailand has been a defensive bond market due to its traditionally strong current account, very low inflation, and lower holding of bonds by foreigners (now at 11.3% of total). In periods of stress, the baht usually falls less than most other EM currencies; and often Thai bond yields fall more (or rise less) than overall GBI-EM yields (Chart 18, top panel). Chart 18Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Thai Bonds' Relative Performance Can Get Better During Periods Of Risk-Off Chart 17Thai Domestic Bonds' Absolute Performance Is Highly Contingent On The Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht Thai Domestic Bonds' Absolute Performance Is Highly Contingent On the Baht   The net result is that Thai bonds outperform their overall EM brethren in common currency terms during risk-off periods. This is what happened during the EM slowdown of 2014-15, and again during the pandemic scare in early 2020 (Chart 18, bottom panel). Given we are entering a period of volatility in risk assets, it makes sense to have a neutral positioning on Thai bonds in an EM domestic bond portfolio. The Philippines: Underweight To Neutral The Philippines also merits an underweight allocation in an emerging Asian domestic bond portfolio, but a neutral stance within EM. This is because of this market’s dependence on the appetite of foreign debt investors for Philippine debt securities. This appetite depends on how much extra yield the country offers over US Treasuries. Chart 19 shows that whenever the yield differential between the Philippines’ local bonds and US Treasuries widens to 400 basis points or more, the Philippines typically witnesses net debt portfolio inflows over the following year. On the other end, when the yield differential narrows to around 300 basis points or less, foreign fixed income inflows typically stop, and often turn into outflows during the following year. This is what is happening now. Chart 19Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Narrow Yield Differential With US Treasuries Is Hurting Philippines' Portfolio Inflows Chart 20Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Philippines Peso Is At Risk As The Current Account Has Slid Back Into Deficit Going forward, rising US yields would mean that the Philippines’ bond spreads over US Treasuries will continue to stay less than 300 basis points. Consequently, reduced foreign debt inflows will weigh on the peso. Notably, the Philippines’ current account balance has also slid back to deficit, which makes the peso more vulnerable (Chart 20). On a positive note, contained inflation means little upward pressure on bond yields. Further, there might be a lower need of new bond issuances this year as a substantial amount of proceeds from past bond issuances are lying unspent with the central bank. This would help put a cap on bond yields.  Investment Conclusions Emerging Asian local bonds will outperform their counterparts in Latin America and EMEA in common currency terms for now. In the medium and long run, emerging Asian bonds will outperform US/DM bonds on a total return basis in common currency terms. We will discuss rationale for the latter in our future reports. Considering both the overarching macro backdrop as well as their individual situations, it makes sense to overweight China, Korea, India and Malaysia in an emerging Asian domestic bonds portfolio. Whereas Indonesia, Thailand and the Philippines warrant an underweight allocation. Yet, in an overall EM domestic bond portfolio, we recommend a neutral allocation for Thailand and the Philippines. The reason is they have a much better inflation outlook compared to economies in EMEA and Latin America. Chart 21Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Book Profit On Our Recommended Short Korean Won Trade Notably, among the Asian currencies, we have a positive bias on the Chinese yuan and the Indian rupee. On the contrary, we have been shorting the Korean won, the Thai baht, the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. That said, this week we recommend taking profits on the short Korean won position: this trade has generated a 5.2% gain since its initiation on March 25, 2021 (Chart 21). Our view on the won has played out well. While the exchange rate might continue depreciating in the near run, the risk/reward of staying short is not very attractive now. Finally, we recommend continuing to receive 10-year swap rates in China and Malaysia. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     For a detailed discussion on each country’s inflation dynamics, please click on our reports on China, India, Indonesia, Malaysia, Thailand, Philippines.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary At last week’s press conference, Fed Chair Jay Powell signaled that rate hikes will begin next month. He also implied that the pace of hiking will be faster than the 25 bps per quarter seen during the 2015-18 tightening cycle. The market re-priced on the back of Powell’s comments and the overnight index swap curve is now discounting close to five rate hikes for 2022 (see Chart). Risk assets also sold off on the news and market-derived inflation expectations fell. Our sense is that tightening financial conditions and falling inflation expectations will limit the near-term pace of Fed tightening. We expect the Fed to deliver only three or four rate hikes this year. We also see a higher endpoint for tightening than the market, as we expect the fed funds rate to break above 2% before the end of the cycle. The Market Is Looking For Five Hikes This Year The Market Is Looking For Five Hikes This Year The Market Is Looking For Five Hikes This Year Bottom Line: We expect a slower initial pace of rate hikes than the market, culminating in a higher endpoint for the fed funds rate. This suggests that investors should keep portfolio duration below benchmark and hold Treasury curve steepeners. Yet Another Hawkish Surprise Chart 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction Fed Chair Jay Powell managed to surprise markets yet again last week by signaling that rate hikes are imminent and by suggesting that they will occur at a quicker pace than was previously thought. The financial market response was the textbook reaction to a hawkish Fed surprise: Risky assets sold off, short-maturity Treasury yields surged, and the yield curve flattened (Chart 1). What exactly did the Fed say to cause such a market move? Here is a summary of our most important takeaways from last week’s meeting. First, the Fed signaled that the first rate hike will occur at the next FOMC meeting in March. The post-meeting statement added a sentence saying that “it will soon be appropriate to raise the target range for the federal funds rate.” Then, Powell said in his press conference that he believes “the Committee is of a mind to raise the federal funds rate at the March meeting.”1 Powell also repeatedly noted that the economy is in a very different place than it was during the last Fed tightening cycle, which spanned from 2015 to 2018. Specifically, he said that the labor market is far stronger and inflation is much higher. He added that “these differences are likely to have important implications for the appropriate pace of policy adjustments.” Given that the Fed tightened at a pace of 25 bps per quarter during the 2015-18 cycle, Powell’s comments seem to suggest that the Fed will lift rates at a faster-than-quarterly pace this time around.2 That would mean at least five rate hikes this year, significantly more than the median FOMC projection of three rate hikes that was published in December (Chart 2). The front-end of the overnight index swap (OIS) curve shifted up following the meeting, and it is now consistent with 122 bps of tightening in 2022, a little less than five rate hikes. Notably, Chart 2 shows that the OIS curve still expects the funds rate to level-off at 1.75% starting in 2024. Chart 2The Market Is Looking For Five Hikes This Year The Market Is Looking For Five Hikes This Year The Market Is Looking For Five Hikes This Year Finally, the Fed provided some details on its plans for reducing the size of its balance sheet.3 The plan follows the same roadmap as the last round of balance sheet runoff. The Fed will start running down its balance sheet sometime after rate hikes begin and it will shrink its balance sheet at a “predictable” pace via the passive runoff of securities. In other words, outright asset sales are highly unlikely. Importantly, Powell repeatedly stressed that he wants balance sheet runoff to occur “in the background”. That is, the Fed will respond to swings in the economic outlook with its interest rate policy and will simply let the balance sheet shrink at a steady pre-announced pace. In line with what we published two weeks ago, we expect balance sheet runoff to commence in May or June and to proceed at a faster pace than last time.4 Constraints On The Pace Of Hiking While Jay Powell’s comments undoubtedly suggest that the Fed intends to deliver between five and seven 25 basis point rate hikes this year, we think it’s more likely that we’ll see three or four. The reason is that the near-term pace of tightening will be constrained by two vital monetary policy inputs: financial conditions and inflation expectations. Financial Conditions This publication has often illustrated the relationship between monetary policy and financial conditions with our Fed Policy Loop (Chart 3). The Loop shows that hawkish monetary policy pivots tend to be followed by periods of tightening financial conditions, i.e. a stronger dollar, flatter yield curve, wider credit spreads and falling equity prices. Indeed, this is exactly the market reaction we’ve witnessed during the past week. The Loop also illustrates that tighter financial conditions then feed back into the market’s pricing of the near-term pace of tightening. It is as if financial markets are a regulator on the near-term pace of hikes. Financial conditions tighten when the expected near-term pace of hiking is too fast. This causes the expected pace to fall, which in turn leads to a renewed easing of financial conditions and then to another hawkish response from the Fed. The top panel of Chart 4 shows that the S&P 500 was performing well even when the market was priced for 75 bps of hiking during the next 12 months. But equities sold off as the bond market moved to price-in 100 bps and then 125 bps of near-term hiking. A similar pattern is observed in excess corporate bond returns (Chart 4, bottom panel). The pattern in Chart 4 suggests that the market is not comfortable with the pace of hiking that is currently priced into the yield curve. This could change, but if the risky asset selloff continues it will eventually lead to a decline in near-term rate hike expectations. Chart 3The Fed Policy Loop The Best Laid Plans The Best Laid Plans Chart 4Five Hikes Too Many Five Hikes Too Many Five Hikes Too Many Inflation Expectations Some may dispute the idea that the near-term pace of rate hikes will slow in response to a selloff in equity and credit markets. Why would the Fed care about the stock market when inflation is the highest it’s been in decades? It’s of course true that higher inflation means that the Fed will be less responsive to swings in financial conditions, though a large enough tightening would certainly get the committee’s attention. We also contend, however, that the inflation picture will look a lot different by the middle of this year. Against a backdrop of lower inflation and inflation expectations, the Fed will have more incentive to slow the pace of hiking in response to tighter financial conditions. On this point, let’s first look at inflation expectations (Chart 5). Short-maturity TIPS breakeven inflation rates remain elevated, but they stopped rising once the Fed started its hawkish pivot. Further out the curve, we see that the 10-year TIPS breakeven inflation rate has dipped in recent weeks and that the 5-year/5-year forward TIPS breakeven inflation rate – the most important indicator of long-term inflation expectations – is now below the Fed’s 2.3% to 2.5% target. Household inflation expectations are high and rising (Chart 5, bottom panel) but, much like short-maturity TIPS breakevens, they are highly sensitive to the realized inflation data. They will come down as inflation moderates in the second half of the year. We remain confident that inflation will come down in 2022, though it will probably stay above the Fed’s 2% target. First, core inflation tends to move toward trimmed mean inflation over time. With 12-month core PCE inflation at 4.85% and 12-month trimmed mean PCE inflation at 3.05%, there is significant room for the core rate to fall (Chart 6). The divergence between core and trimmed mean inflation is attributable to the extremely high inflation rates we’re seeing in the core goods sector (Chart 6, panel 2). The pandemic forced consumers to shift consumption from services to goods, and the quick transition from the delta wave to the omicron wave has meant that a re-balancing back to services has not yet occurred. With the omicron wave peaking, it is likely that the re-balancing will take place this year. In fact, we already see some preliminary signs of peaking goods inflation from the ISM Manufacturing Survey’s Prices Paid component (Chart 6, bottom panel). Chart 6Is Inflation Finally Close To Peaking? Is Inflation Finally Close To Peaking? Is Inflation Finally Close To Peaking? Chart 5Inflation Expectations Inflation Expectations Inflation Expectations In our view, the case for persistently high inflation depends on services inflation accelerating to offset falling goods prices. To that point, we note that service sector inflation is tightly linked to wage growth. While wage growth remains strong, the Employment Cost Index did moderate its pace in 2021 Q4 compared to Q3 (Chart 7).5 Further wage deceleration is also possible this year if fading pandemic concerns spur more people to re-join the labor force. According to the Census Bureau’s Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 8). This is a huge potential supply of labor that could come online this year, taking some of the sting out of wage growth.   Chart 8Omicron Weighs On Labor Supply Omicron Weighs On Labor Supply Omicron Weighs On Labor Supply Chart 7Is Wage Growth Close To Peaking? Is Wage Growth Close To Peaking? Is Wage Growth Close To Peaking?   All in all, the recent shift in market expectations from three-to-four 2022 rate hikes to five 2022 rate hikes has only served to tighten financial conditions and push down inflation expectations. In our view, this makes it less likely that the Fed will actually be able to deliver five or more rate hikes this year. Falling inflation in the back half of the year will give the Fed even less urgency. We expect to see only three or four Fed rate hikes this year. Investment Implications Chart 9Keep Duration Low And Own Steepeners Keep Duration Low And Own Steepeners Keep Duration Low And Own Steepeners As explained above, our view is that the Fed will lift rates three or four times this year, less than the five rate hikes that are currently discounted in the market. It’s also worth noting that we think the endpoint of the tightening cycle will occur at a higher funds rate than is currently discounted in the market. Chart 2 shows that the market is priced for the funds rate to level-off at 1.75% starting in 2024. Our sense is that interest rates will be above 2% when the cycle ends. Survey estimates of the long-run neutral fed funds rate agree with our assessment. The median respondent from the New York Fed’s Survey of Market Participants thinks that interest rates will average 2% in the long run. The median respondent from the Survey of Primary Dealers thinks the long-run neutral rate is 2.25% and the median FOMC participant estimates a rate of 2.5% (Chart 9). A slower initial pace of rate hikes that lasts longer than markets expect and has a higher endpoint leads to two actionable investment ideas. First, we advocate keeping portfolio duration below benchmark. The 5-year/5-year forward Treasury yield is currently 1.96%, below the range of survey estimates of the long-run neutral rate (Chart 9). History suggests that the 5-year/5-year yield will settle into the middle of the range of survey estimates as Fed tightening gets underway. The second investment conclusion is that investors should favor Treasury curve steepeners. Specifically, we advocate buying the 2-year Treasury note versus a duration-matched barbell consisting of cash and the 10-year note. While the 2/10 Treasury slope has flattened dramatically in recent weeks, we see this flattening taking a pause during the next few months (Chart 9, bottom panel). The pause will be driven by the market pricing-in a slower near-term pace of tightening at the front-end of the curve and a higher terminal fed funds rate at the long end. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Link for both the post-meeting statement and press conference transcript: https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm 2  The Fed generally tightened at a pace of 25 bps per quarter during the 2015-18 cycle. However, it skipped one meeting in 2017 to announce balance sheet reduction plans and it kept rates unchanged between December 2015 and December 2016 in response to a weaker-than-expected economy.  3 https://www.federalreserve.gov/newsevents/pressreleases/monetary20220126c.htm 4 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Treasury Market”, dated January 18, 2022. 5 Please see Daily Insights, “US ECI Elevated, Softens On A Sequential Basis”, dated January 31, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

HighlightsThe current surge in US measured productivity looks very unlike what occurred in the mid-to-late 1990s. A detailed breakdown of labor productivity growth points to atypical labor market compositional effects – namely a significant decline in services employment – as being responsible for the apparent rise in productivity. In addition, technological disinflation, a major ingredient of the late 1990s “disinflationary boom”, is absent today.A cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the crisis. US output per worker surged compared to other countries, but the US fiscal response also generated a significant amount of excess income to support economic activity – unlike in the euro area, UK, and Japan.Micro-level arguments and some academic studies argue against the idea that work from home arrangements will ultimately be productivity-enhancing. Remote work makes it more difficult for firms to train the next generation of senior employees, which will raise the staffing risks for many businesses.While the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output.If inflation remains significantly above target after the pandemic is over, the Fed’s long-term interest rate projections may rise. US stocks would suffer potentially large losses in a scenario where 10-year US Treasury yields rise towards the potential growth rate of the economy. Investors should consider reducing their equity exposure if 5-year, 5-year forward US Treasury yields break above 2.5%. We do not expect that to occur this year, which for now justifies an overweight stance towards risky assets.Feature Chart II-1A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge?  The behavior of US labor productivity during the COVID-19 pandemic has raised several questions among investors. As defined by output per hour worked, US productivity accelerated significantly over the first six quarters of the COVID-19 pandemic, but then fell sharply in Q3 2021 (Chart II-1). While some market participants have questioned the cause of the recent decline, investors have generally been more interested in the question of whether the US is in the middle of a long-lasting productivity surge that will help alleviate inflationary pressure – akin to what occurred in the second half of the 1990s.In this report, we review the recent surge in US labor productivity in contrast to what occurred in the late-1990s, and then compare it with what has occurred globally. While we are not pessimistic about the pace of technological advancement and its potential to drive long-run productivity, we conclude that the US is not likely experiencing a sustained productivity boom driven by technological adoption during the pandemic. This underscores why investors should not expect a significant increase in potential output owing to the pandemic or its effects. It also highlights that, if elevated inflation in response to strongly positive output gaps were to occur over the coming few years, it would likely be met by significantly tighter fiscal or monetary policy.Today Versus The 1990s: Total Factor Productivity Versus Capital Intensity Chart II-2The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event  A technologically-driven surge in productivity growth in the second half of the 1990s was a highly significant macroeconomic event. Chart II-2 highlights that US labor productivity surged to over 3% from 1995 to 2000, alongside a significant deceleration in core PCE inflation and a sizeable acceleration in potential GDP growth.Given the acceleration in measured productivity during the pandemic, and the accompanying rapid adoption (or broader use) of technology, it is easy to see why some investors have questioned whether a 1990s-style productivity boom is underway. However, a detailed breakdown of the 2020 rise in labor productivity growth highlights substantial differences between the current environment and that of the late 1990s, which points instead to compositional effects as the main driver.Improvements in labor productivity can come from smarter workers, an increase in the amount of capital employed per worker, or from technological innovations and better working practices. The US Bureau of Labor Statistics provides a breakdown of the annual change in labor productivity that attempts to capture these three components:The contribution from shifts in labor composition: This measures the productivity impact of changes in the age, education, and gender structure of the labor force.The contribution from capital intensity: This measures the productivity impact of shifts in the amount of capital equipment available per worker.Total factor (or “multifactor”) productivity: This measures the changes in output per hour that cannot be accounted for by the above two factors. Thus, it includes the effects of technological changes, returns to scale, shifts in the allocation of resources, and other changes in operating procedures.Examining the 2020 rise in labor productivity growth along these three factors underscores key differences between the current environment and that of the late 1990s.The first point for investors to note is that the acceleration in labor productivity in 2020 occurred alongside a contraction in total factor productivity (TFP) growth, in contrast to the 1990s when TFP drove labor productivity (Chart II-3). The fact that TFP growth fell in 2020 means that the increase in labor productivity must have occurred either because of labor composition or capital intensity effects.In 2020, labor composition contributed somewhat to accelerating labor productivity, but that most of the increase was caused by a sharp increase in capital intensity. Some of the increase in overall capital intensity occurred because of an increase in the intensity of information processing equipment and intellectual property products (supporting the idea of an increase in pandemic-driven capital deployment), but this was outstripped by the contribution of “other” capital services (Chart II-4). Chart II-3Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s   Chart II-4The Surge In US Capital Intensity Reflects A Rapid Compositional Shift In The Labor Market February 2022 February 2022  The concept of capital intensity refers to the amount of capital available per worker, but in practice it is measured as the ratio of the amount of capital used relative to the amount of labor hours used to produce output. Thus, a surge in capital intensity that is not accounted for by an increase in the amount of tech-related capital available to workers points to a rapid compositional shift in the economy from relatively low capital-intensive industries to relatively high-intensive industries.Under less extreme economic circumstances we would be more inclined to search for other potential causes of a rapid increase in measured capital intensity, but a shift in employment from less to more capital-intensive industries is exactly what has occurred during the pandemic. Services jobs tend to be much more labor-intensive than goods-producing jobs; Chart II-5 highlights that the former fell far more than the latter during the pandemic, in sharp contrast to what normally occurs during a recession (Chart II-6). This phenomenon is also reflected in a highly unusual decline in services spending compared with very strong goods spending relative to their pre-pandemic trend. Chart II-5Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing   Chart II-6The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented  The takeaway for investors is that the nature of the pandemic and its unique impact on the economy has created the appearance of an acceleration in productivity, when in reality true productivity has fallen and the standard measure of productivity is being flattered by enormous changes in the composition of the labor market.Today Versus The 1990s: IT Investment, And Technological DisinflationThe trends in IT investment and prices highlight another major difference between the current environment and that of the late 1990s. Charts II-7 and II-8 highlight recent trends in comparison to those of the 1990s, with the following notable points: Chart II-7There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s   Chart II-8A One-Off Move A One-Off Move A One-Off Move  The recent pace of real investment in total IT does not point to the pandemic as a sustained source of productivity growth. Real investment in IT has already slowed significantly, in contrast to the 1990s when it accelerated on a sustained basis for years.IT investment as a % of GDP and of total plant and equipment spending has already stopped rising (or is now falling), exhibiting clear signs of a one-off shift and thus undermining the view that IT investment has significantly raised potential output.In pronounced contrast to the mid-1990s when IT equipment prices were collapsing, computing equipment inflation has recently risen into positive territory – to the highest levels recorded since the data became available in 1959.Higher prices for IT equipment clearly reflect, at least in part, pandemic-driven pressure on global supply chains and the production of semiconductors. So we do not expect sustained increases in the price of computing equipment. But the key point for investors is that a major ingredient of the late 1990s “disinflationary boom” is missing today.The US Versus The WorldWe have presented Chart II-9 in previous reports to highlight that there is certainly no evidence of a global productivity surge, using output per worker as a proxy for the standard measure of labor productivity (output per hour worked). Some investors have countered that the US is a more dynamic economy, and that a sustained productivity boom would be more apparent in the US prior to its emergence in other countries. Or simply that the US alone is experiencing a productivity boom that will help reduce very elevated US inflation, with strong implications for Fed policy. Chart II-9During The Pandemic, Cross-Country Changes In Real Output Per Worker… February 2022 February 2022   Chart II-10…Are Mostly Explained By Different Fiscal Responses February 2022 February 2022   Chart II-11High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels  Charts II-10 and II-11 present a different cross-country comparison that reinforces the view that the US is not likely experiencing a long-lasting productivity surge that will help reduce inflation. Chart II-10 highlights that in the face of a significant decline in employment, US output was supported by a substantial amount of “excess income” – the cumulative amount of household disposable income earned over the course of the pandemic in excess of what would have been predicted based on the pre-pandemic trend.Other major DM economies (such as the UK and euro area) either saw negative excess income or a modestly positive amount (Japan), underscoring that the fiscal response to the pandemic in most advanced economies was aimed at stabilizing income rather than raising it. In combination with Chart II-11 – which highlights that the US labor market recovery has significantly lagged behind the European and Canadian economies in terms of returning to the pre-pandemic employment trend – this would appear to explain why the US has experienced stronger real output per worker than other countries. Chart II-12Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases?  Canada stands out as the outlier compared with the US, in the sense that it’s growth in real output per worker has been much lower but Canadian fiscal policy created a similar amount of excess income. However, it may be the case that the Canadian experience highlights that the US labor market recovery is the outlier, which could imply that the surge in US labor productivity may in fact have inflationary rather than disinflationary consequences at the margin.We discussed the factors that we believe are driving the slow recovery in the US working-age population in our 2022 annual outlook report, and how they are strongly linked to the pandemic. However, Canada has also clearly been affected by COVID-19, and yet it has experienced a more significant recovery in jobs.Chart II-12 highlights that there has been one major difference between the US and Canada during the pandemic: a substantial gap in the burden of disease from COVID-19. This raises the question of whether Canada has outperformed the US in terms of its labor market recovery, despite a similarly impactful fiscal response, because of a smaller labor shortage stemming from long-term COVID symptoms.Over the past two years, there have been many reports about people who have recovered from COVID but who continue to experience some symptoms of the disease. The medical community has labeled this condition as post-acute sequelae of SARS-CoV-2 infection (PASC), colloquially referred to as “long COVID.” Chart II-13Long-COVID Might Help Explain The US’ Lagged Return To Pre-Pandemic Employment February 2022 February 2022  The medical community’s understanding of long COVID is currently poor, and doctors do not know why some people get the condition or what treatment options are likely to be the most effective. Given this, it is possible that some reports of long COVID are, in fact, related to other conditions.But a recent research report from Brookings estimated that the US labor market may be missing 1.6 million workers because of long COVID’s effects (Chart II-13), which alone would account for 1 percentage point (or roughly 1/4th) of the growth in US real output per worker since the pandemic began. This circumstance would be inflationary rather than disinflationary on the margin, as it would imply that accelerating first and second quartile US wage growth may be sticky even as the pandemic recedes.Is Working From Home Positive For Productivity?We have noted above that the macro data argues against the idea of a sustained rise in US productivity stemming from the pandemic. A more micro-level perspective, one that examines the working-from-home (WFH) experience, also appears to support our case.It is true that surveys of employees highlight that their experience of WFH has been significantly better on average than workers expected and report their being more productive while working from home during the pandemic. Chart II-14 emphasizes that, based on the running surveys from Barrero, Bloom, and Davis (“BBD”), 60% of workers have conveyed better WFH outcomes relative to expectations, versus just 14% reporting worse outcomes. In addition, Chart II-15 clearly highlights that workers prefer at least some form of hybrid WFH arrangement, with just 22% of survey respondents reporting the desire to work from home either rarely or never. Chart II-14Remote Workers Have Reported Better Work-From-Home Outcomes Than What Was Expected February 2022 February 2022   Chart II-15Remote Workers Clearly Prefer A Hybrid Work Model February 2022 February 2022  However, worker preferences do not necessarily correlate with productivity gains, at least not to the same degree. Chart II-16 from the BBD surveys highlights that the share of workers reporting more efficiency while working from home is not as large as those reporting better outcomes relative to expectations, suggesting that employees are considering whether WFH arrangements are benefiting them personally when responding to their desired post-pandemic level of remote work. Chart II-17 also shows that employees working from home only spend a third of the time ordinarily allocated to commuting to working on their primary job; the rest is spent on childcare, leisure, home improvement, or working on a second job (which may or may not be a sustainable source of income). Chart II-16Less Than Half Of Workers Report Being More Efficient While Working Remotely February 2022 February 2022   Chart II-17Only 1/3rd Of Time Saved Commuting Is Spent On Primary Employment February 2022 February 2022  There is also some evidence from academic studies that indicates productivity fell during the pandemic for some remote workers. Michael Gibbs, Friederike Mengel, and Christoph Siemroth (2021) surveyed 10,000 professionals at a large Asian IT services company, and found that productivity declined because of a slight decline in average output and a rise in hours worked.1 Admittedly, elements of the study did point to some factors potentially impacting this decline in productivity that were more prominent in the earlier phase of the pandemic, specifically the issue of childcare (which would not likely be a drag on remote worker productivity in a post-pandemic environment).But it also noted that employees with a longer company tenure fared better, which in our view is an often overlooked element of remote work that points to less future productivity gains from WFH arrangements than may be recognized by investors. The outperformance of senior staff in a WFH environment is not particularly surprising: once employees have accrued significant experience, they spend less of their working time learning and more (or all) of their working time “doing.” It makes sense that employees who predominantly “platform” their existing experience may fare the same or better in a WFH arrangement, but it is highly questionable whether it is sustainable, because it makes it much more difficult for businesses to train the next generation of senior employees.The Gibbs, Mengel, and Siemroth study noted that higher communication and coordination costs featured prominently in their findings of reduced remote worker productivity. Importantly, they found that employees communicated with fewer individuals and business units, both inside and outside the firm, and received less coaching and one-to-one meetings with supervisors. While some firms may be able to mitigate these risks to the advancement and development of more junior staff while maintaining a hybrid on-site / WFH model, we suspect that many firms will fail to do so fully.Future Productivity: Pessimism Unwarranted, But No Inflation SalvationThe fact that the US is not likely in the middle of a pandemic-driven productivity boom does not mean that the outlook for productivity is poor. In fact, we would point to two factors that lead us to believe that productivity growth will be better in the future than it has been over the past decade:The pronounced consumer deleveraging phase that existed for several years following the global financial crisis is over, andThere are several identifiable technologies currently under development that are likely to have legitimate commercial applications and productivity-enhancing benefits in the futureOn the first point, we have contended in previous reports that the weak productivity growth observed during the first half of the last economic expansion was because of demand rather than supply-side factors. This notion is jarring for many investors, who are accustomed to think of productivity trends as being exclusively driven by supply-side phenomena. This is typically correct, in that the cyclical impact of fluctuating aggregate demand on measured productivity – particularly during and immediately after recessions – is usually temporary in nature.However, the 2008/2009 recession was highly atypical, in the sense that it was a household “balance sheet” recession rather than a normal “income” recession. This led to a prolonged period of US household deleveraging, below-average corporate sales growth, and poor growth in output per hour worked. In effect, the post-2008 deleveraging phase created a long-lasting, multi-year cyclical effect on measured productivity growth.In early-2009, pessimistic investors held to an understandable reason for why they doubted the sustainability of the economic recovery: there could be no meaningful labor market recovery if businesses expected several years of weak demand because of the likelihood of consumer deleveraging. In this respect, the post-2008 period served as an important natural experiment for macroeconomists and investors: we have learned that the response of firms to a durable but shallow economic recovery is, on the one hand, to hire additional workers, but, on the other hand, also to control wage and salary costs aggressively. Chart II-18Slow Productivity Growth Last Cycle Was A Demand Story, Not A Supply Story February 2022 February 2022  Chart II-18 encapsulates the point that weak productivity during the last economic cycle was closely tied to US household deleveraging. The chart highlights that the decline in total factor productivity due to goods-producing industries – heavily concentrated in manufacturing – was much larger than for private services from 2007 to 2019. Since there was no technological slowdown that disproportionally impacted the manufacturing industry during the period, this clearly points to demand-side rather than supply-side factors as the main driver of the post-GFC productivity slowdown.On the second point about future productivity growth, Table II-1 outlines five well-known technologies that are in various stages of development and are likely to lead to significant applications at some point in the future: artificial intelligence, automated driving (a specific application of AI), quantum computing, augmented/virtual reality and human-machine interface, and CRISPR/gene editing. The table outlines the nature of potential future applications, as well as projections from McKinsey Global Institute about the most likely commercialization timeline. Table II-1Technological Advancement Is Ongoing. It Won’t Likely Help Fight Inflation Over The Next Few Years February 2022 February 2022  A detailed analysis of each of these technologies is beyond the scope of this report, but Table II-1 underscores two key points for investors. The first is that further, technologically-driven productivity growth is not just possible, it is likely. It is clear what advancements will probably drive these productivity gains, and Table II-1 highlights only the most well-known technologies to which experts in the field would point to.The second point is that most major changes from these technologies are projected to occur beyond 2025, and, in many cases, beyond this decade. In the case of quantum computing, while it could potentially lead to an explosion of algorithmic power that would almost certainly have major commercial implications, it is even possible that this technology will initially subtract from total factor productivity growth before contributing positively. This is because of its potential to render much of the existing global internet security and privacy infrastructure useless, as highlighted by a NIST Cybersecurity White Paper last April:“Continued progress in the development of quantum computing foreshadows a particularly disruptive cryptographic transition. All widely used public-key cryptographic algorithms are theoretically vulnerable to attacks based on Shor’s algorithm, but the algorithm depends upon operations that can only be achieved by a large-scale quantum computer. Practical quantum computing, when available to cyber adversaries, will break the security of nearly all modern public-key cryptographic systems.”2Some experts believe that the preparation required to avoid this outcome may dwarf that of the millennium bug (“Y2K”) problem of the late-1990s,3 which cost roughly 1% of GDP to fix – and thus was clearly not productivity-enhancing.The bottom line for investors is that while the long-term outlook for technologically-driven productivity growth is bright, it is unlikely to save the US and/or global economies from elevated inflation over the next several years if output gaps in advanced economies rise to strongly positive levels in the wake of the pandemic.Investment ConclusionsOur analysis above has highlighted that the current surge in measured productivity looks very unlike what occurred in the mid-to-late 1990s, and that very atypical labor market compositional effects are likely responsible for the apparent rise in labor productivity. We have also highlighted that a cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the pandemic, and that there are micro-level arguments against the idea that work from home arrangements are productivity-enhancing. Finally, while the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output.While we believe that the COVID-19 pandemic will recede in importance this year, it is not yet over. As such, investors do not yet know how strong the output gap in the US and other advanced economies will be on average over the coming two to three years, or what the pace of consumer price inflation will look like in the face of strong aggregate demand but substantially lower (or no) pressure from the supply-side of the economy (as we expect). Chart II-19There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates  In a scenario in which aggregate demand remains strong next year and inflation remains above-target, even in the face of Fed tightening and a normalization in services/goods spending, we would expect to see significantly tighter fiscal or monetary policy. This is a scenario in which the secular stagnation narrative, which underpins the Fed’s low long-term interest rate projection, would likely be aggressively challenged by investors. Chart II-19 highlights that US equities would potentially suffer a 24% contraction in the forward P/E in a scenario in which the equity risk premium is in line with its historical average and 10-year US Treasury yields rise to the potential growth rate of the economy.We do not yet believe that a significant rise in long-term interest rate expectations will occur this year, meaning that investors should still be overweight stocks versus government bonds over the coming 6-12 months. But as we noted in last month’s report, we may recommend that investors reduce their equity exposure if 5-year, 5-year forward Treasury yields break above 2.5% (the FOMC’s long-run Fed funds rate projection), which we noted in Section 1 of our report is 50 basis points above current levels.Jonathan LaBerge, CFAVice PresidentThe Bank Credit AnalystFootnotes1 Michael Gibbs, Friederike Mengel, and Christoph Siemroth. “Work from Home & Productivity: Evidence from Personnel & Analytics Data.” Working Paper No. 2021-56. July 13, 2021. Pp. 1-30.2 William Barker, William Polk, and Murugiah Souppaya. “Getting Ready for Post-Quantum Cryptography: Exploring Challenges Associated with Adopting and Using Post-Quantum Cryptographic Algorithms.” National Institute of Standards and Technology, US Department of Commerce. April 28, 2021. Pp. 1-7.3 Jonathan Ruane, Andrew McAfee, and William Oliver. “Quantum Computing for Business Leaders.” Harvard Business Review, January-February 2022.

Highlights The combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency for the Fed to raise interest rates. The central bank’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, and it will move forward with a rate hike at its March meeting. We expect that the Fed funds rate will rise to 1% by the end of this year. The Fed’s asset purchase reductions will not have a direct impact on economic activity, but they could have an indirect effect by prompting a faster rise in US Treasury yields towards their fair value levels. The US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year, rather than by the end of 2022 as we previously expected. Part of the generalized rise in risk premia this month relates to the potential Russian invasion of Ukraine, but the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates. Rising long-maturity bond yields are being driven by the short end of the curve, which we see as a sign that the generalized selloff in the US equity market is uncalled for. Investors should buy the US stock market at current levels on a 6-12 month time horizon. It is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. A Russian invasion of Ukraine has become a likely event, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but investors should gird for a risk-off reaction over shorter-term time horizons. Omicron, The Supply-Side, And The Fed January was a poor month for the global equity market, which sold off 10% from its high at the beginning of the year. Chart I-1 highlights that in the US, the S&P 500 has now fallen below its 200-day moving average, in contrast to global ex-US stocks which have fared somewhat better in US$ terms. Equities have declined this month because of a combination of imminent Fed tightening and a geopolitical crisis, both of which we will discuss in detail below. On the pandemic front, the number of confirmed cases of COVID-19 has surged globally (Chart I-2), which is likely an underestimation of the total number of infections given capacity limits on testing in many countries. Panel 2 highlights that services PMIs fell sharply in January in several economies because of the Omicron wave, reflecting both renewed pandemic control measures in some countries as well as precautionary changes in behavior amongst consumers in countries where widespread “non-pharmaceutical interventions” (“NPIs”) were not reintroduced. Manufacturing PMIs, on the other hand, held up quite well, even in Europe where natural gas prices remain high. Chart I-1A Significant Correction In US Stock Prices A Significant Correction In US Stock Prices A Significant Correction In US Stock Prices Chart I-2Omicron Is Impacting Services, Not Manufacturing Omicron Is Impacting Services, Not Manufacturing Omicron Is Impacting Services, Not Manufacturing   Some positive signs have emerged from the hospitalization data in advanced economies, as they appear to be pointing to a cresting wave of patients with COVID-19 both in hospitals overall and specifically in intensive care units (Chart I-3). The evolution of the pandemic remains highly uncertain, and the development of new variants continues to remain a risk. But incoming data on hospitalizations, the rapid increase in the number of vaccine booster doses administered in many advanced economies, and the sheer speed at which the disease has recently been spreading all point to a possible imminent peak in the impact of the Omicron variant on the demand side of the economy – at least in the developed world. However, Chart I-4 highlights that there is no sign yet of a waning impact of the pandemic on the supply side of the economy. The chart shows that rising European natural gas prices are having less of an impact on our supply-side pressure indicator, but that the indicator remains flat excluding this effect. We noted in last month’s report that the Omicron variant posed a significant risk of more frequent or longer lockdowns in China, because of the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to provide any protection against contracting Omicron. Panel 2 of Chart I-4 highlights that shipping costs between China/East Asia and the west coast of the US have started to tick higher again, suggesting that the impact of ongoing lockdowns as well as mandatory quarantines and testing in key areas such as Shenzhen, Tianjin, Ningbo, and Xi’an may already be having an effect. Chart I-3Hospitalizations From Omicron Appear To Be Peaking Hospitalizations From Omicron Appear To Be Peaking Hospitalizations From Omicron Appear To Be Peaking Chart I-4Pandemic-Related Supply-Side Pressures Remain Severe Pandemic-Related Supply-Side Pressures Remain Severe Pandemic-Related Supply-Side Pressures Remain Severe   From the Fed’s perspective, a combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency to raise interest rates. The Fed’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, which is being partially driven by demand (even if supply-chain factors are also materially boosting global goods prices). Chart I-5The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year Chart I-5 shows that our inflation momentum model is signaling falling odds of 4% or higher core PCE inflation, but the model’s probability remains above the 50% mark. Thus, while it is possible that US inflation will soon peak in year-over-year terms, the Fed will move forward with a rate hike at its March meeting. For now, we believe that the Fed will move at a pace of four quarter-point rate hikes per year (regardless of how they are sequenced), suggesting that the effective Fed funds rate will rise to 1% by the end of this year. Quantitative Tightening And Financial Markets Investors continue to wrestle with the Fed’s recent hawkish shift and the implications that it may have for economic activity and financial markets. Investors are not just concerned about the pace and magnitude of Fed rate hikes, but also the potential impact of quantitative tightening as the Fed moves to slow the pace of its asset purchases over the coming few months. Chart I-6The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one In our view, investors should be more concerned with the former rather than the latter. Chart I-6 highlights the reason that investors were so focused on the magnitude of the Fed’s balance sheet during the first half of the last economic expansion. Panel 1 of the chart shows that the level of the S&P 500 correlated almost perfectly with the Fed’s total holdings of securities from 2008 to 2015. However, panel 2 highlights that this relationship broke down from 2016 to early 2020, only to correlate positively again as the Fed’s holdings of securities surged higher during the pandemic. To us, the experience of the past decade highlights that the correlation between the Fed’s balance sheet and the equity market is mostly a spurious one. The two are indirectly related; periods when the Fed’s security holdings increase reflect periods of monetary easing, which is typically positive for risky asset prices. But we do not agree that the impact of asset purchases on long-maturity bond yields can be effectively separated from the direct impact of changes in short-term interest rates, which are typically falling as the Fed’s balance sheet rises. In addition, asset purchases signal important information by the Fed about the future path of short-term interest rates when it changes the pace of its purchases. And finally, the 2016-2019 period strongly underscores that there is no direct link between Fed asset purchases and the stock market. It is possible that periods of rising Fed asset purchases are associated with a low government bond term premium or more dovish investor sentiment about the future path of interest rates than is projected by the Fed. If so, that could imply that the Fed’s asset purchase reductions will have some impact on financial markets over the coming months. Chart I-7 suggests that the term premium on 10-year Treasurys is no longer low, but these series are based on surveys of primary dealers and fixed-income market participants, and thus may not reflect the aggregate views of investors. Chart I-8 highlights that 10-year government bond yields are 40 basis points below the fair value implied by the Fed’s interest rate projections, and panel 2 highlights a similar conclusion based on a regression of the 10-year yield on the 2-year yield and 5-year/5-year forward CPI swap rates. Thus, it is possible that the Fed’s rapid reduction in the pace of its asset purchases will cause bond yields to converge quickly with these estimates of fair value, implying that the US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year rather than by the end of 2022, as we previously expected. Chart I-7Surveys Suggest The Term Premium Is No Longer Deeply Negative... Surveys Suggest The Term Premium Is No Longer Deeply Negative... Surveys Suggest The Term Premium Is No Longer Deeply Negative... Chart I-8...But 10-Year Treasury Yields Are Lower Than They Should Be ...But 10-Year Treasury Yields Are Lower Than They Should Be ...But 10-Year Treasury Yields Are Lower Than They Should Be The Stock Market, Interest Rates, And Value Versus Growth Chart I-9The US Equity Market Selloff Has Been Driven By Tech Stocks The US Equity Market Selloff Has Been Driven By Tech Stocks The US Equity Market Selloff Has Been Driven By Tech Stocks The fact that the global equity selloff had been concentrated in the US prior to the escalation in tensions over Ukraine reveals the root cause of the decline. Chart I-9 highlights that the Nasdaq has fallen more than the S&P 500, as have US growth stocks compared with value stocks. As such, the recent selloff in the stock market reflects some of the major themes that we presented in our 2022 annual outlook. We highlighted in our outlook, as well as several previous reports, that the relative performance of global growth versus value since the pandemic has been driven primarily by changes in valuation that could reverse if bond yields rose. Chart I-10 highlights that this is exactly what has occurred over the past month, which also explains the underperformance of US equities given how heavily-weighted the US market is toward broadly-defined technology stocks. However, the underperformance of US growth stocks has occurred within the context of a nontrivial decline in the overall US market, which was somewhat beyond our expectation. We anticipated a period of elevated financial market volatility in advance of the Fed’s first rate hike, and we warned investors that 2022 was likely to be a year of meaningfully lower total returns (mid-to-high single digits) compared with the past two years. The fact that equity multiples for growth stocks are falling in response to higher long-maturity bond yields is not surprising to us. But investors have punished both growth and value stocks as bond yields have risen, behavior that we do not think is justified given the large difference in valuation between the two. Chart I-11 highlights that our (standardized) proxy for the equity risk premium (ERP) is above its 2003-2021 average for value stocks, whereas it is quite low for growth stocks. Had the ERP for value stocks fallen to its historical average this month value stocks would have risen between 1-4% in January despite rising real 10-year government bond yields. And the historically average levels shown in Chart I-11 might themselves be too high, given that other ERP estimates like the ones we showed in our annual outlook highlight that the 2003-2021 period was one in which the US ERP was historically elevated. Chart I-10Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Chart I-11The ERP For Value Stocks Does Not Need To Rise The ERP For Value Stocks Does Not Need To Rise The ERP For Value Stocks Does Not Need To Rise Chart I-12The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks As noted, part of a generalized rise in the ERP this month relates to the potential Russian invasion of Ukraine, an event that we now see as likely (discussed below). But the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates, particularly given the (mistaken) perception amongst investors that Fed hawkishness is entirely driven by elevated inflation. We acknowledge that the Fed’s hawkish shift has been a rapid one, and that this has led US government bond yields to rise quickly. Both the level and change in interest rates matter for economic activity and financial market sentiment, but our view is that the former is more important. Changes in interest rates are mainly significant because they create uncertainty about where rates will ultimately settle, and whether that level would be sustainable for economic activity and the valuation of financial assets. In this respect, Chart I-12 should be encouraging for investors. The chart shows that the 10-year Treasury yield recently reached a new pandemic high, but that this rise was driven by yields on shorter-maturity bonds. 5-year/5-year forward Treasury yields remain 50 basis points below the Fed’s long-term Fed funds rate projection (2.5%), suggesting that the rapid move in US Treasury yields simply reflects a revised pace of rate hikes – not ultimately a higher level. This underscores that the generalized selloff in the US equity market is uncalled for, and that investors should buy the US stock market at current levels. Chart I-13Recession Fears May Rise Early Next Year Recession Fears May Rise Early Next Year Recession Fears May Rise Early Next Year Chart I-13 highlights that an accelerated pace of rate hikes will likely cause the yield curve to be flatter at the end of the year than would have otherwise been the case, which may eventually be interpreted by investors as a sign that a recession is drawing nearer (potentially implicating both value and growth stocks). We discussed this risk in last month’s report, but for now we maintain the view that this is more likely to occur in 2023 rather than this year. The chart highlights that the S&P 500 did not sell off in response to growth/recession concerns in 2018 before the 2/10 yield curve had flattened to 20-30 basis points, which isn’t likely to occur until 1H 2023 according to fair value calculations derived from the FOMC’s rate projections. The Dollar, Chinese Policy, Commodities, And Global Ex-US Stocks Chart I-14Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Despite the recent surge in US interest rate expectations, and up until last week, the US dollar had behaved in a somewhat strange fashion since late November– even as the Omicron variant spread rapidly around the globe. Chart I-14 highlights that the dollar had traded counter to both relative interest rate differentials and the intensity of the pandemic, both of which appear to have strongly explained the dollar’s trend in the first three quarters of 2021. As we go to press, the US dollar is rallying again, although at least some of the rise is being driven by the prospect of imminent war in Ukraine. We argued in our annual outlook that the dollar was likely to fall this year, and that it was both technically stretched and expensive according to our PPP models. Chart I-15 highlights that the prior weakness in the dollar may also be explained by slowing net foreign purchases of US equities, as the impact of global equity investors flocking to the tech-heavy US market during the pandemic begins to wane. However, we suspect that two additional factors may have been impacting the broad dollar trend before this week’s surge in geopolitical risk. The first is a possible reversal in the correlation between the number of COVID-19 cases and the dollar (from positive to negative). For most of the pandemic, investors have treated new waves of the pandemic as an indication that global growth will slow, which certainly occurred in the services sector this month. But the sheer speed at which the Omicron variant is spreading, in combination with the fact that it causes less severe disease than previous variants, has likely prompted some investors to expect that Omicron has shortened the amount of time to COVID-19 endemicity. An endemic disease, while still a public health issue, would imply less transmission and much less COVID-19-related hospitalization and death. Correspondingly, it would also likely be associated with a significant increase in services spending alongside stronger international travel, which would be positive for global growth (and thus negative for the dollar). Second, it is apparent that China-related assets have caught a bid, as illustrated by our market-based China growth indicator and its accompanying diffusion index (Chart I-16). While the indicators shown in Chart I-16 remain below the boom/bust line, they are rising quickly, and in a manner that suggests investors are reacting to new information. Chart I-15Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Chart I-16Since November, Optimism Towards China Has Also Likely Weakened The Dollar Since November, Optimism Towards China Has Also Likely Weakened The Dollar Since November, Optimism Towards China Has Also Likely Weakened The Dollar Chart I-17China Bulls Are Probably A Bit Too Early China Bulls Are Probably A Bit Too Early China Bulls Are Probably A Bit Too Early We doubt that investors would be upgrading their outlook for Chinese economic growth based on expectations of COVID-19 endemicity, given the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to prevent transmission of Omicron. Therefore, we conclude that investors have become more optimistic about the pace of easing from Chinese policymakers, potentially sparked by a recent pickup in the pace of special purpose local government bond issuance (Chart I-17). We agree with investors that Chinese monetary policy is becoming easier at the margin. For example, the PBoC recently reduced its one-year loan prime rate (LPR) by 10 bps and five-year rate by 5 bps, following last week’s 10bps cut in the 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rate. This is on top of December’s 50 bps drop in the reserve requirement ratio (RRR). But we do not think that China’s credit data is yet heralding a meaningfully stronger growth impulse. Panel 2 of Chart I-17 presents the 12-month flow of China’s ex-equity total social financing as a share of nominal GDP, both including and excluding local government bond issuance. The chart highlights that the significant pickup in local government bond issuance has led to only a slight uptick in China’s overall credit impulse. Excluding local government bonds, China’s credit impulse continues to decline, reflecting an impaired monetary policy transmission mechanism and slowing bank loan growth. The implication is that it is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. At least some of the pickup in our market-based indicator reflects passive outperformance of some China-sensitive assets; Chart I-18 highlights that global ex-stocks and industrial metals prices have risen relative to US stock prices over the past month, but mostly because US stocks sold off in reaction to Fed hawkishness. Chart I-19 highlights that industrial metals prices continue to advance in a fashion that is not explained by the pace of China’s credit growth (as has generally been the case over the past decade), suggesting that metals are being somewhat supported by investment demand that is likely being driven by inflation hedging. We noted in our November Special Report that industrial commodities performed well during the stagflationary period of the 1970s,1 and over the past 40 years during months in which stock and bond returns are both negative. This makes metals an ideal portfolio hedge in the current environment, and we suspect that this factor – in addition to global inventory drawdowns last year – have kept prices elevated. Chart I-18Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Chart I-19Metals Prices Are Higher Than What Chinese Economic Growth Would Imply Metals Prices Are Higher Than What Chinese Economic Growth Would Imply Metals Prices Are Higher Than What Chinese Economic Growth Would Imply However, this also implies that metals prices could sell off at some point over the coming few months if US inflation fears begin to peak and Chinese monetary policy has not yet turned decisively reflationary. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. Similarly, while we believe that investors should maintain global ex-US stocks on upgrade watch, we would prefer to see more evidence of a likely acceleration in Chinese economic activity before upgrading. In addition, we would also recommend that investors wait for the Ukrainian situation to play out, given the recent selloff in European stocks in response to the deepening crisis. A Likely War In Ukraine Last week, US President Joe Biden publicly predicted that Russia would likely invade parts of Ukraine, and implied that the sanction response from Western countries might be muted if the invasion were “minor”. Biden’s remarks have since been described as a gaffe, but in our view they were likely accurate. When combined with reports that the White House is warning domestic chipmakers of potential export restrictions to Russia in the event of an invasion, Biden’s remarks suggest that the US government does not believe that a diplomatic solution is likely and that Russia will probably send troops into Ukrainian territory. A full-scale invasion of Ukraine is very unlikely, as it would unite the Western world in delivering crippling economic sanctions towards Russia. The question for investors is whether the economic consequences of a minor incursion have significant enough implications to change one’s 12-month asset allocation stance. The extent of the rise in energy prices following a minor Russian incursion into Ukraine would be the key determinant of the impact that Russian military action would have on financial markets. Russia could withhold natural gas or oil exports to punish Europe if the Nord Stream II pipeline were cancelled. Oil prices would likely rise, even if retaliatory action was limited to the natural gas market, because oil consumption would rise as a substitute. This would further exacerbate the European energy crisis, although as we noted above, the PMI data continues to point to COVID as a more serious near-term threat to European economic activity than energy prices. Our geopolitical strategy team recently upgraded the odds of Russia invading Ukraine from 50% to 75%, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but it is likely to have a near-term impact on the performance of some assets. While some of the risk of this event has already been priced in, on a 0-3 month time horizon, the US dollar would likely rally even further in response to an invasion and we suspect that the recent outperformance of global ex-US stocks would reverse (with the US outperforming). Our sense is that global equities may underperform government bonds for a short period following a minor incursion, but that a more aggressive Russian invasion would likely be needed to cause a persistent rise in the US dollar, US equity outperformance, and stocks to underperform bonds on a 12-month time horizon. Investment Conclusions Chart I-20We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio Relative to the investment positions that we presented in our annual outlook report, we see no compelling reason to alter any of our recommendations on a 6-12 month time horizon. Over the nearer-term, a minor Russian incursion of Ukraine is now likely, and may further roil financial markets for a period of time. But the bar for the Ukrainian situation to durably impact returns on a 12-month time horizon is high, and implies a degree of conflict that we do not currently expect. US equities have sold off because of a rise in the discount rate and in the equity risk premium. We do not believe the latter is justified for the market as a whole. Our view that US equities have overreacted to the Fed’s hawkish shift and that long-maturity US bond yields have roughly another 50 basis points of upside this year strongly point to an overweight stance towards stocks versus bonds and a short-duration stance as still justified. We continue to expect that growth stocks will underperform value stocks over the coming year, but in the context of a rising rather than falling overall market (Chart I-20). It is too early to position aggressively toward China-sensitive commodities and global ex-US stocks, but investors should maintain these assets on upgrade watch. The US dollar may continue to reverse some of its recent decline over the coming 3 months in response to military conflict in Ukraine or if investors dial back their expectations for Chinese economic growth, but we expect a lower dollar in a year’s time. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2022 Next Report: February 24, 2022 II. The US Productivity Surge: Less Than Meets The Eye The current surge in US measured productivity looks very unlike what occurred in the mid-to-late 1990s. A detailed breakdown of labor productivity growth points to atypical labor market compositional effects – namely a significant decline in services employment – as being responsible for the apparent rise in productivity. In addition, technological disinflation, a major ingredient of the late 1990s “disinflationary boom”, is absent today. A cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the crisis. US output per worker surged compared to other countries, but the US fiscal response also generated a significant amount of excess income to support economic activity – unlike in the euro area, UK, and Japan. Micro-level arguments and some academic studies argue against the idea that work from home arrangements will ultimately be productivity-enhancing. Remote work makes it more difficult for firms to train the next generation of senior employees, which will raise the staffing risks for many businesses. While the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. If inflation remains significantly above target after the pandemic is over, the Fed’s long-term interest rate projections may rise. US stocks would suffer potentially large losses in a scenario where 10-year US Treasury yields rise towards the potential growth rate of the economy. Investors should consider reducing their equity exposure if 5-year, 5-year forward US Treasury yields break above 2.5%. We do not expect that to occur this year, which for now justifies an overweight stance towards risky assets. Chart II-1A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge? The behavior of US labor productivity during the COVID-19 pandemic has raised several questions among investors. As defined by output per hour worked, US productivity accelerated significantly over the first six quarters of the COVID-19 pandemic, but then fell sharply in Q3 2021 (Chart II-1). While some market participants have questioned the cause of the recent decline, investors have generally been more interested in the question of whether the US is in the middle of a long-lasting productivity surge that will help alleviate inflationary pressure – akin to what occurred in the second half of the 1990s. In this report, we review the recent surge in US labor productivity in contrast to what occurred in the late-1990s, and then compare it with what has occurred globally. While we are not pessimistic about the pace of technological advancement and its potential to drive long-run productivity, we conclude that the US is not likely experiencing a sustained productivity boom driven by technological adoption during the pandemic. This underscores why investors should not expect a significant increase in potential output owing to the pandemic or its effects. It also highlights that, if elevated inflation in response to strongly positive output gaps were to occur over the coming few years, it would likely be met by significantly tighter fiscal or monetary policy. Today Versus The 1990s: Total Factor Productivity Versus Capital Intensity Chart II-2The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event A technologically-driven surge in productivity growth in the second half of the 1990s was a highly significant macroeconomic event. Chart II-2 highlights that US labor productivity surged to over 3% from 1995 to 2000, alongside a significant deceleration in core PCE inflation and a sizeable acceleration in potential GDP growth. Given the acceleration in measured productivity during the pandemic, and the accompanying rapid adoption (or broader use) of technology, it is easy to see why some investors have questioned whether a 1990s-style productivity boom is underway. However, a detailed breakdown of the 2020 rise in labor productivity growth highlights substantial differences between the current environment and that of the late 1990s, which points instead to compositional effects as the main driver. Improvements in labor productivity can come from smarter workers, an increase in the amount of capital employed per worker, or from technological innovations and better working practices. The US Bureau of Labor Statistics provides a breakdown of the annual change in labor productivity that attempts to capture these three components: The contribution from shifts in labor composition: This measures the productivity impact of changes in the age, education, and gender structure of the labor force. The contribution from capital intensity: This measures the productivity impact of shifts in the amount of capital equipment available per worker. Total factor (or “multifactor”) productivity: This measures the changes in output per hour that cannot be accounted for by the above two factors. Thus, it includes the effects of technological changes, returns to scale, shifts in the allocation of resources, and other changes in operating procedures. Examining the 2020 rise in labor productivity growth along these three factors underscores key differences between the current environment and that of the late 1990s. The first point for investors to note is that the acceleration in labor productivity in 2020 occurred alongside a contraction in total factor productivity (TFP) growth, in contrast to the 1990s when TFP drove labor productivity (Chart II-3). The fact that TFP growth fell in 2020 means that the increase in labor productivity must have occurred either because of labor composition or capital intensity effects. In 2020, labor composition contributed somewhat to accelerating labor productivity, but that most of the increase was caused by a sharp increase in capital intensity. Some of the increase in overall capital intensity occurred because of an increase in the intensity of information processing equipment and intellectual property products (supporting the idea of an increase in pandemic-driven capital deployment), but this was outstripped by the contribution of “other” capital services (Chart II-4). Chart II-3Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Chart II-4The Surge In US Capital Intensity Reflects A Rapid Compositional Shift In The Labor Market February 2022 February 2022 The concept of capital intensity refers to the amount of capital available per worker, but in practice it is measured as the ratio of the amount of capital used relative to the amount of labor hours used to produce output. Thus, a surge in capital intensity that is not accounted for by an increase in the amount of tech-related capital available to workers points to a rapid compositional shift in the economy from relatively low capital-intensive industries to relatively high-intensive industries. Under less extreme economic circumstances we would be more inclined to search for other potential causes of a rapid increase in measured capital intensity, but a shift in employment from less to more capital-intensive industries is exactly what has occurred during the pandemic. Services jobs tend to be much more labor-intensive than goods-producing jobs; Chart II-5 highlights that the former fell far more than the latter during the pandemic, in sharp contrast to what normally occurs during a recession (Chart II-6). This phenomenon is also reflected in a highly unusual decline in services spending compared with very strong goods spending relative to their pre-pandemic trend. Chart II-5Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Chart II-6The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The takeaway for investors is that the nature of the pandemic and its unique impact on the economy has created the appearance of an acceleration in productivity, when in reality true productivity has fallen and the standard measure of productivity is being flattered by enormous changes in the composition of the labor market. Today Versus The 1990s: IT Investment, And Technological Disinflation The trends in IT investment and prices highlight another major difference between the current environment and that of the late 1990s. Charts II-7 and II-8 highlight recent trends in comparison to those of the 1990s, with the following notable points: Chart II-7There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s Chart II-8A One-Off Move A One-Off Move A One-Off Move The recent pace of real investment in total IT does not point to the pandemic as a sustained source of productivity growth. Real investment in IT has already slowed significantly, in contrast to the 1990s when it accelerated on a sustained basis for years. IT investment as a % of GDP and of total plant and equipment spending has already stopped rising (or is now falling), exhibiting clear signs of a one-off shift and thus undermining the view that IT investment has significantly raised potential output. In pronounced contrast to the mid-1990s when IT equipment prices were collapsing, computing equipment inflation has recently risen into positive territory – to the highest levels recorded since the data became available in 1959. Higher prices for IT equipment clearly reflect, at least in part, pandemic-driven pressure on global supply chains and the production of semiconductors. So we do not expect sustained increases in the price of computing equipment. But the key point for investors is that a major ingredient of the late 1990s “disinflationary boom” is missing today. The US Versus The World We have presented Chart II-9 in previous reports to highlight that there is certainly no evidence of a global productivity surge, using output per worker as a proxy for the standard measure of labor productivity (output per hour worked). Some investors have countered that the US is a more dynamic economy, and that a sustained productivity boom would be more apparent in the US prior to its emergence in other countries. Or simply that the US alone is experiencing a productivity boom that will help reduce very elevated US inflation, with strong implications for Fed policy. Chart II-9During The Pandemic, Cross-Country Changes In Real Output Per Worker… February 2022 February 2022 Chart II-10…Are Mostly Explained By Different Fiscal Responses February 2022 February 2022 Chart II-11High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels Charts II-10 and II-11 present a different cross-country comparison that reinforces the view that the US is not likely experiencing a long-lasting productivity surge that will help reduce inflation. Chart II-10 highlights that in the face of a significant decline in employment, US output was supported by a substantial amount of “excess income” – the cumulative amount of household disposable income earned over the course of the pandemic in excess of what would have been predicted based on the pre-pandemic trend. Other major DM economies (such as the UK and euro area) either saw negative excess income or a modestly positive amount (Japan), underscoring that the fiscal response to the pandemic in most advanced economies was aimed at stabilizing income rather than raising it. In combination with Chart II-11 – which highlights that the US labor market recovery has significantly lagged behind the European and Canadian economies in terms of returning to the pre-pandemic employment trend – this would appear to explain why the US has experienced stronger real output per worker than other countries. Chart II-12Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Canada stands out as the outlier compared with the US, in the sense that it’s growth in real output per worker has been much lower but Canadian fiscal policy created a similar amount of excess income. However, it may be the case that the Canadian experience highlights that the US labor market recovery is the outlier, which could imply that the surge in US labor productivity may in fact have inflationary rather than disinflationary consequences at the margin. We discussed the factors that we believe are driving the slow recovery in the US working-age population in our 2022 annual outlook report, and how they are strongly linked to the pandemic. However, Canada has also clearly been affected by COVID-19, and yet it has experienced a more significant recovery in jobs. Chart II-12 highlights that there has been one major difference between the US and Canada during the pandemic: a substantial gap in the burden of disease from COVID-19. This raises the question of whether Canada has outperformed the US in terms of its labor market recovery, despite a similarly impactful fiscal response, because of a smaller labor shortage stemming from long-term COVID symptoms. Over the past two years, there have been many reports about people who have recovered from COVID but who continue to experience some symptoms of the disease. The medical community has labeled this condition as post-acute sequelae of SARS-CoV-2 infection (PASC), colloquially referred to as “long COVID.” Chart II-13Long-COVID Might Help Explain The US’ Lagged Return To Pre-Pandemic Employment February 2022 February 2022 The medical community’s understanding of long COVID is currently poor, and doctors do not know why some people get the condition or what treatment options are likely to be the most effective. Given this, it is possible that some reports of long COVID are, in fact, related to other conditions. But a recent research report from Brookings estimated that the US labor market may be missing 1.6 million workers because of long COVID’s effects (Chart II-13), which alone would account for 1 percentage point (or roughly 1/4th) of the growth in US real output per worker since the pandemic began. This circumstance would be inflationary rather than disinflationary on the margin, as it would imply that accelerating first and second quartile US wage growth may be sticky even as the pandemic recedes. Is Working From Home Positive For Productivity? We have noted above that the macro data argues against the idea of a sustained rise in US productivity stemming from the pandemic. A more micro-level perspective, one that examines the working-from-home (WFH) experience, also appears to support our case. It is true that surveys of employees highlight that their experience of WFH has been significantly better on average than workers expected and report their being more productive while working from home during the pandemic. Chart II-14 emphasizes that, based on the running surveys from Barrero, Bloom, and Davis (“BBD”), 60% of workers have conveyed better WFH outcomes relative to expectations, versus just 14% reporting worse outcomes. In addition, Chart II-15 clearly highlights that workers prefer at least some form of hybrid WFH arrangement, with just 22% of survey respondents reporting the desire to work from home either rarely or never. Chart II-14Remote Workers Have Reported Better Work-From-Home Outcomes Than What Was Expected February 2022 February 2022 Chart II-15Remote Workers Clearly Prefer A Hybrid Work Model February 2022 February 2022 However, worker preferences do not necessarily correlate with productivity gains, at least not to the same degree. Chart II-16 from the BBD surveys highlights that the share of workers reporting more efficiency while working from home is not as large as those reporting better outcomes relative to expectations, suggesting that employees are considering whether WFH arrangements are benefiting them personally when responding to their desired post-pandemic level of remote work. Chart II-17 also shows that employees working from home only spend a third of the time ordinarily allocated to commuting to working on their primary job; the rest is spent on childcare, leisure, home improvement, or working on a second job (which may or may not be a sustainable source of income). Chart II-16Less Than Half Of Workers Report Being More Efficient While Working Remotely February 2022 February 2022 Chart II-17Only 1/3rd Of Time Saved Commuting Is Spent On Primary Employment February 2022 February 2022 There is also some evidence from academic studies that indicates productivity fell during the pandemic for some remote workers. Michael Gibbs, Friederike Mengel, and Christoph Siemroth (2021) surveyed 10,000 professionals at a large Asian IT services company, and found that productivity declined because of a slight decline in average output and a rise in hours worked.2 Admittedly, elements of the study did point to some factors potentially impacting this decline in productivity that were more prominent in the earlier phase of the pandemic, specifically the issue of childcare (which would not likely be a drag on remote worker productivity in a post-pandemic environment). But it also noted that employees with a longer company tenure fared better, which in our view is an often overlooked element of remote work that points to less future productivity gains from WFH arrangements than may be recognized by investors. The outperformance of senior staff in a WFH environment is not particularly surprising: once employees have accrued significant experience, they spend less of their working time learning and more (or all) of their working time “doing.” It makes sense that employees who predominantly “platform” their existing experience may fare the same or better in a WFH arrangement, but it is highly questionable whether it is sustainable, because it makes it much more difficult for businesses to train the next generation of senior employees. The Gibbs, Mengel, and Siemroth study noted that higher communication and coordination costs featured prominently in their findings of reduced remote worker productivity. Importantly, they found that employees communicated with fewer individuals and business units, both inside and outside the firm, and received less coaching and one-to-one meetings with supervisors. While some firms may be able to mitigate these risks to the advancement and development of more junior staff while maintaining a hybrid on-site / WFH model, we suspect that many firms will fail to do so fully. Future Productivity: Pessimism Unwarranted, But No Inflation Salvation The fact that the US is not likely in the middle of a pandemic-driven productivity boom does not mean that the outlook for productivity is poor. In fact, we would point to two factors that lead us to believe that productivity growth will be better in the future than it has been over the past decade: The pronounced consumer deleveraging phase that existed for several years following the global financial crisis is over, and There are several identifiable technologies currently under development that are likely to have legitimate commercial applications and productivity-enhancing benefits in the future On the first point, we have contended in previous reports that the weak productivity growth observed during the first half of the last economic expansion was because of demand rather than supply-side factors. This notion is jarring for many investors, who are accustomed to think of productivity trends as being exclusively driven by supply-side phenomena. This is typically correct, in that the cyclical impact of fluctuating aggregate demand on measured productivity – particularly during and immediately after recessions – is usually temporary in nature. However, the 2008/2009 recession was highly atypical, in the sense that it was a household “balance sheet” recession rather than a normal “income” recession. This led to a prolonged period of US household deleveraging, below-average corporate sales growth, and poor growth in output per hour worked. In effect, the post-2008 deleveraging phase created a long-lasting, multi-year cyclical effect on measured productivity growth. In early-2009, pessimistic investors held to an understandable reason for why they doubted the sustainability of the economic recovery: there could be no meaningful labor market recovery if businesses expected several years of weak demand because of the likelihood of consumer deleveraging. In this respect, the post-2008 period served as an important natural experiment for macroeconomists and investors: we have learned that the response of firms to a durable but shallow economic recovery is, on the one hand, to hire additional workers, but, on the other hand, also to control wage and salary costs aggressively. Chart II-18Slow Productivity Growth Last Cycle Was A Demand Story, Not A Supply Story February 2022 February 2022 Chart II-18 encapsulates the point that weak productivity during the last economic cycle was closely tied to US household deleveraging. The chart highlights that the decline in total factor productivity due to goods-producing industries – heavily concentrated in manufacturing – was much larger than for private services from 2007 to 2019. Since there was no technological slowdown that disproportionally impacted the manufacturing industry during the period, this clearly points to demand-side rather than supply-side factors as the main driver of the post-GFC productivity slowdown. On the second point about future productivity growth, Table II-1 outlines five well-known technologies that are in various stages of development and are likely to lead to significant applications at some point in the future: artificial intelligence, automated driving (a specific application of AI), quantum computing, augmented/virtual reality and human-machine interface, and CRISPR/gene editing. The table outlines the nature of potential future applications, as well as projections from McKinsey Global Institute about the most likely commercialization timeline. Table II-1Technological Advancement Is Ongoing. It Won’t Likely Help Fight Inflation Over The Next Few Years February 2022 February 2022 A detailed analysis of each of these technologies is beyond the scope of this report, but Table II-1 underscores two key points for investors. The first is that further, technologically-driven productivity growth is not just possible, it is likely. It is clear what advancements will probably drive these productivity gains, and Table II-1 highlights only the most well-known technologies to which experts in the field would point to. The second point is that most major changes from these technologies are projected to occur beyond 2025, and, in many cases, beyond this decade. In the case of quantum computing, while it could potentially lead to an explosion of algorithmic power that would almost certainly have major commercial implications, it is even possible that this technology will initially subtract from total factor productivity growth before contributing positively. This is because of its potential to render much of the existing global internet security and privacy infrastructure useless, as highlighted by a NIST Cybersecurity White Paper last April: “Continued progress in the development of quantum computing foreshadows a particularly disruptive cryptographic transition. All widely used public-key cryptographic algorithms are theoretically vulnerable to attacks based on Shor’s algorithm, but the algorithm depends upon operations that can only be achieved by a large-scale quantum computer. Practical quantum computing, when available to cyber adversaries, will break the security of nearly all modern public-key cryptographic systems.”3 Some experts believe that the preparation required to avoid this outcome may dwarf that of the millennium bug (“Y2K”) problem of the late-1990s,4 which cost roughly 1% of GDP to fix – and thus was clearly not productivity-enhancing. The bottom line for investors is that while the long-term outlook for technologically-driven productivity growth is bright, it is unlikely to save the US and/or global economies from elevated inflation over the next several years if output gaps in advanced economies rise to strongly positive levels in the wake of the pandemic. Investment Conclusions Our analysis above has highlighted that the current surge in measured productivity looks very unlike what occurred in the mid-to-late 1990s, and that very atypical labor market compositional effects are likely responsible for the apparent rise in labor productivity. We have also highlighted that a cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the pandemic, and that there are micro-level arguments against the idea that work from home arrangements are productivity-enhancing. Finally, while the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. While we believe that the COVID-19 pandemic will recede in importance this year, it is not yet over. As such, investors do not yet know how strong the output gap in the US and other advanced economies will be on average over the coming two to three years, or what the pace of consumer price inflation will look like in the face of strong aggregate demand but substantially lower (or no) pressure from the supply-side of the economy (as we expect). Chart II-19There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates In a scenario in which aggregate demand remains strong next year and inflation remains above-target, even in the face of Fed tightening and a normalization in services/goods spending, we would expect to see significantly tighter fiscal or monetary policy. This is a scenario in which the secular stagnation narrative, which underpins the Fed’s low long-term interest rate projection, would likely be aggressively challenged by investors. Chart II-19 highlights that US equities would potentially suffer a 24% contraction in the forward P/E in a scenario in which the equity risk premium is in line with its historical average and 10-year US Treasury yields rise to the potential growth rate of the economy. We do not yet believe that a significant rise in long-term interest rate expectations will occur this year, meaning that investors should still be overweight stocks versus government bonds over the coming 6-12 months. But as we noted in last month’s report, we may recommend that investors reduce their equity exposure if 5-year, 5-year forward Treasury yields break above 2.5% (the FOMC’s long-run Fed funds rate projection), which we noted in Section 1 of our report is 50 basis points above current levels. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst 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, 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 (whose vaccination progress is still lagging). 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 Content 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 The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2     Michael Gibbs, Friederike Mengel, and Christoph Siemroth. “Work from Home & Productivity: Evidence from Personnel & Analytics Data.” Working Paper No. 2021-56. July 13, 2021. Pp. 1-30. 3    William Barker, William Polk, and Murugiah Souppaya. “Getting Ready for Post-Quantum Cryptography: Exploring Challenges Associated with Adopting and Using Post-Quantum Cryptographic Algorithms.” National Institute of Standards and Technology, US Department of Commerce. April 28, 2021. Pp. 1-7. 4    Jonathan Ruane, Andrew McAfee, and William Oliver. “Quantum Computing for Business Leaders.” Harvard Business Review, January-February 2022.

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover A Correction Not A Bear Market A Correction Not A Bear Market Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Business Cycles Drive Earnings Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive US Homebuilders Looking Attractive US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix A Correction Not A Bear Market A Correction Not A Bear Market Special Trade Recommendations Current MacroQuant Model Scores A Correction Not A Bear Market A Correction Not A Bear Market

Highlights Federal Reserve: Market turbulence will not dissuade the Fed from starting to hike rates in March, with longer-term consumer inflation expectations climbing steadily higher. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Canada: Canadian growth is set to recover as the intense Omicron wave has peaked, further intensifying inflationary pressures. The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with inflation expectations above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates. Feature Chart of the WeekA Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets Risk assets have taken a beating over the past week, with major equity indices in the US and Europe suffering the sharpest selloffs seen since the early days of the pandemic. There are many sources of investor angst fueling the risk aversion wave - a potential Russian invasion of Ukraine, some mixed results on Q4/2021 corporate earnings reports, the lingering Omicron wave and most importantly, fears of tighter global monetary policy. The latter is most evident in the US, with a few prominent Wall Street investment banks now calling for the Fed to deliver much more than the 3-4 rate hikes currently discounted for 2022. The Fed is now in a difficult spot. Realized US inflation remains very high, supply chain disruptions are not going away, and wage growth is accelerating amid tight US labor market conditions. Survey-based consumer inflation expectations show little sign of peaking, with longer-term expectations now climbing steadily higher. As a result, the Fed has been forced to rapidly shift its policy guidance in a more hawkish direction. These trends are not unique to the US, however, as similar inflation dynamics are playing out in places like the UK and Canada where central banks are also expected to deliver a lot of monetary tightening this year (Chart of the Week). For inflation targeting central banks, a surge in inflation that becomes increasingly embedded in longer-term inflation expectations is a direct challenge to their credibility. The policy prescription must involve monetary tightening to raise real interest rates in a bid to stabilize inflation expectations. At the same time, given the starting point of near-0% nominal policy rates and high inflation, deeply negative real interest rates have a lot of room to rise before becoming a serious restraint on economic growth. This limits how far bond yields can decline in response to a generalized risk-off move like the one seen over the past week. For financial markets hooked on easy monetary policies, an inflation-induced monetary tightening cycle will lead to even higher bond yields – especially real yields - and more frequent bouts of market volatility this year. The events of the past week will likely not be a one-off. The Fed Cares About Inflation, Not Your Equity Portfolio US equity markets have had a rough start to 2022. The S&P 500 is down -9% so far in January, with the tech-heavy NASDAQ index down a whopping -13% (Chart 2). The VIX index now sits at 31, nearly double the level seen at the end of 2021. The selloff in risk assets has occurred alongside an increase in real US bond yields. TIPS yields for the 2yr, 5yr and 10yr maturities are up +20bps, +36bps and +43bps, respectively since the start of the year - a reflection of increasing Fed rate hike expectations. Yet other financial markets have seen more limited swings so far in 2022. Non-US equities are sharply outperforming the US; the EuroStoxx index of European equities is down -6%, while the MSCI emerging market (EM) equity index is down just -2%. US investment grade and high-yield spreads, using the Bloomberg benchmark indices, are up a relatively modest +9bps and +36bps, respectively, while the DXY US dollar index is up only +0.4%. The risk asset selloff seen year-to-date has been sharp, but has likely not been enough for the Fed to postpone the expected March liftoff of the fed funds rate. US financial conditions have tightened, but not nearly by enough to make the Fed to more concerned about the US economic growth outlook (Chart 3). Also, financial markets appear to be functioning normally, suggesting what is happening is a repricing of risk assets rather than a selloff driven by poor market liquidity conditions. Chart 2A 'Real' Equity Market Correction A 'Real' Equity Market Correction A 'Real' Equity Market Correction ​​​​​​ Chart 3High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern ​​​​​​ The bigger risk to US growth may actually come from high inflation, rather than falling asset values. Real US household income growth, derived from responses in the New York Fed’s Survey of Consumer Expectations to individual questions on incomes and inflation, is expected to contract -3% over the next year (bottom panel). Given that decline in perceived spending power, with inflation far exceeding wage growth, it is no surprise that the University of Michigan consumer confidence index is near an 8-year low. US business confidence has also been hit by high inflation. The NFIB survey of small business sentiment and the Conference Board survey of corporate CEO confidence declined in the latter half of 2021, largely in response to inflationary supply chain disruptions and labor shortages. Nearly one-quarter of NFIB survey respondents cite “inflation” as the single most important problem in operating their businesses. Economic sentiment has clearly taken a hit because of elevated US inflation, even with the US unemployment rate at 3.9% and overall real GDP growth remaining solidly above trend. This suggests that slowing inflation could actually provide a more sustainable boost to the US growth through improved confidence – if the Fed can first successfully engineer a “soft landing” for the economy once it begins hiking rates. The problem the Fed now faces is that the high inflation of the past year is starting to leak into longer-term survey-based measures of inflation expectations. 5-10 year ahead consumer inflation expectations from the University of Michigan survey are now at a 10-year high of 3.1%, while the 10-year-ahead inflation forecast from the Philadelphia Fed’s Survey of Professional Forecasters is at a 23-year high of 2.6% (Chart 4). Market-based inflation expectations like TIPS breakevens have stopped rising, as a more hawkish Fed has boosted real TIPS yields, but remain elevated at levels consistent with the Fed achieving, but not exceeding, it's 2% medium-term inflation target (bottom panel). The combination of a tight US labor market and consumers expecting more inflation raises the risk that the US could enter a wage-price spiral, where workers demand wage increases in response to higher inflation and companies are therefore forced to raise prices to maintain profitability. The conditions for a wage-price spiral seem to now be in place in the US (Chart 5): unemployment is low, wages are accelerating and a growing number of US workers are quitting jobs to find better work. Perhaps most importantly, US consumers are more uncertain about where inflation will be in the future. Chart 4US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched ​​​​​ Chart 5The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? ​​​​​​ The New York Fed Survey of Consumer Expectations asks respondents to place probabilities on certain ranges for future US inflation rates one and three years ahead. The probability-weighted average of those inflation rates is dubbed “inflation uncertainty”, and those have doubled over the past year from 2% to 4% (bottom panel). This means that the survey respondents now see higher inflation outcomes as more probable, which will likely result in increased wage demands to “keep up” with the cost of living. With the US labor market looking tight as a drum, amid extensive shortages of quality workers as reported in business confidence surveys, the odds of wage increases because of higher inflation instead of higher productivity – a.k.a. a wage-price spiral – have shot up significantly. Already, the 5-year-annualized growth rate of US unit labor costs has doubled since the start of the pandemic (Chart 6), evidence that wage increases are not being matched by faster productivity. Given the strong historical correlation between unit labor cost growth and core inflation in the US, the rise in the latter will be more persistent if US workers ask for bigger cost-of-living driven wage increases. Chart 6Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation ​​​​​​ Chart 7 ​​​​​ Former Fed Chair Alan Greenspan famously described “price stability” – the Fed’s stated medium-term goal - as a situation where “… households and businesses need not factor expectations of changes in the average level of prices into their decisions.” This is clearly not the situation in the US today, which is why the Fed has no choice but to move ahead with interest rate increases to begin the road back to price stability. Financial market selloffs may actually assist the Fed in achieving that goal through tighter financial conditions, thereby limiting how much interest rates must increase to cool off above-trend US economic growth. Interest rates must still go up first, though – especially in real terms. Already, investors have adjusted to that reality by lifting their medium-term “real rate expectations”. We proxy the latter by taking the difference between the forward path for nominal US interest rates discounted in the US overnight index swap (OIS) curve and the forward path of US inflation discounted in the US CPI swap curve. Over just the past month, that market-implied forward path for the real fed funds rate has shifted from discounting an average level of around -1% over the next decade to something closer to -0.25% (Chart 7). We anticipate that those real rate expectations will move even higher as the Fed begins to hike rates in March and continues its tightening cycle over the next 1-2 years. This will underpin the move higher in US bond yields that we expect this year, for both government and corporate debt, with the benchmark 10-year Treasury yield reaching a high of 2.25% by year-end. Bottom Line: Market turbulence will not dissuade the Fed from starting to hike rates in March. Longer-term consumer inflation expectations are climbing steadily higher, which is starting to feed into higher wage demands in a very tight labor market. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Stay below-benchmark on US interest rate exposure, both in terms of duration and country allocation, in global bond portfolios. Canada Update: The BoC Has A Lot Of Work To Do The Bank of Canada (BoC) meets this week and we anticipate that the first rate hike of this tightening cycle will be announced. This will just be the beginning of what will likely be an extended cycle. Canadian monetary conditions are far too accommodative given above-trend growth and accelerating inflation. The BoC places a lot of analytical weight on its Business Outlook Survey when assessing the state of the Canadian economy. The Q4/2021 survey signaled very strong business confidence and robust demand (both domestic and foreign), with a growing majority of firms surveyed planning to increase investment and hiring over the next year (Chart 8). Survey respondents also reported significant capacity constraints, especially in industries that have experienced strong demand during the pandemic, like retail, manufacturing and housing. This is related to global supply chain disruptions, but also to intensifying labor shortages. Chart 8A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy The survey was conducted before the Omicron variant began to spread through Canada, which lead to the reimposition of severe economic restrictions. The number of Canadian COVID cases has peaked, however, and some restrictions have already begun to be lifted in Ontario, Canada’s largest province by population. The economic impact of Omicron will therefore be concentrated in the first couple of months of 2022 and should not derail the hiring and investment plans indicated in the Business Outlook Survey. A reacceleration of Canadian economic growth post-Omicron would magnify high Canadian inflation at a time of intense capacity constraints and tight labor markets. The Canadian unemployment rate fell to 5.9% in December, just 0.2 percentage points above the pre-COVID low seen in February 2020. Headline CPI inflation reached a 31-year high of 4.8% in December 2021, with trimmed CPI inflation (which omits the most volatile components) reaching an 30-year high of 3.7% (Chart 9). The rise in inflation has been broad-based, with large increases seen for both goods inflation (6.8%) and services inflation (3.7%). Like the US, high inflation is becoming more embedded in survey-based inflation expectations. Canadian businesses expect inflation to be 3.2% over the next two years, according to the Business Outlook Survey.1 Canadian consumers expect inflation to be 4.9% over the next year and 3.5% over the next five years, according to the BoC’s Canadian Survey Of Consumer Expectations (Chart 10). The latter had been very stable around 3% since the survey began back in 2014, thus the 0.5 percentage point jump seen in the latest quarterly survey is a highly significant move that suggests the 2021 inflation surge is become more embedded in Canadian consumer psychology. Chart 9The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands ​​​​​​ Chart 10Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising ​​​​​​ The Canadian inflation backdrop has similarities to the US situation described earlier in this report. Like the US, one-year-ahead Canadian consumer inflation expectations are far above wage expectations (only +2%), which suggests that Canadian consumers expect real wages to contract -2.9%. Also like the US, falling real wage expectations are acting as a drag on Canadian consumer confidence (bottom panel). And also like the US, we expect Canadian workers to increase their wage demands to restore real purchasing power, potentially starting a wage-price spiral. Given widespread Canadian labor market shortages, this process has likely already started. According to the BoC Business Outlook Survey, 43% of firms had to boost wages in Q4/2021 because of “cost of living adjustments”, compared to 29% in Q3/2021 (Chart 11). An even larger share of respondents in the Q4 survey (54%) reported having to raise wages to attract and retain workers, up significantly from Q3 and an indication of how Canadian firms are seeing their wage bill go up trying to find quality labor in a tight job market. Chart 11 Given the messages on growth and inflation from its surveys, the BoC has all the evidence it needs to begin the rate hiking process as soon as possible. The bigger question is how high will rates have to go to cool off Canadian economic growth and bring inflation back into the BoC’s 1-3% target range. The BoC’s own internal models estimate that the neutral level of the policy interest rate is between 1.75% and 2.75%. Those estimates were last produced back in April 2021, however, and the range may need to be revised higher to reflect the changes seen in the Canadian economy since then – most notably the greater supply constraints and higher inflation. At a minimum, the BoC will likely have to raise the policy rate to the higher end of its last estimated range for the neutral rate. Current market pricing in the Canadian OIS curve discounts the BoC hiking the policy rate from 0.25% today to 1.6% by the end of 2022 (Chart 12). With eight scheduled BoC policy meetings this year, including this week, the 2022 pricing is realistically achievable. However, only another 50bps of hikes are priced for 2023 and no additional hikes after that. Chart 12Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Chart 13Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds A peak policy rate around 2% would only be in the lower half of the BoC’s range of neutral rate estimates. It would also represent a very low peak real rate of 0% assuming inflation returns to the midpoint of the BoC target range. It is possible that markets are underestimating how high the BoC will have to lift rates, both in nominal and real terms, because of a fear that rate increases will hurt highly indebted Canadian homeowners and trigger a sharp pullback in house prices. This is a legitimate concern given the stretched housing valuations across most major Canadian cities. However, the BoC is facing the same credibility issue that the Fed and other inflation-targeting central banks are facing in the pandemic era. Canadian inflation is too high and becoming more embedded in inflation expectations. Also like the Fed, the BoC will have to fight the inflation battle now and deal with the collateral damage on financial conditions (and the housing market) later. Importantly, with the Fed also likely to deliver several rate hike in 2022. Thus, the BoC has less need to fear a surge in the Canadian dollar, driven by widening interest rate differentials, that could aggressively tighten financial conditions beyond the impact on asset markets and house prices from higher interest rates (Chart 13). Summing it all up, we maintain our negative strategic outlook on Canadian government bonds as markets are underestimating the tightening that will be required from the BoC over the next 1-2 years. Bottom Line: The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with medium-term consumer inflation expectations now above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Business inflation expectations calculated as the share of respondents reporting expected inflation within a certain range multiplied by the midpoint of the range. We assume a value of 0.5 for “less than 1” and a value of 3.5 for “greater than 3”. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. 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