Equities

Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). ​​​​​ Chart 3Social Restrictions Short Of Lockdown​​​​​​ Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened)​​​​​ Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production  peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place​​​​​ Chart 13EM: Political Risk High But Governments Not Recapitalized​​​​​​ Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. ​​​​​​ Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22).  Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable​​​​​​ Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets​​​​​​ We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound.     We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks.   -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail.   Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2     Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

Dear Clients, This is the final publication for the year, in which we recap some of the key economic developments this month. Our publishing schedule will resume on January 6, 2022. The China Investment Strategy team wishes you a very happy and safe holiday season and a prosperous New Year! Best regards, Jing Sima China Strategist   Feature Recently released data show China’s economy is weakening despite easing monetary policy and power-supply constraints. Our credit impulse – measured by the year-on-year change in total social financing as a share of GDP – inched up in November (Chart 1, top panel).  Given that the indicator leads economic activity by about six to nine months, we maintain the view that China’s economy will not bottom until Q2 next year. Chinese stocks, driven by business cycle, will remain under downward pressures in the next three to six months (Chart 1, middle and bottom panels). On the policy front, the PBoC announced a 50bps cut in the reserve requirement ratio (RRR) rate taking effect in mid-December. Last week’s Central Economic Work Conference (CEWC) signaled that stabilizing the economy will be the government’s core policy objective for 2022. However, we believe that policymakers will be data dependent and will only allow an overshoot in credit growth when the slowdown in the economy gathers pace in early 2022. Thus, investors should maintain an underweight allocation to Chinese equities relative to global stocks, at least for the next three to six months, until credit growth significantly improves.   Chart 1Downside Risks Remain High For Chinese Stocks Until The Econmomy Troughs Chart 2Chinese Internet Stocks Are Not Cheap Chinese investable stocks, particularly internet companies, will continue to face geopolitical and regulatory headwinds in the next 12 months. Chinese tech stocks sold off this year, but they are not cheap (Chart 2). Economic weakness in the onshore market in the next three to six months may trigger more selloffs and further multiples compressions in Chinese investable stocks.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Cuts To The RRR And Relending Rates: Not Game Changers Chart 3RRR Cut Is Not A Game Changer Following the RRR cut announcement in early December, the PBoC announced a 25bps decrease in the relending rate targeting agriculture and small businesses (Chart 3). The measures sent an easing signal in response to mounting downside risks in the economy. However, their impact on credit growth will likely be limited for the following reasons: First, the PBoC indicated that the RRR cut will release around RMB1.2 trillion in liquidity to the banks. From that amount, RMB950 billion will be used to replace maturing Medium-term Lending Facility (MLF) this month, which leaves only RMB250 billion for new liquidity injection. Chart 4Business Conditions For SMEs Deteriorated Faster Than For Larger Businesses Secondly, the PBoC is trying to prevent a jump in market-based rates in the next two quarters.  Demand for liquidity is usually high due to tax season by year-end plus a front-loading of local government bond (LGB) issuance. Moreover, the Chinese New Year in Q1 2022 will further boost demand for liquidity. Thirdly, the targeted relending rate drop is intended to lower the borrowing costs of small-medium enterprises (SMEs) whose profitability has been challenged by rising input costs and sluggish consumer demand (Chart 4). Loan demand from small enterprises, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their larger peers (Chart 4, bottom panel). The rate cut has decreased the possibility of a broadly based decline in interest rates in the near-term. China’s Credit Growth May Have Bottomed, But The Rebound Is Moderate  Chart 5Below-Expectation Credit Growth In November China’s aggregate credit growth ticked up slightly in November. The modest advance mainly reflects an acceleration in LGB issuance. Chart 5 highlights that excluding LGB financing, China’s credit impulse remains on a downward trend. LGBs will be frontloaded in Q1 2022 before the March National People’s Congress sets the full-year quota for LGBs.  However, without a meaningful rebound in bank loan growth, the effects of LGB issuance on infrastructure investment will be limited and short-lived, as occurred in Q1 2019 (Chart 6). Shadow banking, which historically has had a tight correlation with infrastructure investment, continued to slide in November to an all-time low. Infrastructure project approval also does not show any signs of strengthening (Chart 7). Chart 6Improvement In Infrastructure Investment Will Be Limited Without An Acceleration In Loan Growth Chart 7Key Indicators Show Weak Signs Of Revival In Infrastructure Spending Weak demand for bank loans from corporations dragged down credit growth in November as evidenced by softening growth in medium- and long-term corporate loans (Chart 8). Both corporate financing needs and investment willingness continued to wane, implying that corporate demand for bank lending may not turn around soon despite recent monetary easing (Chart 8, bottom panel). In addition, marginal easing measures in the property market have not worked their way into the sector. Bank loans to real estate developers plummeted to all-time lows last month, while trust loans contracted significantly in November, which indicates that financing conditions for real estate developers have not improved (Chart 9). Chart 8Loan Demand Remains Weak And Unlikely To Turn Around Imminently Chart 9Deepening Contraction In Trust Loans Indicates Deteriorating Financing Conditions For Real Estate Developers Easing Of Property Restrictions Will Marginally Benefit The Housing Market Last week’s Politburo meeting and the CEWC both proposed to promote affordable rental housing and support reasonable housing demand. Loan growth to government-subsidized social welfare housing has been decelerating since 2018 and started to contract this year (Chart 10). It will likely strengthen next year amid policy support, but from a very low level and at a modest rate. In addition, although social welfare housing loans account for around 40% of bank loans to real estate developers, they are only about 6% of developers’ total source of funding as of 2020. We expect more policy finetuning in the coming months, which may help slow the pace of deterioration in real estate developers’ financing conditions. Real estate developers’ financing from banks may bottom on the back of government’s intervention, but the improvement in total funds to developers will be gradual without mortgage rate cuts and a pickup in home sales (Chart 11). Meanwhile, the downward trend in housing completion will be sustained in the coming months (Chart 11, top panel). Chart 10Bank Loans To Social Welfare Housing Will Likely Improve Modestly Amid Policy Support Chart 11Less Funding = Reduced Completions And Investments Housing prices in most Tier-one and Tier-two cities continued to move down through November. Data for high-frequency floor space sold show that housing demand continued to abate last month despite a modest uptick in household mortgage loans (Chart 12). Home sales will remain depressed as buyers expect more discounts in housing prices and real estate tax reforms loom. Falling prices and constraints in developers’ financing will continue to weigh on housing starts, given the strong positive correlation between property starts and housing prices (Chart 13). Chart 12Demand For Housing In November Showed Little Signs Of Revival Chart 13Housing Starts Are Highly Correlated With Prices   The Rebound In November’s PMI Does Not Signal A Bottom In China’s Economy Chart 14China's PMI Rebounds Amid Supply-Side Improvement The NBS manufacturing PMI returned to above the 50-expansionary threshold in November, but the rise reflects a near-term supply-side improvement related to the power shortage rather than a demand-driven recovery (Chart 14). China’s overall business conditions and domestic demand are still worsening, indicating that the rebound in the manufacturing PMI may be short-lived. The production subindex jumped by three and half percentage points in November from October, reflecting re-started operation of heavy-industry enterprises that were halted amid electricity shortages in September and October. Robust global demand for China’s manufactured goods supported a strong reading in November’s new export orders subindex. However, domestic demand remains lackluster. A proxy for the new domestic orders derived from the PMI reached its lowest level since February 2020 (Chart 14, bottom panel). In addition, service PMI weakened last month. A sharp resurgence in domestic COVID cases curbed service sector activity last month. Given uncertainties surrounding the Omicron variant and China’s zero-tolerance policy towards COVID, the service sector’s recovery will likely remain below-trend into 1H 2022 (Chart 15 and 16). Chart 15Lingering COVID Effects Will Continue To Impede Service Sector Activity In 1H22 Chart 16Service Sector Recovery In China Has Lagged Inflation Passthroughs Ongoing Producer price index (PPI) inflation may have peaked. Meanwhile, the consumer price index (CPI) shows another upturn in November. Despite the peak in PPI inflation, it will likely remain above trend through at least 1H22, supported by elevated commodity and energy prices (Chart 17). Chart 17PPI May Have Peaked, But Will Remain Elevated In The Near Term Chart 18Ongoing Inflation Passthroughs A synchronized rise between PPI consumer goods and non-food CPI, and a narrower gap between PPI and CPI inflation, suggest an ongoing inflation passthrough from producers to consumers (Chart 18). Price increases in some key sectors of manufactured consumer goods sped up in November (Chart 19). However, we do not think China’s consumer price inflation will prevent policymakers from further policy easing. Consumer goods prices are lightly weighted in China’s CPI. An acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates. Headline CPI may gather steam next year if food prices rise while energy prices remain at current levels. Nonetheless, in recent years China’s monetary policymaking has been more tightly correlated with the PPI and core CPI, and not headline CPI (Chart 20). Chart 19Manufactured Consumer Goods Prices On The Rise Chart 20Monetary Policy Is Tightly Correlated With Core CPI And Not Headline CPI Surging Prices Underpin China’s Exports, While The Rebound In Imports Is Unsustainable Chart 21Surging Export Prices Underpinned Strong Growth In The Value Of China's Exports Chinese exports in volume tumbled in November, however, surging export prices underpinned the strong growth in the value of exports (Chart 21). Demand from the US drove Chinese exports this year and the moderation in volume growth was more than offset by escalating prices (Chart 22). China’s export prices have caught up with the global average (Chart 23). Chart 22Strong Demand From US Has Driven Up China's Exports Chart 23Chinese Export Prices Have Caught Up With The Global Average We expect China’s export growth to slow in the new year on the back of softer global growth and a rotation in US household consumption from goods to services  (Chart 24). However, while slowing, global economic growth is projected to remain above trend. The low level of industrial inventories will also provide support to the demand for goods, which will help to sustain strong growth in Chinese exports (Chart 25). China’s imports surprised to the upside in November, boosted by imports of commodities such as coal and crude oil. November’s acceleration in imports reflects a higher demand for primary commodities from Chinese producers, who recovered some production capacity from the power shortages in the previous few months. Chart 24US Household Spending Will Shift From Goods To Services Chart 25Inventory Restocking In The US Will Support Chinese Exports Next Year Furthermore, the increase in import prices in November outpaced the very modest uptick in the volume of imports, indicating that domestic demand remains sluggish (Chart 26). Credit growth, which normally leads import growth by about six months, only climbed moderately in November and will provide limited support to imports in the coming months (Chart 27). Chart 26Rising Import Prices Masked Weakness In China's Domestic Demand Chart 27Modest Rebound In Credit Impulse Will Provide Little Support To Chinese Imports Chart 28Chinese Demand For Industrial Metals Remains In Deep Contraction China’s imports of industrial metals, such as copper and steel, improved a little in November, but their year-on-year growth remains in deep contraction (Chart 28). Weakening construction activity amid a continued downtrend in China’s property market will likely reduce the demand for industrial metals. Therefore, the rebound in November’s import growth may be short-lived. The RMB Faces Headwinds In 2022 Regardless Of A Rise In FX Deposit RRR The RMB has climbed about 2% against the dollar since late July despite broad-based dollar strength. In trade-weighted terms, the RMB is at its strongest level since late 2015 (Chart 29). A rapidly appreciating RMB does not bode well for China’s industrial sector profits, and thus not at the PBoC’s best interests (Chart 30). Under this backdrop, last week the PBoC announced that it will raise the banks’ foreign exchange (FX) deposit reserve requirement ratio (RRR) to 9% from 7%, effective December 15. This is the second increase this year aimed at easing the RMB’s pace of appreciation. The RMB fell slightly against the US dollar following the announcement last week. Chart 29The RMB Has Strengthened Despite A Strong USD Chart 30Strengthening RMB Does Not Bode Well For Corporate Profit Growth The RMB appreciation against dollar this year was mainly enhanced by China’s record current account surplus and favorable interest rate differentials between China and the US (Chart 31 and 32). Although the increase in the deposit RRR rate will force banks to hold more foreign currencies and lift the cost of RMB speculation, the RRR hike itself has little impact on altering the existing path in RMB exchange rate. Moreover, the balance of FX deposits stands at US$1 trillion as of November this year. The 200bps increase in the FX deposit reserve ratio will only freeze about US$20 billion in FX liquidity, which is negligible compared with the US$580 billion in China’s trade surplus so far this year. Chart 31Current Account Surplus Will Likely Shrink Next Year Chart 32Interest Rate Differentials Will Narrow Further However, looking forward the conditions favored RMB this year are at risk of reversing in 2022. China’s weaker economic fundamentals and a slower pace in trade surplus next year, as well as narrowed interest rate differentials between the US and China due to falling long-duration bond yields in China, will provide headwinds to RMB. Therefore, investors should closely follow these key factors and to be cautious to bet on continued RMB appreciation. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Market/Sector Recommendations Cyclical Investment Stance

Highlights 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it. Economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. Corporate profitability will return to trend. The likely deceleration in earnings growth and margin contraction will be driven by a combination of factors: A slowdown in top-line growth, a decline in corporate pricing power, and increases in labor and input costs. The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle, and volatility is heightened. We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation as in the middle single digits. Overweight Small vs. Large for the following reasons: First, Small is expected to outperform in an environment of rising rates - A BCA view for 2022. Second, Small is cheap. Third, the profitability of Small has improved dramatically which attests to the ability of smaller companies to efficiently manage their operations even under duress. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double of Large, 20% vs. 10%. We are neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. Overweight Cyclicals vs. Defensives as the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives. Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. Further, rising rates is an environment favorable for Cyclicals at the expense of Defensives. Within Cyclicals, we prefer the following sectors and themes: Consumers are flush with cash and there is strong pent-up demand for services and selected consumer goods like services: Overweight Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Also, overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. New Capex Cycle: Businesses bring their supply chains back to the US and excess consumer demand has driven the need for expanded capacity. Capex intentions are on the rise. Overweight Construction and Engineering, Building Materials, and Capital Goods. New Credit Cycle: Early signs that both consumer and business lending is picking up. Rising rates will also lend a helping hand to Banks – overweight Overweight Energy as demand for oil is robust on the back of global recovery and chronic underinvestment in Capex. Underweight resource stocks, which are exposed to a slowdown in China. The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. Overweight Real Estate and Homebuilders Multi-year structural themes are Millennials, Generation Z, EV revolution, and Cybersecurity. 2022 will be a big year for the new technology themes. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports. Feature House Views Last Week, BCA published its annual outlook, a transcript of our yearly discussion with the firm’s long-time clients, Mr. X and his daughter, Ms. X. In this document, we discussed the major themes for 2022. Below are some of the main conclusions: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. We expect actual inflation will come in lower next year than what short-maturity inflation expectations currently suggest. Economic growth in advanced economies will be above trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the latter half of next year rather than in the coming six months. Stocks will outperform bonds in 2022, but equity market returns will be in the single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may increase in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields—which will not threaten economic activity or cause a major decline in equity multiples. Equity investors should favor small-cap over large-cap stocks in 2022. Small-cap stocks tend to outperform when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year but stretched relative performance versus defensives means that we expect to rotate away from cyclicals at some point over the coming year. A window exists for value outperformance versus growth in 2022, in response to higher long-maturity government bond yields. We do recommend the former over the latter. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. In this report, we will explore the implications of the above views for US Equities. 2022 Is A Year Of Normalization If 2021 passed under the banner of recovery, 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it, variants and all, and it will become less disruptive to the economy and our personal lives. As such, economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. US Economic Growth And Corporate Profitability Will Return To Trend The economy is expected to grow at a robust pace next year (7.3% nominal GDP growth), albeit slower than this year (Chart 1). After a growth surge on the back of the post-COVID recovery, the economy has entered the slowdown phase of the business cycle. Economic growth is poised to shift closer to its long-term trend in 2022. Corporate profitability is also expected to trend lower next year (Chart 2). While corporate earnings in 2021 have been impressive, this performance is unlikely to be repeated, as the unique circumstances of the pandemic and the recovery are giving way to more ordinary business conditions. Amid the pandemic and during the early innings of recovery, companies have cut costs aggressively, improved productivity, while lower interest rates have reduced debt servicing burdens, and a weaker dollar has boosted overseas earnings. As the economy restarted, sales growth surged, and corporate pricing power was on the rise thanks to significant pent-up demand for goods and services and consumers being flush with cash. Chart 1Economic Growth Will Return To Trend Chart 2Sales Growth Is Poised To Slow   In 2022, earnings growth will return to trend (Chart 3). The likely deceleration in earnings growth and margin contraction (Chart 4) next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth, a decline in corporate pricing power, i.e., the ability of companies to raise prices, which has been diminished by consumers’ income increasing slower than inflation. Chart 4Profit Margins Are Set To Compress In the meantime, the tight labor market is putting upward pressure on wage growth (Chart 5). Labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items. Input costs are also on the rise with PPI soaring, cutting into corporate profitability (although we do expect PPI to decelerate) (Chart 6). Chart 5Wage Growth Is Accelerating Chart 6Corporate Pricing Power Has Been Waning In addition, there are a few minor expenses that are set to rise in 2022: Capex recovery will push up depreciation expense, interest expense is set to go up because of rising rates and corporate re-leveraging, and taxes are projected to increase, especially for the US multinationals exposed to the international minimum tax. And of course, there is also an appreciating dollar, diminishing the translated value of overseas profits. While each of these line items is minor, in concert they will have a noticeable adverse effect on corporate profitability. We provide analysis of the S&P 500 margins in Marginally Worse and Sector Margin Scorecard reports. 2022: Pedestrian Returns And Higher Volatility The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle (Chart 7). Slowdowns are also usually accompanied by heightened volatility. The TINA trade is still on – there are few inexpensive asset classes, and yield is hard to come by. With rates expected to rise, equities are still a more attractive alternative to bonds (Chart 8). Equities are real assets that do a good job protecting investments from rising prices (that is until inflation triggers tighter monetary policy). With rate hikes still a few quarters away, the party is continuing. There is still a lot of liquidity sloshing around looking for attractive corners of the market. This is manifested in positive equity inflows and a “buy-on-dips” mentality, which, so far, has precluded any major market corrections. Buybacks are on the rise – many corporations have had bumper profits and are returning cash to shareholders (Chart 9). This trend is exacerbated by the current administration’s hostility to M&A activity. Chart 9Buybacks Are Reverting To The Pre-pandemic Level   Returns: Multiple Expansion Passes Baton To Earnings Growth Multiple expansion was a key driver of returns in 2020. In 2021, the baton was passed to earnings growth, which contributed 40% to realized returns this year (Chart 10). 2022 will be more like 2021 than 2020. Multiple expansion is highly unlikely as it tends to be a driver of returns during the recovery stage of the business cycle when the market anticipates economic rejuvenation. Furthermore, valuations are already elevated. When the S&P 500 is trading at over 21x forward earnings, the probability of negative returns over the next 12 months has historically been around 65% (Chart 11). While we believe that there are many factors supporting equities delivering positive returns next year, it is hard to be overly optimistic. Hence, it will be earnings growth again that will rule the day in 2022, with a little help from dividends and buybacks. However, while earnings growth is a key driver of returns, it is expected to slow from the current levels, returning to its historical trend (Chart 12). The blockbuster returns of 2021 will be in the rear-view mirror. Chart 12Earnings Growth Is Slowing Total Return Estimate: Mid-To-High Single Digits Above-trend economic growth and consumer price inflation point to revenue growth in the high single digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, margins are expected to compress in 2022, and earnings growth to decelerate. We proxy sales growth to nominal GDP growth of 7.6%. With margins expected to contract, the best scenario for the degree of operating leverage for the S&P 500 is a historical average of 0.96, translating sales growth into earnings growth of 7.3% (Table 1). For reference, sell-side analysts expect S&P 500 earnings to grow by 8% in 2022 (Chart 13). S&P 500 PE NTM stands at 20.5 which, historically, on average, is about three points below realized PE LTM in 12 months. We assume that PE LTM at the end of 2022 will be 25.6, or a 1.6% contraction from the 25.2 multiple today. Table 12022 S&P 500 Price Target And Total Return Estimate With an average historical dividend yield of 2.2%, we get: (1+7.3%)*(1-1.6%)*(1+2.2%) = 7.9% - Total Return Estimate 4,591*(1+7.3%)*(1-1.6%) =~ 4,850 - Price Target We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation in the middle single digits. The rate of multiple contraction, earnings growth, and dividend yield in 2022 are just educated guesses. Sector And Styles Key Views Small Vs. Large Cap: It Is Finally A Small World 2021 was a tumultuous year for small caps. After a strong outperformance at the beginning of the year on the back of a recovery trade, this asset class has been languishing since March, with each new attempt for a prolonged rally failing (Chart 14). Over the year, small caps have become extremely cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. So why was Small so unloved considering two blockbuster reporting seasons with earnings growth of more than 200%? Even on an annualized basis, since 2019 Small has delivered 47% annualized growth compared to 14% from Large (Chart 15). Moreover, smaller companies have been successful in repairing their balance sheets, which now look much healthier. Chart 14Small Had A Tumultuous Year Small was out of favor as investors fretted about an economic slowdown (Chart 16), the Delta variant (along with the other Greeks), razor-thin margins, and the ability of smaller companies to navigate the economy, plagued with supply bottlenecks and labor shortages. Yet, we went overweight Small vs. Large back in October and are still sticking to our guns. First, Small, which has higher allocations to Cyclicals, such as Financials and Industrials, is expected to outperform in the environment of rising rates (Chart 17) - A BCA view for 2022. Second, in a market where most asset classes are exuberantly expensive, Small is cheap. Third, the profitability of Small has improved dramatically, which attests to the ability of smaller companies to efficiently manage their operations even under duress, as well as to pass costs on to their customers. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double that of Large, 20% vs. 10%. The froth in expectations for the earnings growth of Small has also come down from its peak at 88% and now appears to be a low bar to clear. Chart 16Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Chart 17Small Is Expected To Outperform In The Environment Of Rising Rates What are the risks to this call? If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take. Growth Vs. Value: Be Nimble The story of Growth vs. Value is similar to that of Large vs. Small. Value had a fantastic run as the pandemic started to recede, but then as worries about the Delta variant emerged, Growth took over yet again. Over the past year, Growth outperformed Value by 11%, and by 18% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is a 80% premium to Value (which is trading at 16x). The Growth/Value BCA Valuation indicator is nearly 3 standard deviations above average, and from a statistical perspective, is 99% likely to mean revert. What makes this valuation discrepancy absurd is that both asset classes are bound to deliver roughly the same earnings growth over the next year, i.e., 10%. What is the deal? Just like Small vs. Large, this year, Value vs. Growth has been strongly linked to the 30-year Treasury yield (Chart 18). This has not always been the case in the past, but since the onset of the pandemic, very long-maturity bond yields have done a good job at explaining the relative performance of these asset classes. Growth is overweight Technology, which has been a star of the “work from home” theme. Further, falling long rates inflate the present value of cash flows and earnings of the growth stocks. In the meantime, Value is highly exposed to Financials, which have a hard time maintaining their profitability during times of falling rates and flattening yield curves. Apart from sector composition, Growth as an asset class has also become synonymous with quality, which comes to the rescue at times of heightened risk aversion and uncertainty. This is usually accompanied by falling rates. Indeed, profit margins for Growth are 7% higher than for Value. Since 2019, the annualized earnings growth of Growth is 14.4% compared to 9.8% for Value. The difference is even more dramatic for Sales growth: 6.5% for Growth vs. -1.1% for Value (Chart 19). Chart 18US Value Versus Growth Is Strongly Correlated With Interest Rates However, while we observe that Growth is more reliable for churning out strong numbers, falling sales of Value indicate substantial pent-up demand for products and services. Value also thrives in the environment of robust economic growth and the steepening yield curve. We are currently neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. We have also retained some exposure to Growth by staying with our overweights to Technology and Pharma, as a means of protecting our portfolio from the kind of volatility we have experienced because of the Omicron scare and the Fed’s policy adjustments. Growth Is Robust And COVID Is Receding: Overweight Cyclicals Cyclical sectors have significantly outperformed Defensives this year (by 12%), benefiting from economic reopening and ubiquitous pent-up demand both from businesses and consumers. Despite a strong run and exceeding the pre-pandemic peak (Chart 20), Cyclicals have room to move higher when compared with the prevailing levels in 2010-2011, but that period reflected resource price levels that we are unlikely to see in the coming year. Yet, we expect further outperformance of Cyclicals in 2022. Chart 20Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Chart 21Cyclicals Rally When COVID Fears Reced We do hope that the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives (Chart 21). Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. For many cyclical sectors, such as Consumer Discretionary, Financials, Real Estate, and Industrials, annualized sales growth from 2019 to 2021 is below historical levels, suggesting that there is room for catchup growth (Chart 22). One of the cornerstones of the BCA outlook is that rates will rise. This is an environment favorable for Cyclicals. Defensive sectors tend to underperform when bond yields are rising, as many of them are heavily indebted and have somewhat fixed cash flows because of regulations (Utilities, Telecoms) or strong competition from cheaper substitutes (Pharma amid challenges from generics and biosimilars). Cyclicals are not that much more expensive than Defensives (22x vs. 19x forward earnings) and are trading with a 13% premium. The Cyclical/Defensive Valuations Indicator has come down from three to two standard deviations (Chart 23). Despite a modest valuations premium, earnings of Cyclical sectors are expected to grow at 25% while Defensives will only grow at 6% over the next 12 months. In short, Cyclicals are more attractive than Defensives as a group, but we prefer a granular approach and handpick cyclical sectors that we expect to thrive in the current macroeconomic environment and have favorable sales and earnings growth prospects. Later in the report, we will discuss some of our cyclical sector picks. Chart 23Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Despite Worries About Inflation, Consumers Still Have Money To Spend: Overweight Consumer Services The US government has supported consumers during the lockdowns with a series of helicopter cash drops to all Americans, enumerated in trillions of dollars. As a result, even nine months after the last cash disbursement, consumers are sitting on $2.3 trillion in excess savings (Chart 24). Extremely loose fiscal and monetary policy have lifted household net worth by 128% of GDP (Chart 25). And while consumers do indeed worry about inflation, expecting it to rise to 7.5% in 12 months, there is still plenty of dry powder sitting in their bank accounts. Chart 24Consumers And Businesses Have A Lot Of Dry Powder Chart 25Household Wealth Has Soared Consumer spending on goods has been above the pre-pandemic trend for months and has recently turned. In the meantime, spending on services is still below pre-pandemic levels, suggesting that there is plenty of pent-up demand (Chart 26). Specifically, spending on sports clubs, public transportation, personal care, medical services, and professional services are still below pre-pandemic levels. Pent-up demand will boost Consumer Services, and we recommend overweights to Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Further, while pent-up demand for goods has generally been met, there are still pockets of demand out there due to shortages, such as for automobiles and selected consumer durables. We are also overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. Chart 26Spending On Services Is Still Below The Pre-pandemic Trend New Capex Cycle: Overweight Industrials Industrials is another cyclical sector that we favor. Supply chain disruptions have demonstrated for many businesses that they need to bring their supply chains back to the US, launching the US Manufacturing Renaissance. Also, excess consumer demand has driven the need for expanded capacity. For months now, manufacturers have been inundated with orders (Chart 27). The industrial sector is also exposed to the restocking of inventories and is poised to benefit from the Infrastructure Bill. Therefore, Industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders. Capex intentions have been on the rise as well (Chart 28). Chart 27Producers Inundated With Orders And Need More Capacity To profit from this emerging trend, we are overweight Construction and Engineering, Building Materials, and Capital Goods. Chart 28Surge In Capital Expenditure Will Benefit Industrials New Credit Cycle: Overweight Banks 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. Both businesses and consumers have repaired their balance sheets, and the re-leveraging cycle is set to commence to finance Capex and higher price tag purchases like autos. There are early signs that lending is likely to pick up next year (Chart 29). According to JPM: “The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again.” Credit card spending is recovering (Chart 30). Chart 29Early Innings Of A New Credit Cycle Chart 30Consumers Are Borrowing Again While sell-side analysts anticipate that margins will decline, we believe that they may surprise on the upside: High operating leverage, improving pricing power, and growing demand for loans will contribute to strong profitability. Further, the BCA house view is 10-year rates rising to 2.0 – 2.25% in 2022, which will support net interest margins. Energy Sector Vs. Materials Energy profit margins are linked to underlying commodity prices. The BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate Capex. Although the price of oil has risen above the break-even level, energy companies are reluctant to invest in Capex due to pressure from shareholder activists and newly found financial discipline (Chart 31). As a result, prices are likely to remain high until “high prices cure high prices.” In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yields. Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Chart 31Chronic Underinvestment Is Driving Up Price Of Oil Chart 32A Slowdown In China Is Hurting Demand For Raw Materials Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently – our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year (Chart 32). US Housing Rally Still Has Legs To Run On The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since the GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. The data is also reflective of the supply/demand mismatch with inventories of new and existing homes for sale, and the homeowner vacancy rate at all-time lows, and housing prices exploding higher. At the same time, US building permits are still below the two million SAAR print that historically marked previous housing cycle peaks (Chart 33). The implication is that the current housing boom still has room to go further, benefiting US homebuilders as they monetize the supply/demand mismatch. Homebuilder sentiment rose to a six-month high in November. Tack on the 80bps sell-off in the 30-year US Treasury yield that translates into more affordable mortgage rates for consumers, and there is little that can undercut the US housing market throughout 2022. We are bullish on both the Real Estate and Homebuilders sectors. However, we would be remiss not to mention risks to this call: The performance of the real estate market is highly dependent on the direction of the rates. If long rates rise substantially, this sector will be in the crosscurrents of housing shortages and less affordable mortgages. However, the 2-2.25% 10-year yield that BCA anticipates by end -2022 should not put a significant dent into house ownership affordability. Chart 33Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Risks To The Outlook Rising rates are a key condition for our sector and style calls to pan out. However, if supply chain bottlenecks do not clear soon, inflation will not slow down meaningfully, and the US economy will enter a rising price-wage spiral. The Fed will realize that it is behind the curve and will start hiking rates aggressively, i.e., faster than the pace currently anticipated by the market. As a result, economic growth will disappoint, and the unemployment rate will rise. The yield curve will continue flattening with long rates staying range-bound or moving lower. In this scenario, Growth and Defensives will outperform, while Small, Value and Cyclicals will underperform. Multi-Year Structural Themes To finish, we want to remind clients of our long-term themes, which we expect to continue to pan out next year. Millennials Are Not Coming Of Age; They Are Already Here According to the US Census Bureau, millennials (born 1982 to 2000), are the US's largest living generation and represent more than one-quarter of the US population. This is a generation that is highly educated, and relatively unburdened by debt. While in the past, this generation was perceived as “forever young,” it is rapidly showing signs of maturing: Joining the labor force, starting families, and shopping for houses and cars, thereby pushing consumption up. However, millennials’ consumption basket is different, with an emphasis on new technology, homeownership, electric vehicles, and green energy. ETFs that capture the theme are MILN and GENY. Gen Z Is Coming Of Age And Has Money To Spend Generation Z in the US includes 62 million people born between 1997 and 2012. With $143B in buying power in the US alone, making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. We have created a Gen Z basket with stocks representing fintech, investing and crypto, online gaming, quality-over-price, and some others. There are no ETFs just yet that capture this emerging theme. Cybersecurity Is A Must-Have Global digital transformation as well as rising geopolitical tensions create fertile ground for attacks by both cybercriminals and malicious state actors. The cyber defenses of most private and public companies are still ill-prepared, and the space is poised for robust growth since cybersecurity is a “must-have” for survival. This growing market has attracted a plethora of new cybersecurity players who provide cloud-based SaaS solutions and are well-versed in deploying AI and ML to counter cyber threats. While many of these companies are still young with relatively small capitalization, their potential is enormous. We recommend tactical and structural overweights to the theme. The following ETFs provide exposure to the theme: BUG, CIBR, and HACK. EV Revolution The auto industry is undergoing a major technological disruption. This process is expensive and perilous yet presents an enormous future earnings growth opportunity. And all the ingredients for success are in place: The proliferation of new technologies, government support, changing consumer preferences, and a surging US economy. This tide will lift all boats: Legacy and EV-only auto manufacturers and suppliers as well as EV ecosystem players. We are bullish on the sector on a 12-month investment horizon. ETFs are DRIV, IDRIV, KARS, BATT, and LIT. What We Are Researching For 2022 2022 will be a big year for the new technology themes. Some are brand new, while others have been around for a while. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022,  and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years.  Chart 9Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The helicopter drops are over, … : The economic impact payments and supplemental unemployment insurance benefits may have stopped, but their full impact has yet to be felt.  … but fiscal and monetary policy will continue to support demand, … : US households are sitting on more than $2 trillion of excess pandemic savings. If they were to spend just half of their stash over the next two or three years, the economy would gain a steady tailwind.  … and the macro backdrop will remain equity-friendly, … : Monetary policy will be less accommodative going forward but it will remain solidly supportive of markets and the economy across all of 2022.  … so investors should stick around for one last round: Equities and spread product outperform when monetary policy is easy. As long as COVID-19 doesn’t spring a nasty surprise, the expansion will continue and risk assets will once again generate positive excess returns over Treasuries and cash. Feature BCA editors’ annual sit-down with Mr. and Ms. X provides a welcome opportunity to gather our thoughts for the coming year and review how this year’s calls panned out. Looking back to this time last year,1 our risk-friendly recommendations performed well as the rationale behind them proved to be sound. Financial markets thrived in the wake of monetary and fiscal policy measures intended to err on the side of providing too much accommodation. The policy efforts were massive, and their support for markets and the economy has yet to be fully exhausted; indeed, their lengthy half-life is a key pillar of our sanguine 2022 outlook. Unlike last December, investors cannot look forward to peak accommodation in the year ahead; the peak is behind us and monetary and fiscal stimulus will be throttled back. The Fed is currently deliberating how much to accelerate its taper timetable, with an eye toward gaining the flexibility to hike rates sooner than previously planned. The hawkish turn foreshadowed by Chair Powell two weeks ago in Congressional testimony unsettled markets somewhat, but it is important to note that monetary policy settings are merely on track to become less accommodative – they are nowhere near crossing the line to restrictive and will not approach it anytime soon. Investors can be certain that markets will enjoy ample policy support across all of 2022 and we expect that equities will still be in a bull market when Mr. and Ms. X return to discuss the outlook for 2023. We are on board with the BCA consensus as detailed in the Bank Credit Analyst’s 2022 outlook.2 Early indications suggest that the Omicron variant will not be enough of a threat to provoke a negative growth surprise and we expect that the pandemic will recede in importance as the year unfolds. As it fades, supply chains should become less snarled, easing the near-term pressures that have been pushing prices higher. We expect that markets are overestimating inflation in the near term and that growth will be robust in the US and other developed economies. Despite the dialing back of some accommodation, monetary policy will remain easy, supporting economic activity and market valuations. We foresee another year of solidly positive excess returns for risk assets. The Economy Is Firing On All Cylinders You wouldn’t necessarily know it to talk with investors, much less consumer confidence survey respondents, but aggregate demand is surging and ought to remain robust going forward. Households are in fantastic shape. Although their net worth growth slowed in the third quarter, its 13% annualized seven-quarter (1Q20 through 3Q21) pace is within a whisker of all-time highs (Chart 1). They have accumulated $2.3 trillion of excess savings since the pandemic began and have plenty of capacity to borrow to augment their spending power. Just about anyone who wants a job can have one: the ratio of job openings to unemployed workers is making new highs (Chart 2) and the share of people in the labor force filing initial jobless claims is approaching the all-time lows set before the pandemic (Chart 3). Chart 1The Wealth Effect Will Support Consumption​​​​​​ Chart 2More Jobs Than People Without Them ...​​​​​​ Businesses are on a solid financial footing, as well. Debt as a share of net worth is near the lower end of its typical range since the high yield bond market got going in the late ‘80s (Chart 4). Borrowing costs are scraping all-time lows (Chart 5) and profit margins are wide (Chart 6). Banks and fixed income asset managers are falling all over themselves to lend to businesses and will continue to do so while default rates remain low. Chart 3... And Almost No Layoffs​​​​​​ Chart 4Corporations Have Less Debt And More Equity, ...​​​​​​ Chart 5... But Debt Has Never Cost Less ...​​​​​​ Chart 6... And Profit Margins Are Wide​​​​​​ Financial conditions will remain highly accommodative despite the Fed’s and other major developed world central banks’ moves to make them less easy at the margin. Below-equilibrium policy rates will continue to encourage financed purchases of homes, autos and other durable goods and entice investment via low hurdle rates. If sovereign bond yields rise modestly in 2022 in line with our high-conviction base case, governments won’t feel any pressure to tighten the fiscal screws. That may nourish modern monetary theory fantasies to the ultimate detriment of public finances, but it should ensure that all three engines of domestic demand – households, businesses and government – will hum in 2022. Omicron has reminded everyone that the pandemic is not over, but the shadow it casts on public health and economic activity is set to shrink. Booster shots of the Pfizer vaccine apparently provide effective protection, and Omicron’s mutations will not allow it to evade Merck’s and Pfizer’s soon-to-be-approved antiviral pills. The availability of pills to treat those who contract COVID could possibly be a game-changer in terms of neutralizing its global threat. Distributing shelf-stable pills is vastly simpler than delivering vaccines that need to be transported at temperatures below -70 degrees Fahrenheit. The Earnings Bar Has Been Set Very Low Our constructive view would not translate into risk friendly investment strategy if asset prices already discounted it or were expecting something even better. Just as the economy is on a better path than consumers seem to perceive and investors believe can persist, S&P 500 earnings per share are poised to grow over the next four quarters by more than the bottom-up analyst consensus expects. As compared to the simple annualized run rate of last quarter’s earnings ($215.76, or $53.89 times 4), the analyst consensus is calling for effectively no growth ($215.87) over the four quarters through 3Q22. That is a surprising prediction based on two sets of empirical evidence. First, earnings typically rise outside of recessions (Chart 7). Second, analysts have consistently forecast that forward four-quarter earnings would top the run rate of the last reported quarter’s earnings for four decades (Chart 8). This year, though, analysts have repeatedly called for quarter-over-quarter declines in earnings (Table 1), only to have reported numbers shred their estimates by jaw-dropping margins, just as they have in all six full quarters since COVID-19 arrived (Chart 9). We interpret the phase shift in the magnitude of earnings beats as evidence that companies have surprised themselves by how much they’ve been able to increase efficiency and/or cut costs during the pandemic. Our interactions with the investment community suggest that it has also been surprised but views the gains as one-off events that are unlikely to continue. Chart 7Earnings Declines Outside Of Recessions Are Rare Chart 8This Has Been An Odd Time To Expect 40-Year Lows In Earnings Growth Table 1Grim Expectations Expectations of sequentially declining earnings would fit if the economy were flirting with falling below stall speed, as it regularly did during the sluggish post-GFC expansion. But they are completely at odds with the Bloomberg economist consensus that GDP will grow at a 5% real annualized rate this quarter and 3.9% in calendar 2022 (Table 2). Over time, S&P 500 revenue growth should converge with nominal GDP growth, so the current expectations for around 10% and 7% annualized nominal GDP growth in 4Q21 and 2022, respectively, are a decent starting point for estimating S&P 500 revenue growth over those periods. While we expect that S&P 500 profit margins have peaked, we do not foresee a sharp decline in 2022, and operating leverage should ensure that high single-digit revenue growth will translate into healthy earnings gains. ​​​​​​ Table 2Above-Trend Growth Ahead​​​​​​ Bottom Line: The S&P 500 should have no trouble topping consensus estimates that foresee next to no growth in earnings over the next four quarters. There is ample room for corporate earnings to surprise to the upside. Our Major Disagreement With Markets Differences of opinion make markets and our biggest one pertains to the future direction of interest rates. We think the widespread conviction that the Fed will be unwilling or unable to raise the fed funds above 2%, if that, lest it crush financial markets and the real economy is way off base. The majority of investors seem to have taken the decade between the crisis and the pandemic as evidence that rates will remain very low for very long. Many of them must be buying the longer end of the Treasury curve in anticipation that an expedited liftoff date is the first step on the path to the next recession (Chart 10). Chart 10The Bond Market Sees Ice, Not Fire The risk asset selloff that ensued in December 2018 after the FOMC marched the fed funds rate up to 2.5% looms large in the markets’ minds and feeds the widespread view that an ambitious program of rate hikes will pull the rug out from under financial assets and the economy. Many investors have also been conditioned by the post-crisis decade to assume that inflation cannot exceed 2% for a sustained period. The market view is rooted in honest-to-goodness evidence, but we think it is of little relevance now, given the way the massive pandemic fiscal stimulus programs have altered the backdrop. In the space of thirteen months from March 2020 through March 2021, Congress passed bills injecting over $5 trillion of aid – 25% of a year’s GDP – into the economy. The Herculean effort contrasted sharply with the skittish disbursement of less than 5% of GDP on the Bush and Obama administrations’ watch from 2008 through 2010. The aftermath of the crisis demonstrated that even multiple rounds of QE do not by themselves trigger inflation, especially if demoralized households and businesses are disinclined to borrow money to consume or invest, and chastened banks are subjected to regulatory strictures forcing them to maintain sizable new capital buffers and discouraging them from making any but plain-vanilla loans to highly rated borrowers. The Bernanke Fed’s three rounds of QE presumably tamped down interest rates, but the cash that bought the Treasury and agency securities barely tiptoed into the wider world before the primary dealer banks sent it right back to the Fed as excess reserves. With banks hiding their QE money under the mattress, the money supply didn’t expand in any notable way after the crisis. Thanks to Congress’ series of 2020-21 helicopter drops, the money supply has been growing at rates that would make the late Paul Volcker’s head spin (Chart 11). Inflation is fiendishly more complicated than Milton Friedman’s always-and-everywhere dictum suggests, but there’s now a whole lot of money chasing a limited amount of goods, services and assets. We expect that a receding pandemic will allow greater quantities of goods and services to be produced, and that securities underwriters and their clients are hard at work ramping up asset supply, but inflation has far more of a chance to gain traction now than it did in the decade before the pandemic. Chart 11Bringing "Always And Everywhere" Back Into Vogue? We therefore think the lower-for-longer and lower-for-ever crowd will find itself offsides at some point in the next few years. We do not think it will get its comeuppance in 2022, however, as we see long yields rising only modestly, with the 10-year Treasury yield ending next year at 2-2.25%. Though we expect the fed funds rate will end the upcoming hiking cycle well north of 2%, bringing about the end of the bull markets in equities and credit, and quite possibly inducing the next recession, we do not think markets will abandon their new-normal rates view by the end of next year. This story will be continued, likely with a greater sense of urgency, in our 2023 outlook. Investment Recommendations Consistent with the foregoing, we make the following recommendations for 2022: Overweight equities in multi-asset portfolios. Although they are not cheap, and may experience a turbulent ride in 2022 as inflation concerns wax and wane, COVID-19 infections periodically surge and the Fed tries to adjust its messaging and actions on the fly, stocks should continue to generate sizable positive excess returns over Treasuries and cash. Overweight cyclical sectors and underweight defensive sectors within equity portfolios. If we’re right to be constructive on the global economy, Energy, Industrials, Materials and Financials are better positioned to benefit than Health Care, Staples and Utilities. Overweight small-cap equities versus large-cap equities. The S&P 600 SmallCap Index has greater exposure to our cyclicals-over-defensives call and our US Equity Strategy colleagues highlight that its constituents are cheaper than the S&P 500’s and are projected to have better earnings growth. Adding small-cap exposure to equity portfolios aligns with our constructive view on the economy and markets. Underweight fixed income in multi-asset portfolios. Underweight Treasuries within bond portfolios. Maintain below-benchmark duration within bond portfolios. Though we do not expect the bond market to see things entirely our way next year, we think the long end of the yield curve will shift out somewhat. We therefore have little appetite for duration and Treasuries and expect spread product will outperform Treasuries and high-yield corporate bonds will outperform investment-grade corporates. Consider hybrid alternatives to traditional fixed income securities. When we roll out our multi-asset ETF portfolio next month, it will include a hybrid bucket of income-generating assets to help multi-asset investors seeking income find low-beta destinations with a fighting chance of generating positive real total returns.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Please see the December 14, 2020 US Investment Strategy Report, "2021 Key Views: It’s The Policy, Stupid." 2     Please see the December 2021 Bank Credit Analyst, "OUTLOOK 2022: Peak Inflation – Or Just Getting Started?"

Highlights 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1.  How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2.    Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend   Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’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-7). The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4.    How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive.  This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5.    Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6.    How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7.    Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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    

The S&P 500 return is becoming concentrated once again. Over the past three months, the combined return from the 257 S&P stocks that rallied was 316 index points, 62 (20%) of which came from only two tickers: MSFT and AAPL. As a group, FAANG-like stocks represent high-quality defensive Growth due to their sheer size, liquidity, predictable and growing cash flows, and sound balance sheets.  High-quality growth stocks outperform in an environment of slowing growth and falling 10-year US Treasury yield as it justifies the valuations premium FAANGs command (see Charts 1 & 2). Further, FAANGs also provide downside protection during times of heightened risk aversion (please see here).  However, the BCA house view remains that US Treasury rates will rise over the course of 2022, and that economic growth will remain above trend. In this scenario, Growth will underperform Value, and Small caps will outperform Large caps. Bottom Line: We recommend staying away from FAANG-like stocks in 2022, and funneling funds into the other 495 S&P 500 stocks. ​​​​​ ​​​​