Economy

Feature Is the worst over for US and EM equities? Clearly, the risk-reward of stocks has somewhat improved, given they are no longer overbought and some bad news has already been priced in. However, conditions for a durable bottom and a sustainable and lasting rally do not yet exist. In the case of the S&P 500, our capitulation indicator has not yet reached the lows that marked the major bottoms of the past 12 years (Chart 1). Chart 1US Stocks Have Not Reached Their Selling Climax Yet Chart 2Components Of US Equity Capitulation Indicator None of its four components – the advance/decline line, momentum, breadth and investor sentiment – are back to their lows of 2010, 2011, 2015-16 and 2018 (Chart 2). In the past three cases, the S&P 500 corrected by 17-20%. A correction of this magnitude is our base case for the S&P 500 at the moment. The S&P drawdown has so far been half of this. US inflation and the Fed’s policy remain the key headwinds to US share prices. Core consumer price inflation is substantially above the Fed’s preferred range (2-2.25%) and wage growth is accelerating. As a result, the Fed will lose credibility if it does not sound ready to hike interest rates materially. The US equity market is vulnerable to such a not-dovish stance from the Fed because it is still very expensive. Inflation has also become a political problem. One reason Biden’s popularity has been sliding in the polls is the rapid pace of consumer price increases. Heading into the mid-term elections in the fall, the White House and the Democrats will not oppose the Fed raising interest rates to fight inflation. Overall, BCA’s Emerging Markets Strategy team believes markets/investors are underestimating inflation risks in the US. Core inflation will not drop below 3% unless the economy slows down and employment/wages slump. High and rising trimmed-mean and median CPI measures suggest inflation is broad-based. Normalization in supply-side factors will not be enough to lower core inflation below 3%. Importantly, the median and trimmed-mean core inflation measures strip out goods and services that post abnormal fluctuations. Their elevated readings corroborate that inflation is genuine and broad-based. Hence, pressure on the Fed to tighten will remain substantial. This is bad news for a still overvalued US stock market. Chart 3EM EPS Is Set To Dissapoint Concerning EM equities and currencies, economic growth in EM will disappoint. Chart 3 suggests that EM corporate profits are set to deteriorate materially in the coming six months or so. Besides, investor sentiment on EM equities is not downbeat – it is neutral (Chart 28 below). From a contrarian perspective, there is not yet a case to buy EM stocks in absolute terms. China’s business cycle recovery is still several months away. In other EM countries, monetary policy has tightened substantially, real interest rates remain high, or the banking system is too unhealthy to support growth. Finally, fiscal policy will be slightly tight this year in the majority of EM. As domestic demand in China and in mainstream EMs disappoint and the Fed does not do a dovish pivot soon, EM currencies will resume their depreciation versus the US dollar. Chart 4 shows that China’s credit and fiscal impulse leads EM currency cycles and is presently pointing to more EM currency depreciation. Charts 32 and 33 (below) are pointing to further greenback strength. Finally, EM growth disappointments and a strong greenback will pressure EM fixed income markets. EM high-yield (HY) credit – both sovereign and corporate – has been selling off, but investment-grade (IG) credit has been holding up (Chart 5). This is a sign that investors have been reluctant to offload EM IG credit and points to lingering positive sentiment on EM and lack of capitulation. Sluggish EM growth and an appreciating US dollar are headwinds for EM credit markets. Chart 4EM Currencies Remain At Risk Chart 5EM Credit Markets: The Selloff Will Broaden Bottom Line: We continue to recommend a defensive strategy for absolute return investors. For global equity portfolios, we recommend underweighting EM and the US, and overweighting Europe and Japan. The path of least resistance for the US dollar is up for now. The charts on the following pages are the most important ones for investors today. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Stocks Have Not Reached Their Selling Climax Yet Even though only 17% of the NASDAQ’s stocks are above their 200-day moving average, the same measure for the NYSE index is 38%, well above its previous lows. Besides, the NYSE’s advance/decline line has broken down, signifying a broadening equity rout. Finally, the US median stock has broken below its 200-day moving average after going sideways for 9-12 months. When such a profile occurs, the sell-off lasts more than a couple of weeks. Chart 6 Chart 7 Chart 8 Chart 9 Non-US Stocks Are Not Oversold Yet Neither global ex-US nor EM stocks are very oversold. Global ex-US and European share prices in SDR terms have been moving sideways for about 9-12 months prior to breaking down recently. Such a breakdown means a weakness in share prices that will likely last for a while. Chart 10 Chart 11 Chart 12 Chart 13 Growth Stocks Have Broken Down Various indexes of growth/TMT stocks have broken below their moving averages that have served as a support since spring 2020. This along with the fact that US interest rates will likely rise suggests that the bull market in growth stocks is either over or in for a prolonged hibernation. Chart 14 Chart 15 Chart 16 Chart 17 Is FAANGM A Bubble? In the past 12 years, US FAANGM stocks rose as much as the previous bubbles. When those bubbles peaked, their prices did not move sideways but rather collapsed. We do not assert that US FAANGM stocks will drop by more than 35% (we simply do not know). The point we would like to emphasize is that the bull market is over for now. At best, US growth stocks will likely be in a trading range in the coming 12-24 months.  Chart 18 Chart 19 US Share Prices And Corporate Margins: Defying Gravity? From a very long-term perspective, the US equity market is rather overextended. Share prices in real terms are almost two standard deviations above their time trend. Similarly, corporate profits in real terms are also very elevated, not least in their reflection of record-high profit margins. The key questions for US equity investors are: (1) how persistent/sticky core inflation will be; and (2) how low corporate profit margins will drop. Wages are the key to both inflation and corporate margins. We believe wage growth will accelerate materially. That will be bad for the outlook of inflation and corporate profit margins, although it will be good news for corporate top lines. Chart 20 Chart 21 The Levels of EM Share Prices And Corporate Profits Have Been Flat For 12 years Contrary to the US, EM share prices are not overextended – they have been flat in absolute terms for the past 12 years. The reason for such dismal performance has been stagnant corporate profits. The latter have been flat-to-down in real terms for the past 12-14 years. A breakout in EM share prices in absolute terms will require their EPS entering a secular uptrend. While this is not impossible this decade, it is not imminent. Chart 22 Chart 23 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Based on a cyclically-adjusted P/E (CAPE) ratio, EM stocks are close to their fair value. In contrast, based on the same measure, US equities are very overvalued. As a result, the relative CAPE ratio of EM versus the US is at a record low. Hence, on a multi-year horizon, odds are that EM share prices will outperform their US peers. In a nutshell, EM ex-China, Korea, Taiwan currencies are also close to their fair value. We will be looking to upgrade EM in the coming months. Chart 24 Chart 25 Chart 26 Chart 27 Investors Are Not Bearish On EM And Europe One missing factor to upgrade EM (non-US markets in general) is investor sentiment. Sentiment is neutral on EM stocks and is fairly upbeat on Europe. In brief, a capitulation has also not yet occurred in non-US markets. On the whole, the current EM sell-off will likely linger until sentiment becomes downbeat. Chart 28 Chart 29 Directional Indicators For EM Stocks Points To More Downside The cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) moves in tandem with EM share prices. The same holds for the NZD versus the USD. The rationale is as follows: all of these currencies correlate with the global business cycle and global risk-on/off trends. Presently, the SEK/CHF cross and the NZD point to lower EM share prices. Chart 30 Chart 31 The US Dollar Is To Rally Further The Fed’s willingness (for now) to hike rates is positive for the greenback. The trend in relative TIPS yields between the US and Germany heralds further USD strength against the euro. Also, the cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) entails more upside in the broad trade-weighted US dollar. Chart 32 Chart 33 Worrisome Market Profiles Several markets such as EM non-TMT share prices, Korean tech stocks, the Chinese onshore CSI300 stock index and silver prices have all failed to break above their 200-day moving averages and are now relapsing. Such a profile is often consistent with new cyclical lows in these markets. Chart 34 Chart 35 Chart 36 Chart 37 China’s Liquidity And Credit Cycles Even though China has heightened the pace of monetary easing, it will take several months before its credit impulse rebounds. On average, it takes about six months for reductions in the required reserve ratio (liquidity injections) to produce a meaningful recovery in the credit impulse. So far, the excess reserve ratio has stabilized but not improved. This means the credit impulse will continue stabilizing in the coming months, but a major rise is unlikely in the near term. In turn, the credit cycle leads share prices by several months. All in all, a risk window for China-related plays remains open in the coming months. Chart 38 Chart 39   Footnotes

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The Biden administration faces significant risks from outside the US economy – our third “key view” for 2022. The Ukraine conflict brings one external risk to the forefront. These external risks would exacerbate the global supply squeeze, potentially pushing up commodity prices until they start to kill demand. Investors should prepare for oil price overshoots.  Exogenous risks – such as foreign policy crises – rarely help the president’s party in the midterm election. Any crisis that adds to short-term inflation will hurt the ruling party. Tactically we continue to prefer defensive equities. Close our tactical long industrials / short consumer discretionary trade for a gain of 11.6%. Close long energy stocks for a 15.6% gain and convert to long energy small caps versus large caps. Buy the dip in cyber security stocks. Feature Stock market volatility is back, thanks in no small part to external risks such as Europe’s energy shortage and Russia’s conflict with the West over Ukraine. In our forecast for 2022, we highlighted the Biden administration’s external risks as our third key view. The rapidly deteriorating geopolitical situation was one of several reasons behind this view and it has now clearly moved to the forefront. In this report we highlight the consequences for domestic-oriented US investors. Biden’s immediate external risks, if they materialize, will increase the likelihood that Democrats will lose control of Congress, causing US fiscal policy to freeze and driving policy uncertainty and the dollar upward. For detailed coverage of the Ukraine conflict and its global geopolitical, macro, and market implications please refer to our Geopolitical Strategy reports. Why Is Biden Vulnerable To External Risks The Biden administration and the Democratic Party face serious external risks in 2022. The Omicron variant and global supply constraints are a major factor. Also the US’s domestic political divisions invite challenges from abroad. President Biden is politically weak ahead of midterm elections on November 8. His net approval rating is under water at -10 percentage points. Republicans are now leading the generic congressional ballot with 45.5% support against Democrats’ 41.8%. On a deeper level, Democrats are beset by a socialist fringe on their left wing, making it difficult to pass legislation, and an enthusiastic nationalist opposition movement with a viable challenger for the presidency in 2024 (former President Trump). At best they will pass one more major bill this year before Congress gets gridlocked. Foreign rivals have an advantage in this context. America’s chief rivals face limited political constraints at home (no midterm elections) but they can make low-cost, high-impact threats against the Biden administration through their leverage over the global supply chain and hence voters’ pocketbooks. External Risks Are Inflationary (At Least At First) External risks begin with inflation. The US’s large imbalance of investment over savings is evident in a current account deficit of 3.3% and deteriorating terms of trade. American demand is exceedingly strong due to accumulated household savings, a new capex cycle, and lingering effects of monetary and fiscal stimulus. Yet global supply is impeded. Import prices are rising at a 5.7% rate, the fastest since the BLS started the series in 2010, while imports from China are rising at a 4.7% clip. China’s “zero Covid” policy implies that supply disruptions will keep up the inflationary pressure this year (Chart 1, first panel). The US is also importing inflation from rising commodity prices. West Texas Intermediate crude oil prices have risen to $83 per barrel and average gasoline prices stand at $3.3. With global supply-demand balances tight, WTI prices should average $77 per barrel this year and $78 next year, according to our Commodity & Energy Strategy. In this context, unplanned supply disruptions are likely and will put more pressure on the supply side. Any conflicts with oil producers such as Russia and Iran will backfire in the form of higher prices at the pump (Chart 1, second panel). Yet geopolitical competitors (Russia, Iran, China) have unfinished business with the US stemming from the Trump administration. It is also possible that Biden could negotiate diplomatic solutions, reducing the risk of an oil price spike, but that is not the current trajectory. Chart 1Biden's External Risks Are Inflationary For Now Interest rate hikes from the Federal Reserve will not easily control inflation derived from external sources and supply constraints. They will take time to dampen domestic demand. Yet voters usually solidify their opinions by mid-summer. Inflation may not have come down much by that time. Biden and the Democratic Party are at the mercy of the global supply chain. In this context Russia deliberately forced its way to the top of the US and global agenda by demanding that the West renounce any attempt to threaten its national security via Ukraine or the former Soviet Union. Energy Shock From Russia? The Ukraine crisis threatens an increase in global energy prices. Russia provides 8% of Europe’s commodity imports, 18% of its energy imports, and 16% of its natural gas imports (Chart 2). Russia is already withholding energy supplies from Europe, helping push natural gas prices up by 122% since last August. If war ignites, Russia could reduce energy flows to Ukraine and hence to the rest of Europe. Europe would not be willing to impose as harsh of sanctions as the US because its energy supply depends on it. The US can increase exports to Europe but it cannot replace Russia without depriving its other allies and partners, including India, Japan, and South Korea (Chart 3). The squeeze will cause prices to rise at first but if it is not addressed by higher output from the US and OPEC 2.0, then demand will be destroyed. Note that in 1979, 2008, and 2014, Russian military invasions coincided with a peak in global oil prices. Chart 2Geopolitical Risks Cause Resource Squeeze Chart 3Can US Replace Russia For Europe? Not Really. If other supply problems emerged simultaneously, the slowdown could be especially disruptive. If US-Iran negotiations fail, then another energy supply risk will emerge immediately this spring. The implication is not only a rise in oil prices but also a resilient dollar, which is also the implication of the Fed’s looming rate hikes. Defensive plays would tend to beat cyclical plays, at least in the short run until the crisis abates. But it is important to look at previous examples of Russian aggression to test this hypothesis. US Market Response To Russian Belligerence When Russia invaded Georgia in August 2008, the attack had limited impact on global financial markets, which were focused on the subprime mortgage crisis unfolding on Wall Street. Naturally stocks underperformed bonds, cyclicals underperformed defensives, and value went sideways against growth. Small caps rallied at first versus large caps but then hit a turning point from outperformance to underperformance (Chart 4). Note that the invasion began while President Putin watched the summer Olympics live in Beijing. So one cannot rule out a limited military action against Ukraine in the near term just because Putin is also headed to Beijing for this winter’s Olympics. When Russia invaded Ukraine in February 2014, seizing the Crimean peninsula in the Black Sea, the attack had a greater impact on global financial markets than with Georgia, although Ukraine’s relevance to the global economy was (and is) still limited. Chart 4Market Reaction To Russia Invasion Of Georgia, 2008 Chart 5Market Reaction To Russia Invasion Of Ukraine, 2014 Bonds outperformed stocks, cyclicals were flat-to-up against defensives (energy clearly outperformed defensives), and small caps stumbled but then beat out large caps (Chart 5). Energy stocks theoretically stood to benefit but crashed later that year due to supply glut and China policy tightening. In 2022 the situation is different from these previous Russian invasions in that the world is already in the thrall of an energy supply squeeze brought on by various factors. China’s economy is growing slowly but authorities are easing policy. A comparison of the winter of 2021-22 with that of 2013-14, when Russia invaded Crimea, suggests that energy stocks have already far outpaced growth and defensives (Chart 6). Energy small caps, however, could rally substantially against large cap peers. Tactically US investors should maintain a risk-averse positioning until the Russians make a military decision and the West announces its retaliatory measures. This analysis suggests that cyclicals and small caps face volatility but can ultimately grind higher after the onset of any new war in Ukraine. The magnitude of the war will obviously matter, which is why we maintain a defensive tactical positioning. The next question centers on the medium-term policy impact of Biden’s external risks. Chart 6Market Context: 2022 Versus 2014 Implications For US Midterms And Policy It is possible that Biden’s external risks will play a role in the 2022 midterms. It depends on which risks materialize. Most likely a Russian re-invasion of Ukraine would have a negative effect on the Democrats, especially if it adds to voters’ inflation woes. Major foreign policy successes or failures have a substantial impact on a president’s re-election chances but midterms are less obvious. Midterms almost always go against the president’s party because the previous election’s losers turn out in droves while winners sit home in complacency or disillusionment. The midterm electorate tends to be older, whiter, and more educated than the presidential electorate. Chart 7 shows only midterm elections in which external risks – such as foreign policy – played a major role. In the House, the only time the president’s party gained seats was in 2002, though it only lost four seats in 1962. In the Senate, the president’s party gained seats in 1962, 2002, and 2018 and only lost 2 seats in 1954. From these points we can draw the following conclusions: Chart 7US Midterm Elections: Ruling Party Performance Amid Foreign Policy Crises Foreign policy crises do not generally help the president’s party. While major crises like 9/11 helped the Republicans, and the 1962 Cuban Missile Crisis minimized Democrats’ losses, nevertheless the 1942 midterm occurred after Pearl Harbor and the Democrats lost seats. Minor crises like the 1958 “Lebanon Crisis” also do not help. Russia’s invasion of Ukraine in 2014 falls under this category and did not help President Obama’s Democrats. A major threat to the homeland can help the president’s party on the margin. This is the significance of 1962 and 2002. The ruling party either minimized losses or made absolute gains in the House, while gaining seats in the Senate. (The 2018 midterm is the other case in which the president’s party gained Senate seats, amid President Trump’s trade war with China, but Republicans suffered heavily in the House.) Wartime escalation and entanglement hurt the president’s party. President Johnson’s Democrats suffered deep losses in 1966, as did President George W. Bush’s Republicans in 2006. Obama’s troop surge in Afghanistan was not the main issue but did not help his party in 2010. Ceasefires and peace treaties do not help the president’s party, even when the end of the war is seen as a victory. World War I was drawing to a close in 1918 but Democrats suffered for having gotten the US involved. Democrats also lost in 1946, despite US triumph in WWII. The Korean war ended on a far more ambivalent note and Republicans suffered at the ballot box. Vietnam was drawing to an ignominious close in 1974, which also occurred in the aftermath of the Arab oil embargo, recession, and Watergate scandal, so no surprise Republicans lost seats. If there is a foreign policy crisis this year, the “best case” for Biden’s Democrats – in crass political terms – would be one that engenders a patriotic rally, like happened with the Cuban Missile Crisis or 9/11. If Democrats only lose four seats in 2022, like Kennedy in 1962, they will have a one-seat majority in the House. However, this best-case scenario is unlikely. As noted, 1962 and 2002 consisted of direct threats to the US homeland. All other crises either hurt or did not help the president’s party. In 2014, while voters had other things on their minds that year, Russia’s invasion of Crimea reinforced criticisms of Obama’s foreign policy already centered on Libya, Syria, and Iran. Obama responded with sanctions and aid to Ukraine, as Biden threatens to do today. Democrats lost 13 seats in the House and 9 seats in the Senate. A similar negative impact should be expected if Russia re-invades in 2022. Biden is already vulnerable: his approval rating collapsed after his messy withdrawal from Afghanistan (reinforcing the fourth bullet about ending wars above). A new foreign policy crisis could cement the narrative of foreign policy incompetence. It matters a great deal whether an exogenous crisis automatically hurts the voter’s pocketbook. If it does, then any initial rally around the flag will fade over time, leaving the negative material impact behind and angering voters. In 1974, President Ford’s approval rating shot up above 50% as he took over from Nixon, yet his party still suffered from the inflationary economic backdrop and dour foreign policy backdrop. In 1978, President Carter’s approval rating also recovered to nearly 50% in time for the vote but it was not enough to overcome inflationary malaise – and Iranian oil strikes began in September (Chart 8). If we subtract the Misery Index (unemployment plus inflation) from the president’s approval rating, we see that Kennedy had a 70% approval during the Cuban Missile Crisis, and Bush had a 62% approval in 2002. But Johnson and Carter were sinking toward 35% during their first midterms, which is where Biden stands today (Chart 9). Chart 8Different Reactions For Different Crises Chart 9Best And Worst Case Scenarios Of Foreign Policy Crisis For Democrats Thus Biden’s external risks, depending on which ones materialize, suggest that the Democratic Party will face another headwind in November. Democrats are very likely to lose the House and somewhat likely to lose the Senate. Gridlock is already setting in – as will be apparent with the potential government shutdown over the February 18 deadline to pass spending bills. But the midterm will formalize it. Policy uncertainty will continue to creep up and weigh on investor risk appetite this year. In other words, even if cyclicals rally through a Ukraine conflict, they may not outperform defensives later this year. Investment Takeaways Cyclically we are booking an 15.6% gain on our long energy trade and will convert it to a long US energy small caps relative to large caps trade. The external risks highlighted in this report would push up oil prices at least initially (Chart 10). However, volatility will pick up from here. OPEC 2.0 will want to keep Brent crude prices from settling above the $90 per barrel that starts to crimp demand, as our Commodity & Energy Strategy argues. Higher prices will also encourage new production, including from the US shale patch (Chart 11). Note that energy stocks, like other cyclicals, tend to underperform during midterm election years as policy uncertainty affects markets. Chart 10Book Gains On Tactical Long Energy Equities Trade Chart 11US Oil Producers Will Step Up  Tactically we recommend closing our long industrials / short consumer discretionary for a gain of 11.6%. Normally, consumer discretionary stocks are the best performing sector during midterm election years while industrials are the worst. But because of China’s policy easing, we took a tactical bet that the opposite would occur at the start of the year. However, external risks should now cause this situation to reverse by pushing up the dollar, penalizing industrials, without hurting the American consumer too much (Chart 12). Industrial equities are pricing in strong capex intentions but geopolitical conflicts would weigh on those intentions, while new orders and core durable goods orders could suffer a bit (Chart 13). The midterms will come into focus later this year and weigh on industrials as well. Chart 12Close Long Industrials Trade For Now Chart 13Industrials Still Attractive On Cyclical Basis Cyclically stick with cyber security stocks. They have sold off along with the tech sector as interest rates rise. But long cyber security is a secular investment thesis based on digitization of the economy, rising cyber crime, and geopolitical risk. Tensions with Russia, proxied by the fall in the ruble and rise in aerospace/defense stocks, point to the fact that investors recognize international tensions will remain high (Chart 14). Cyber space will remain an area of conflict even if physical conflict does not materialize. Growth stocks should also revive later as midterm policy uncertainty picks up. Chart 14Cyber Security Is A Secular Trade ... Buy The Dip Chart 15Overweight Health Care Amid Political Risk Tactically stick with overweight health care on rising uncertainty and expectations that the dollar will pick up (Chart 15). Defensives, especially health, should also outperform as the year goes on and midterms approach. Pricing power is returning to the sector but the Biden administration only has a little legislative ammunition left and its regulatory focus lies elsewhere for now.     Matt Gertken Vice President US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Feature Chart 1Weak Economic Fundamentals Undermine Stock Performance Monetary policy easing has intensified in the past two months. The PBoC reduced one-year loan prime rate (LPR) by 10 bps and five-year by 5 bps following last week’s 10bps cut in policy rates1 and December’s 50 bps drop in the reserve requirement rate (RRR). Nonetheless, the onshore financial market’s response to the monetary policy actions has been muted. China’s A-share market price index fell by 3% in the past month. Credit growth has bottomed, but there is no sign of a strong rebound despite recent rate decreases (Chart 1, top panel). The impaired monetary policy transmission mechanism will likely delay China’s economic recovery, which normally lags the credit cycle by six to nine months. Moreover, the marginal propensity to spend among both corporates and households continues to decline, highlighting a lack of confidence among real economy participants, and will in turn dampen the positive effects of policy stimulus (Chart 2).  The poor performance of Chinese onshore stocks (in absolute terms) is due to a muted improvement in credit growth and deteriorating economic fundamentals (Chart 1, bottom panel). Our model shows that China’s corporate profits are set to contract in next six months, implying that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive (Chart 3). Therefore, investors should maintain an underweight allocation to Chinese equities for the time being. Chart 2Lack Of Confidence Dampens Corporate Earnings Outlook Chart 3China's Corporate Profits Set To Contract In Next Six Months   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Improving Liquidity, Weakening Credit Demand The modest uptick in December’s total social financing (TSF) growth largely reflects a significant increase in government bond issuance, while bank loan growth continued on a downward trend (Chart 4). Corporate loan demand remained sluggish, which dragged down aggregate bank credit growth (Chart 5). Downbeat business confidence suggests that corporate demand for credit will take longer to turn around, and therefore will reduce the effectiveness of current easing measures. Chart 4Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Chart 5Corporate Demand For Loans Weaker Than Suggested By Headline Data Meanwhile, corporate bill financing has risen rapidly in recent months and now accounts for almost 40% of new bank loans, the highest level since 2010 (Chart 5, bottom panel). The high share of short-term lending to the corporate sector highlights the underlying weakness in both loan supply and demand.  Banks are risk averse and reluctant to approve longer-term credit to the corporate sector, while corporates are unwilling to take on more debt.  As a result, banks have had to issue short-term bills in order to meet their lending quota. Proactive Fiscal Policy Will Have A Limited Impact On Infrastructure Investments Chart 6Local Government SPBs Will Be Frontloaded In 2022 Fiscal policy will likely be frontloaded in Q1 this year, but the impact of a proactive fiscal policy on boosting infrastructural investment may be limited. According to a statement by the Ministry of Finance last December, around RMB1.46 trillion in the quota for local government special purpose bonds (SPBs) has been frontloaded for 2022. If we assume that all of the SPBs will be issued in Q1, the amount will be higher than SPBs issued during the same period in 2019, 2020 and 2021 (Chart 6). We expect a total SPBs quota of RMB 3.5 trillion for 2022, roughly the same as 2021.  This implies a zero fiscal impulse on SPBs in 2022 compared with 2021. However, there were an estimated 1.2 trillion in SPB proceeds in 2021 that local governments failed to invest and this amount could be deployed in 2022. If we add last year’s SPB carryover to this year’s quota, there may be a 30% increase in the available funds to invest in infrastructure projects in 2022. Chart 7Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending However, a 30% jump in SPB proceeds does not suggest an equal boost in infrastructure spending this year (Chart 7). As noted in previous reports, SPBs issued by local governments only account for around 15% of total funding for infrastructure spending. Bank loans, which remain in the doldrums, are a much more significant driver in supporting the sector’s investment.  Secondly, infrastructure spending has structurally downshifted since 2017 due to a sweeping financial deleveraging campaign to rein in shadow banking activity by local government financing vehicles (LGFVs). Shadow banking activity, which is highly correlated with infrastructure investment growth, is stuck in a deep contraction with no signs of an imminent turnaround (Chart 7, bottom panel). Thirdly, land sales play a prominent role in local government financing, accounting for more than 40% of local government aggregate revenues2 compared with about 15% from SPBs (Chart 8). Local government fiscal spending power will be constrained due to a significant and ongoing slowdown in land sales and regulatory pressures on LGFVs (Chart 8, bottom panel).    Therefore, we expect that infrastructure spending will only moderately rebound in 2022. At best, it will return to its pre-pandemic rate of around 4% (year-over-year) in 2022 (Chart 9, top panel). Notably, onshore infrastructure stocks have priced in the recent favorable news about proactive fiscal policy support in 2022 (Chart 9, bottom panel). Given that infrastructure investment will likely only improve modestly this year, on a cyclical basis the sector’s stock performance upside will be capped and renewed weakness is likely. Chart 8Government Funds Face Headwinds From Falling Land Sales Chart 9Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate More Policy Fine-Tuning Is Underway, But Housing Policy Reversal Remains Doubtful Last week’s 5bp reduction in the 5-year LPR, which serves as a benchmark for mortgage loans, was positive for the housing market. However, the cut is insufficient to revive the demand for housing. Moreover, the asymmetrical rate reductions - a 10bps drop in the 1-year LPR versus a 5bps reduction in the 5-year - signals that the authorities are reluctant to decisively reverse housing policies. Sentiment in the housing sector remains downbeat. A survey conducted by the PBoC shows that the willingness to buy a home has plunged to the lowest level since 2017 (Chart 10). Medium- to long-term household loan growth, which is highly correlated with home sales, decelerated further in December (Chart 10, bottom panel). Given that home prices continue to decline, buyers may be expecting more price discounts and refrain from making purchases despite slightly cheaper mortgage rates. Although there was a modest pickup in medium- to long-term consumer loan growth in November, it was mainly driven by pent-up mortgage applications delayed by the banks in Q3. Moreover, advance payments for real estate developers remained in contraction through end-2021. The prolonged weakness in the demand for mortgages and homes highlights our view that it will take more than a minor mortgage rate cut to revive sentiment (Chart 11). Chart 10Sentiment In Housing Market Has Plummeted To A Multi-Year Low Chart 11Funding Among Real Estate Developers Has Not Improved Without a decisive improvement in home sales, real estate developers will continue to face funding constraints, which will weigh on new investment and housing projects (Chart 12). We expect the contraction in real estate investment and housing starts to be sustained through at least 1H22 (Chart 13). Chart 12Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Chart 13Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Chinese Export Growth Will Converge To Long-Term Growth Chart 14Vigorous Exports Provided Crucial Support To China's Economy In 2021 China’s exports grew vigorously in 2021, providing critical support to the economy.  Net exports contributed 1.7 percentage points to the 8.1% rate of real GDP growth in 2021, the highest growth contribution since 2006. China’s share of global exports expanded to more than 15%, about 2 percentage points higher than the pre-pandemic average from 2015 to 2019 (Chart 14). The export sector probably will not repeat last year’s strong performance. The widening divergence of exports in value and in volume suggests that the solid aggregate value of exports has been mainly buttressed by soaring export prices since July 2021 (Chart 15). The price effect will likely gradually abate in 2022 due to easing global supply chain constraints, softer global economic growth and a high base factor from 2021. Indeed, export prices from China and other industrialized countries may have already peaked (Chart 16). Chart 15Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Chart 16Export Prices May Have Peaked Services spending worldwide will likely normalize and lead global demand growth in 2022. Meanwhile, goods spending will moderate, implying weaker demand for China’s manufactured goods (Chart 17). Furthermore, China’s strong exports to emerging markets (EM) since Q2 2021 reflected supply shortages due to production interruptions in the EMs (Chart 18). We expect supply chain disruptions in these economies to ease in 2H22 when Omicron-induced infections subside and antiviral treatments become available worldwide. As such, China’s exports to those regions may gradually return to pre-pandemic levels. Chart 17US Household Consumption Will Likely Rotate From Goods To Services In 2022 Chart 18Rising Exports To EMs In 2021 May Not Continue Into 2022 China’s manufacturing utilization capacity reached a historical high in 2021, supported by hardy external demand for goods. However, profit margins in the manufacturing sector have been squeezed due to surging input costs (Chart 19). Manufacturing investment growth has been falling, reflecting the reluctance by manufacturers to expand their business operations amid narrowing profit margins (Chart 20). The profit outlook for the manufacturing sector will be at risk of deterioration when the growth in both export volumes and prices moderate in 2022.  Chart 19Manufacturing Sector's Profit Margins Have Been Squeezed Chart 20Manufacturing Investment Growth And Output Volume Both Rolled Over Rising Import Prices Mask The Weakness In Chinese Domestic Demand Chinese import growth in value remained resilient through December, but has increasingly been driven by rising import prices. Import growth in volume, which is a truer picture of China’s domestic demand, decelerated at a faster rate in 2H21 (Chart 21). Credit impulse, which normally leads import growth by around six months, only ticked up slightly. The minor improvement in the rate of Chinese credit expansion will provide limited support to the country’s imports in 1H 2022 (Chart 22).  Chart 21Rising Import Prices Masked The Weakness In China's Domestic Demand   Chart 22Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Chart 23Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints The volume of Chinese-imported key commodities, such as iron ore and steel, rebounded in the past three months, but its growth remains in contraction on a year-on-year basis (Chart 23). The improvement in Chinese commodity imports, in our view, reflects an easing in production constraints rather than escalating demand. Recently released economic data, ranging from manufacturing PMI, industrial production, fixed-asset investment and construction activity, all point to an imbalanced supply-demand picture in China’s economy (discussed in the next section).    Sluggish Quarterly Economic Growth At End Of 2021 China’s economy expanded by 8.1% in 2021 or at a 5.1% average annual rate in the past two years.  However, quarterly GDP growth on a year-over-year basis slowed further to 4% in Q4 from 4.9% in the previous quarter. On a sequential basis, seasonally adjusted GDP growth in Q4 was 1.6 percentage points above that of Q3, but slightly below its historical mean (Chart 24). Chart 24Subdued GDP Growth In Q4 Chart 25Investment And Consumption Have Been Poor Economic Links Chart 26Softness In Investment And Consumption More Than Offset Robust Exports Although industrial production accelerated somewhat in December, it reflects a catch-up phase following a period of constrained output amid last fall’s energy crisis (Chart 25). On the other hand, lackluster domestic demand and a further slowdown in the housing market significantly dragged down China’s economic expansion in Q4. Both fixed-asset investment and consumption decelerated significantly in 2021 Q4, more than offsetting an improvement in net exports (Chart 26, top panel). Notably, year-over-year growth rates in construction and real estate components of real GDP fell below zero in Q4 (Chart 26, bottom panel). In light of the subdued credit growth through end-2021, China’s economic activity will not regain its footing until mid-2022.  Slow Recovery In Household Consumption Likely Through 1H22 The household consumption recovery was sluggish in 2021 and it will face strong headwinds at least through 1H22. China’s consumption recovery has been hindered by a worsening labor market situation, depressed household sentiment and renewed threats from flareups in domestic COVID-19 cases. China’s labor market situation shows a mixed picture. The urban unemployment rate has dropped to pre-pandemic levels and stabilized at 5.1% in December. It remains well within the government’s 2021 unemployment target of “around 5.5%”. However, urban new job creations plunged sharply and the number of migrant workers returning to the cities remains far below the pre-pandemic trend (Chart 27). China’s imbalanced economic recovery in the past two years led to a substantially slower pace of job creation in labor-intensive service sectors (Chart 28). Moreover, wages have been cut and the unemployment rate among younger workers have climbed rapidly in sectors suffering from last year’s regulatory crackdowns in real estate, education and internet platforms. Even though policies have recently eased at margin, it will take time for labor market dynamics (a lagging indicator) to improve. Chart 27Labor Market Situation Is Worsening Chart 28Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Chinese household expenditures have lagged disposable incomes since the outbreak of the pandemic (Chart 29). The propensity to consume has declined since 2018 and the downward trend has been exacerbated by the pandemic since early 2020 along with a soaring preference to save (Chart 30). Chart 29Chinese Household Expenditures Have Lagged Disposable Income Growth Chart 30Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Household consumption also faces renewed threats from increases in domestic COVID-19 cases. Since Q3 last year, more frequent city-wide lockdowns and inter-regional travel bans have had profound negative effects on the country’s service sector and retail sales (Chart 31 & 32). Omicron has also spread to China, triggering new waves of stringent countermeasures. China will not abandon its zero-tolerance policy towards COVID anytime soon, thus we expect the stop-and-go economic reopening to continue to weigh on the country’s service sector activity and consumption at least through 1H22. Chart 32Service Sector Activities Struggle To Return To Pre-Pandemic Trends Chart 31China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes 1     The 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rates. 2     Including local government budgetary and managed funds revenues.   Strategic View Cyclical Recommendations Tactical Recommendations

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 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​​​​​​ Chart 3High 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​​​​​ Chart 5The 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​​​​​​ ​​​​​ 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 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​​​​​​ Chart 10Canadian 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. 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 Chart 13Stay 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 The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades