Consumer

Highlights The global fight against the Delta variant of COVID-19 continued to show progress in the month of September, but not without cost. Growth in services activity slowed meaningfully, which has likely delayed the return to potential output in the US until March of next year (at the earliest). However, even with this revised timeline, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. In this regard, the Fed’s likely decision at its next meeting to taper the rate of its asset purchases makes sense and is consistent with a first rate hike in the second half of 2022. The rise in long-maturity bond yields following this month’s Fed meeting is consistent with the view that 10-year Treasurys are overvalued and that yields will trend higher over the coming year. Fixed-income investors should stay short duration. The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. In our view, a detailed examination of shipping prices over the past 18 months points to a future pace of inflation that is not dangerously above-target, but does meet the Fed’s liftoff criteria. A mix-shift in consumer spending, away from goods and toward services, is not a threat to economic activity or S&P 500 earnings – so long as the decline in the former is not outsized relative to the rise in the latter. It will, however, disproportionately impact China, and could be the trigger for meaningful further easing by Chinese policymakers. In the interim, a catalyst for EM stocks may remain elusive. We continue to recommend an overweight stance toward value versus growth stocks and global ex-US versus the US, particularly in favor of developed markets ex-US. Investors should remain cyclically overweight stocks versus bonds, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months in response to higher long-maturity bond yields. Still, we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Feature The global fight against the Delta variant of COVID-19 continued to show progress in the month of September. Chart I-1 highlights that an estimate of the reproduction rate of the disease in developed economies has fallen below one, and the weekly change in hospitalizations in both the US and UK – the two countries at the epicenter of the Delta wave that have not reintroduced widespread COVID-19 control measures – have fallen back into negative territory. In addition, we estimate that approximately 6% of the world’s population received vaccines against COVID-19 in September, with now 45% of the globe having received a first dose and 33% now fully vaccinated. Pfizer’s announcement last week that it has found a “favorable safety profile and robust neutralizing antibody responses” from its vaccine trial in children five to eleven years of age suggests that the FDA may grant emergency use authorization within weeks, which would likely raise the vaccination rate in the US (and ultimately other advanced economies) by at least 5 percentage points in fairly short order. This would also further reduce the impact of school/classroom closures on the labor market, via both an increased participation rate and increased hiring in the education sector. This fight, however, has not been without cost. US jobs growth slowed significantly in August, manufacturing and services PMIs continued to slow in September, and, as Chart I-2 highlights, the normalization in transportation use that was well underway in the first half of the year has clearly inflected in both the US and UK in response to the spread of Delta. Consensus market expectations for Q3 growth have been cut in the US, and to a lesser extent in the euro area, and the Fed reduced its forecast for 2021 real GDP growth from 7% to 5.9% following the September FOMC meeting. Chart I-1The Delta Wave Continues To Abate... Chart I-2...But At A Cost To Economic Activity   The Path Toward Eventually Tighter Monetary Policy It has been surprising to some investors that the Fed has moved forward with their plans to taper the rate of its asset purchases against this backdrop of slowing near-term growth – an event that now seems likely to occur at its next meeting barring a disastrous September payroll report. In our view, this is not especially surprising, given that the Fed has expressed a desire for net purchases to reach zero before they raise interest rates for the first time. Chair Powell noted during last week’s press conference that FOMC participants felt a “gradual tapering process that concludes around the middle of next year is likely to be appropriate”, underscoring that the Fed wants the flexibility to raise interest rates in the second half of next year. The timing of the first Fed rate hike is entirely subject to the evolution of the economic data over the next year, and is not, in any way, calendar-based. But we presented in last month's Special Report why the Fed’s maximum employment criteria may be met as early as next summer,1 and the Fed’s projections for the pace of tapering are consistent with our analysis. Chart I-3Maximum Employment Remains A Very Possible Outcome By Next Summer The Fed’s most recent Summary of Economic Projections (“SEP”) also seemingly confirmed Fed Vice Chair Richard Clarida’s view that a 3.8% unemployment rate is consistent with maximum employment, barring any issues with the “breadth and inclusivity” of the labor market recovery. We noted in last month’s report that these issues are unlikely in a scenario where jobs growth is sufficiently high to bring down the unemployment rate below 4%. Chart I-3 highlights that both the Fed’s forecast and Bloomberg consensus expectations imply a closed output gap by March, even after factoring in the near-term impact of the Delta variant. Consequently, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. Long-maturity bond yields rose following the Fed meeting, which is also not especially surprising given how low yields have fallen relative to the fair value implied by the Fed’s SEP forecasts even assuming a December 2022 initial rate hike. Chart I-4 highlights that the fair value of the 10-year Treasury yield today is roughly 2% using this approach, rising to 2.15% by next summer. Ironically, the September SEP update modestly lowered the fair value shown in Chart I-4 relative to what would otherwise have been the case, as it implied that the Fed is expecting to raise interest rates at a pace of approximately three hikes per year – rather than the four that prevailed prior to the pandemic. Investors should also note that the fair value for the 10-year yield is nontrivially lower based on market participant and primary dealer estimates of the terminal Fed funds rate (also shown in Chart I-4), although they still imply that long-maturity yields should trend higher over the coming year. Global Trade, Inflation, And The Fed A return to maximum employment will likely signal the onset of monetary policy tightening, as long as the Fed's inflation criteria for liftoff have been met. For now, inflation is signaling a green light for hikes next year, even after excluding the prices of COVID-impacted services and cars (Chart I-5). In fact, more recently, CPI ex-direct COVID effects has been pointing in the “non-transitory” direction, which continues to prompt questions from investors about whether the Fed will be forced to hike earlier than it currently expects for reasons other than a return to maximum employment. Chart I-4US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year Chart I-5For Now, Inflation Is Signaling A Green Light For Hikes Next Year   At least some portion of the current pace of increase in consumer goods prices is tied to surging import costs, which have run well in-excess of what would be predicted by the relationship with the US dollar (Chart I-6). This, in turn, is being driven by an explosion in shipping costs that has occurred since the onset of the pandemic, which is being driven both by demand and supply-side factors (Chart I-7). Chart I-6US CPI Is Being Affected By Surging Import Prices... Chart I-7...Which Are Being Driven By An Explosion In Shipping Costs   The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. To the extent that demand side factors are mostly responsible, investors should have higher confidence that the recent surge in consumer prices is transitory, because a shift away from above-trend goods spending and toward below-trend services spending is likely over the coming year. If supply-side factors are mostly responsible, then it is conceivable that the global supply chain impact on consumer goods prices will persist for longer than would otherwise be the case, potentially raising the odds of a larger or more sustained rise in inflation expectations. In our view, a detailed examination of shipping prices over the past 18 months points to a mix of both demand and supply effects, even since the beginning of 2021. However, as we highlight below, several facts point toward the view that supply-side factors will be the dominant driver over the coming year, and that they are more likely to exert a disinflationary/deflationary rather than inflationary effect: Chart I-8 breaks down the cumulative change in the overall Freightos Baltic Index by route since December 2019. The chart makes it clear that shipping costs from China/East Asia to the West Coast of the US have risen far more than any other route, underscoring that US demand for goods has been an important part of the rise in shipping costs. Chart I-8US Demand For Goods Is An Important Part Of The Shipping Cost Story Chart I-9US Goods Spending Has Clearly Been Boosted By US Fiscal Policy Chart I-9 shows the level of real US personal consumption expenditures on goods relative to its pre-pandemic trendline, underscoring both that goods spending is currently well-above trend, and that there have been two distinct phases of rising goods spending: from May to October 2020 following the passage of the CARES act, and from January to March 2021 following the December 2020 extension of UI benefits and in anticipation of the passage of the American Rescue Plan. Since March, US real goods spending has trended lower, a pattern that we expect will continue over the coming year. Chart I-10 highlights that while the global supply chain struggled heavily last year in response to surging demand and the lagging effects of labor shortages and factory shutdowns during the earliest phase of the pandemic, there were some signs of supply-side normalization in the first half of 2021. The chart highlights that the number of ships at anchor at the Los Angeles and Long Beach ports declined meaningfully from February to June, and global shipping schedule reliability tentatively improved in March. The chart also shows that shipping costs from China/East Asia to the West Coast of the US continued to rise in Q2 seemingly as a lagged response to the Jan-Mar rise in goods spending, but they were still low at the end of June compared to today’s levels. Chart I-10Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs In Q3, circumstances drastically changed. Shipping costs between China/East Asia to the West Coast of the US rapidly doubled, and the number of ships at anchor at the LA/LB ports exploded well past its peak in early February. This rise in China/US shipping costs since late-June has accounted for nearly 60% of the cumulative rise since the pandemic began, and cannot be attributed to increased demand. Instead, the increase in prices and the surge in port congestion in Q3 appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Yantian is the fourth largest port in the world and exports a sizeable majority of global electronics given its close proximity to Shenzhen, underscoring the impact that its closure likely had on an already bottlenecked logistical system. There are two key points emanating from our analysis of global shipping costs. First, demand has been an important effect driving costs higher, but it does not appear to have driven most of the increase in shipping costs this year. Still, over the coming year, goods demand in advanced economies is likely to wane as consumer spending shifts from goods to services spending, which will help ease clogged global trade channels and lower shipping costs. Second, the (brief) evidence of supply-side normalization in the first half of 2021, when consumer demand was actually strengthening, suggests that the supply-side of the global trade system will turn disinflationary over the coming year if further COVID-related labor market shocks can be avoided. What does this mean for the Fed and the prospect of monetary policy tightening next year? In our view, the combination of a positive output gap, stable but normalized inflation expectations, and disinflation (or outright deflation) in COVID-related goods and services (including import prices) is likely to lead to a pace of inflation that meets the Fed’s liftoff criteria. Chart I-11 highlights that important longer-term inflation expectations measures have recently been well-behaved, despite a surge in actual inflation and shorter-term expectations for inflation. Aided by disinflation/deflation in certain high-profile COVID-related goods and services prices, this argues against meaningful upside risks to inflation. However, the current level of long-term expectations and the fact that the output gap is set to turn positive in the first half of next year argues against the notion that inflation will fall below target outside of COVID-related effects. As such, we continue to expect that the Fed will raise interest rates next year, potentially as early as next summer, driven by the progress towards maximum employment. Spending Shifts And The Equity Market We noted above, and in previous reports, that consumer spending in advanced economies is likely to continue to shift away from goods and toward services over the coming year. This raises the question of whether a contraction in goods spending will weigh disproportionately on the economy and equity earnings, given the close historical correlation between manufacturing activity and the business cycle. Chart I-12 illustrates this risk: in a hypothetical scenario in which real goods spending were to return to the trendline shown in Chart I-9 by March of next year, it would contract on the order of 10% on a year-over-year basis, on par with what occurred last year and vastly in excess of what even normally occurs during a recession. Chart I-11Longer-Term Inflation Expectations Remain Well-Behaved Chart I-12A Contraction In Goods Spending Is Likely Over The Coming Year   Chart I-12 is a hypothetical scenario and not a forecast, as there is some evidence that consumers are currently deferring durable goods purchases on the expectation that prices will become more favorable. In addition, a positive output gap next year implies that goods spending may settle above its pre-pandemic trendline. Nevertheless, the prospect of a potentially significant slowdown in goods spending has unnerved some investors, even given the prospect of improved services spending. Chart I-13highlights that this fear is understandable given how the US economy normally behaves. The top panel of the chart shows the year-over-year contribution to real GDP growth from real goods and services spending, and the bottom panel shows these contributions in absolute terms to better illustrate their relative magnitudes. The chart makes it clear that goods spending is normally a more forceful driver of economic activity than is the case for services spending, which ostensibly supports concerns that a significant slowdown in the former may be destabilizing for overall activity. Chart I-13Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. However, Chart I-13 also highlights that the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-WWII economic environment. This is not surprising given the nature of the COVID-19 pandemic, but it is important because it underscores that investors should not rely excessively on typical rules of thumb about how modern economies tend to function over the course of the business cycle. In terms of the impact on overall economic activity, investors should focus on the net impact of goods plus services spending. It is certainly possible that the former will slow at a pace that is not fully compensated by the latter, but our sense is that this is not likely to occur barring a further extension of the pandemic in advanced economies. Chart I-14Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Chart I-14 presents a similar conclusion for the US equity market. The chart highlights the historical five-year correlation between the quarterly growth of nominal spending and S&P 500 sales per share. The chart shows that S&P 500 revenue was more sensitive to goods versus services spending prior to the 1990s, when the US was more manufacturing-oriented and goods were more likely to be produced domestically than is the case today. Another gap in the correlation emerged following the global financial crisis when the US household sector underwent several years of deleveraging. But over the past five years, Chart I-14 highlights that S&P 500 revenue growth has actually been more strongly correlated with US services spending than goods spending. Some of this increased correlation might reflect technology-related services spending which could suffer in a post-pandemic environment, but the bottom line from Chart I-14 is that there is not much empirical support for the view that US equity fundamentals will be disproportionately impacted by a slowdown in goods spending, so long as services spending rises in lockstep. China: Exacerbating An Underlying Trend Chart I-15China Will Be Disproportionately Affected By Slowing DM Goods Spending China, on the other hand, will be disproportionately affected by slower goods spending in advanced economies, because its exports have disproportionately benefited from the surge in spending on goods over the past year. Chart I-15 highlights that Chinese export volume growth has exploded this year, and that current export growth is running at a pace of 10% in volume terms – significantly higher than has been the case on average over the past decade. Several problems in China have been in the headlines over the past few months: a regulatory crackdown by Chinese authorities on new economy companies, the situation with Evergrande and, more recently, power shortages that have forced factories in several key manufacturing hubs to curtail production as a result of China’s ban on coal imports from Australia (Chart I-16). However, the key point for investors is that these are not truly new risks to China’s growth outlook; rather, they are developments that have the potential to magnify the impact of an already established trend: the ongoing slowdown in China’s economy that has clearly been caused by a decline in its credit impulse (Chart I-17). In turn, China’s decelerating credit impulse has been caused by tighter regulatory and monetary policy. Chart I-16Power Outages: The Latest Negative Headline From China Chart I-17China Is Slowing Because Policymakers Have Tightened   BCA’s China Investment Strategy service has provided a detailed analysis of the ongoing Evergrande saga.2 In short, our view is that the government will likely restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. As such, Beijing may rescue the stakeholders of Evergrande, but likely not its shareholders. However, in terms of stimulating the broader economy, it is still not clear that Chinese policymakers are willing to engage in more than gradual or piecemeal stimulus, given a higher pain threshold for a slower economy and a lower appetite for leverage. This may change once Chinese export growth slows in response to a shift in DM spending from goods to services, as policymakers will no longer be able to rely on the external sector for support. This potentially offsetting nature of eventual Chinese stimulus and global goods spending underscores both the importance of a normalization in DM services spending as an impulse for global growth, as well as the fact that a catalyst for EM stocks may remain elusive over the tactical horizon. Investment Conclusions In Section 2 of this month’s report, we explain why the performance of US stocks may be flat versus their global peers over a structural time horizon. We also highlighted that US stocks are likely to earn low annualized total returns over the coming 10 years (between 1.8 - 4.7%), which would fall well short of the absolute return goals of many investors. Chart I-18Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Over the coming 6-12 month time horizon, we continue to recommend an overweight stance towards value vs. growth stocks and global ex-US vs. US, particularly in favor of developed markets ex-US. The relative performance of value vs. growth stocks is likely to benefit from the transition to a post-pandemic state and a rise in long-maturity bond yields, as monetary policy shifts towards the point of tightening. Regional equity trends have been closely correlated with style over the past two years, and the underperformance of growth strongly implies US equity underperformance. From an asset allocation perspective, investors should remain overweight stocks versus bonds over the coming year, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months. Chart I-18 highlights that outside of the context of recessions, months with negative returns from both stocks and long-maturity bonds are quite rare, but they tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). Fundamentally, we do not see a rise in bond yields to any of the levels shown in Chart I-4 as being threatening to economic growth or necessarily implying lower equity market multiples. But the speed of adjustment in bond yields could unnerve equity investors, and there are open questions as to how far the equity risk premium can fall before T.I.N.A. – “There Is No Alternative” – becomes a less persuasive argument. As such, we would not rule out a brief correction in stocks at some point over the coming several months, but we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst September 30, 2021 Next Report: October 28, 2021 II. The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms Since 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance. There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon. In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples. Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US. The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities. In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar. We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. A Deep Examination Of US Outperformance Since 2008 Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are: Total revenue growth for each equity market, in local currency terms The change in profit margins The impact of changes in capital structure and index composition The change in the trailing P/E ratio The income return from dividends The impact of changes in foreign exchange The sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends. Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects. Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar Box II-1 Proxying The Impact Of Changes In Shares Outstanding We proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects. However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period. What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services. Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion. Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally. The Relative Secular Return Outlook For US Stocks We present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis. Profit Margins Chart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.3 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation. But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.” On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors. Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems. In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive). Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize. Capital Structure And Index Composition As noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments. However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates. Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years. Equity Multiples There are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close. Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The Foreign Exchange Effect As a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance. The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... Chart II-18…And Is Now Expensive   The Absolute Secular Return Outlook For US Stocks Over a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall. For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%. One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium. In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields. This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.4 In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US. Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era. Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum as net revisions and positive earnings surprises remain near record highs. Bottom-up analyst earning expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury yield has broken above its 200-day moving average, beginning its recovery after falling sharply since mid-March. After a decline initially caused by waning growth momentum and the impact of the Delta variant of SARS-COV-2, long-maturity bond yields appear to be responding to the interest rate guidance that the Fed has been providing. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that 10-Year Yields are set to trend higher over the coming year. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the pace of advance in industrial metals prices has eased. Global shipping costs have exploded due to supply-side constraints, but are likely to ease over the coming year if further COVID-related labor market shocks can be avoided. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 2  Please see China Investment Strategy "A Quick Take On Embattled Evergrande," dated September 21, 2021, and China Investment Strategy "The Evergrande Saga Continues," dated September 29, 2021, available at cis.bcaresearch.com 3 Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com 4     Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

Highlights Economy – We find the leading arguments for why households’ excess savings won’t be spent to be wanting: US households do not commonly demonstrate the detached foresight that Ricardian equivalence takes as given and the trauma-will-change-behavior thesis fails to account for the absence of widespread financial trauma. Markets – Public equities account for a record portion of household wealth, but their share gains are not a sign of a budding mania: Our analysis of the Fed’s Flow of Funds data argues that much of equities’ relative share gains have been driven by structural rather than cyclical factors. Strategy – It would be premature to shift to defensive asset allocation settings if monetary policy is going to remain accommodative for another three years: The rate hike progression envisioned by FOMC participants’ dot-plot projections suggests policy won’t become tight until late 2024 at the earliest. Feature The US Investment Strategy team has been at the more bullish end of the continuum within BCA, and among the broader strategist community, since the spring of 2020. Our view was premised on the idea that the fiscal and monetary policy responses to the pandemic were (and would continue to be) so large that they would overwhelm its adverse effects on the economy and markets. That view came to pass as Congress augmented the CARES Act’s fiscal largesse with two subsequent rounds of direct payments to households earning up to $100,000 per adult and a renewed federal supplement to unemployment insurance (UI) benefits. With the expiration of the UI benefit program at the beginning of the month and the Fed poised to end asset purchases by the middle of next year, clients have begun to ask if our underlying bullish premise still applies. We believe that it does, on the grounds that policy remains on an emergency footing even though the emergency has passed. The fiscal transfers may have ended, but their full effect has yet to be felt. They will support the economy on an ongoing basis as households direct their excess pandemic savings toward consumption. No one knows for sure how much of the excess savings will be spent or when, but the arguments citing Ricardian equivalence or consumer trauma as impediments to consumption are flawed. What If Today’s Income Is Taxed Tomorrow? British classical economist David Ricardo is best known to introductory economics students for comparative advantage, but he also posited that deficit spending may fail to boost aggregate demand because taxpayers, anticipating that they will be tapped in the future to repay state loans, may increase savings to cover future taxes. Despite its theoretical appeal, empirical data in support of Ricardian equivalence is elusive. Two centuries and an ocean removed from Ricardo’s England, we submit that Americans are not known for parsimony, studied caution or a tendency to see the glass as half-empty. Although American households began to rebuild savings after the global financial crisis, an additional dollar has tended to burn a hole in their pockets ever since the baby boomers began reaching adulthood (Chart 1). Chart 1The Searing Trauma Of The Depression Weighed On Consumption Decisions Even if Americans were wont to consider future tax burdens, it may be rational for the households who received the fiscal transfers to assume they will largely escape them unless their relative income surges. Per the most recent adjusted gross income (AGI) distribution data (for tax year 2018), 70% of taxpayers earn $75,000 or less (Chart 2). Single taxpayers meeting that threshold (and married taxpayers earning $150,000 or less) received the full amount of the economic impact payments authorized by the CARES Act and subsequent legislation. That bottom 70% paid just 5.1% of AGI in federal taxes (Chart 3), and the current political climate points in the direction of an increasingly progressive tax system, so they may not have to worry about being called upon to cover the expanding deficit down the road. Chart 2The Income Distribution Is Top Heavy ... Chart 3…But So Is The Tax Burden The (Not So Traumatic) Economic Trauma Of COVID-19 While we are confident that Ricardian equivalence will not act as an impediment to consumption, the ultimate disposition of households’ excess pandemic savings is unknown. Our working assumption has been that half of the savings will be spent across 2021 and 2022. Though we do not have any close antecedents for what households might do with a savings windfall equivalent to 10% of a year’s GDP amassed over a thirteen-month span, we reject the notion that those who experienced COVID-19 will behave like the many shell-shocked survivors of the Great Depression who became lifelong precautionary savers. However terrible the human cost of COVID, it did not ravage American households’ financial position; as the Fed’s latest Flow of Funds report showed, their balance sheets flourished, allowing the vast majority of them to escape any sense of financial trauma. Per the Flow of Funds, American household wealth grew by nearly $6 trillion in the second quarter, extending the last five quarters’ gains to $31 trillion since financial markets cratered when the pandemic burst forth in the first quarter of 2020. The 22% annualized five-quarter gain is nearly four standard deviations above the mean and blows away 4Q03 through 4Q04’s 14% second-place mark by two full standard deviations (Chart 4, top panel). The current run sets a record even when it’s stretched to six quarters to include 1Q20, the worst quarter in series history, and the five- and six-quarter gains are also pacesetters after adjusting for inflation (Chart 4, bottom panel). Chart 4Recessions Aren't So Bad When Congress And The Fed Throw Everything They Have At Them Changes in household net worth lead consumption growth with a two-quarter lag (Chart 5), though the four quarters before the most recent one (the red dots with negative consumption growth) were notable outliers. 2Q21 consumption was just a little more than a percentage point below the best-fit line, however, so it is closing in on its modeled value and we expect it will overshoot it in coming quarters upon the release of pent-up demand. We do not believe that the pandemic will dampen household spending simply because the broad mass of consumers did not experience financial trauma on a scale that would alter future behavior. As household wealth and income data have shown, this recession has been a boon for most Americans. Chart 5Consumption Overshoots Are On The Way Chart 6Fiscal Shock And Awe We additionally reject the notion that households have learned a lesson that will make them want to hold more savings. The financial lesson of the pandemic seems to be that policymakers will do their utmost to shelter them from calamity. Between the economic impact payments (Chart 6, top panel) and the UI benefit supplement (Chart 6, middle panel), Congress directly sent nearly $1.5 trillion to US households to offset $300 billion of lost wages (Chart 6, bottom panel). COVID-19 inflicted terrible distress on those who lost loved ones and witnessed or experienced near fatal suffering, but it boosted the lower three quartiles of households who received transfers and the top decile of households who reveled in the financial markets’ advance. Those who experienced it will not hoard their pennies and shun debt like many of the Depression’s survivors; they are more likely to have experienced post-traumatic bliss than stress when it comes to their financial outlook. Too Much Of A Good Thing? We periodically check in on the Flow of Funds for insight into the evolution of households’ asset allocations and the share of net worth accounted for by homes. Directly owned equities and mutual funds have taken share from the other major categories throughout the pandemic run (Chart 7) and now account for a record share of household financial assets after having surpassed their 2000 highs (Chart 8, top panel). It is sensible to approach any equity milestone that invokes the dot-com bubble with some trepidation, but structural factors go a long way toward explaining the new allocation peak. The financialization of the economy has steadily advanced since the Flow of Funds data began to be compiled in 1951, promoting public equity ownership, and consolidation has supported the transfer of commercial ownership from mom-and-pop operations to corporate interests, many of which are publicly traded. Overall equity in businesses as a share of household net worth is merely in line with its ‘50s levels (Chart 8, bottom panel). Chart 7The Running Of The Bulls Chart 8From Mom And Pop To Broad And Wall Home price appreciation has picked up, but it is not out of the ordinary (Chart 9). Home equity gains have outstripped home price gains, relative to each series’ history, testifying to prudent behavior on the part of borrowers and lenders. The low aggregate mortgage loan-to-value ratio (Chart 10) suggests that slowing home price appreciation, or even an outright decline, would not be a source of economic instability. Chart 9Home Price Gains Are Not Out Of The Ordinary ... Chart 10... And Leverage Levels Are Not A Concern The Fed Signals That Tapering Is Near Though the FOMC did not adjust the pace of its asset purchases last week, it indicated that tapering will most likely begin after its November meeting. Chair Powell noted that the economy has made substantial further progress toward reaching the committee’s inflation goal and expressed that “many” members feel that it has made substantial progress toward achieving its full employment objective as well, going so far as to volunteer his personal view that the employment test has been “all but met.” Per the committee’s discussions, the purchases will likely end around the middle of next year if the economy progresses in line with its expectations. The committee would not be talking about reducing the accommodation it’s providing the economy if it weren’t secure in the sense that it is on solid footing. Powell expressed satisfaction with the evolution of inflation expectations (Chart 11) and although the real GDP forecast for this year was lowered in the summary of economic projections (the “dots”), next year’s forecast was raised and slightly higher inflation expectations imply that nominal GDP growth will remain quite robust. A shift in two members’ fed funds rate projections brought the median member’s liftoff date to 2022 from 2023, in line with our view. Chart 11The Fed Has Succeeded In Firming Up Inflation Expectations The chair reiterated that tapering – slowing the pace of accommodation – and hiking the fed funds rate – slowing the economy – are distinct actions subject to separate criteria. We see liftoff as a more significant action than tapering, but much will depend on the pace at which the committee lifts the fed funds rate. It is too soon to speculate on the pace, but we stress that the big move for financial markets will occur once the policy rate exceeds the neutral rate. If the latter is somewhere around 2%, the rate hike pace embedded in the dots suggests that it may take until the end of 2024 or early 2025 before monetary policy becomes restrictive. Investment Implications If monetary policy is not going to become tight for another three years, it is premature to shift a portfolio to more defensive settings, especially for anyone sharing our three-to-twelve-month cyclical timeframe. Growth will be robust in the near term, supported by the income boost that the lower three quartiles of taxpayers received from fiscal transfers and the way wealthier households cleaned up as financial asset prices soared. We expect that a hearty portion of the newly minted wealth will be spent, as Ricardian equivalence requires a longer attention span than Americans typically exhibit, and the pandemic was largely trauma-free for most households from a financial perspective. The clearest policy lesson that a citizen should have taken from COVID is that Congress and the Fed have his/her back in a big way. We are staying the course with our risk-friendly asset allocation recommendations.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Highlights Economy – The inflation question is unresolved, and it will remain that way for the rest of the year: August’s CPI report had something for everyone and ensured the debate will continue. Doves could celebrate the month-over-month decline while hawks could argue that upward inflation pressures are no longer a transitory phenomenon. Markets – Elevated valuations make equities vulnerable, but a little turmoil in China is not likely to trigger a de-rating wave: The demise of large Chinese property developer Evergrande may cause some upheaval in China but it is not likely to ruffle the S&P 500, corporate bonds or other US spread product. Strategy – Policymakers continue to hold the key. As long as the Fed is still easing, and households direct some of their excess savings to consumption, risk assets should outperform: We still think Goldilocks is far more likely that a too-cold or a too-hot outcome. Feature We continue to view the prospects for financial markets and the economy through a Goldilocks-and-the-two-tails lens, with the idea that equities and credit will thrive against a backdrop of supercharged growth and ongoing policy support (Figure 1). The Fed’s unusually pro-cyclical stance will prolong the macro sweet spot for risk assets and ensure positive excess returns provided growth doesn’t flop (the too-cold left tail), or the inflation genie doesn’t get out of the bottle (the too-hot right tail). Though both flanks pose a risk to our base-case Goldilocks scenario, we deem overheating to be the bigger concern. Unless a vaccine-resistant variant reestablishes COVID-19 as a mortal threat to the broad population, we think it is unlikely that growth will tumble below trend this year or next. Figure 1Goldilocks And The Two Tails One does not need to be a sworn devotee of rugged individualism to harbor some misgivings about the magnitude and scope of the direct transfers to American households or the broader fiscal effort to combat the economic effects of the pandemic. Egged on by support amounting to 25% of a year’s output, it remains entirely possible that aggregate demand might overwhelm productive capacity. The emergence of rolling bottlenecks in the spaces that were most crimped by COVID has focused attention on the threat of overheating, but the more lasting risk emanates from spaces that cannot be dismissed as unduly influenced by the pandemic. We have been closely monitoring the path of consumer prices and will continue to do so, but the ultimate outcome remains unclear. Though a Goldilocks macro backdrop remains our base-case expectation, it is far from assured. In this week’s report, we consider three potential disruptions: too much inflation, a change in the Fed’s policy course and a credit shock from China. We do not think that any of the potential disruptions is likely to change the picture in a material way and we therefore reiterate our view that investors with a twelve-month timeframe ought to maintain at least an equal weight exposure to equities and credit in a multi-asset portfolio. Fitting The August CPI Tile Into The Inflation Mosaic The pace of consumer price increases cooled in August, according to the headline and core CPIs. Both measures came in below market expectations, and the leading month-over-month series (Chart 1, dashed line) decelerated more than their year-over-year counterparts (Chart 1, solid line). Although the data were encouraging on their face, the ongoing inflation debate is nowhere near resolved. COVID continues to play havoc with the spaces it impacted most heavily, defying simple interpretations of aggregate CPI data. Base effects have warped year-over-year data once the peak pandemic months of last spring and summer entered the equation. As category-by-category analyses of the April CPI release showed, the lion’s share of the aggregate core CPI increase was powered by new and used cars and a handful of badly disrupted services like air travel, car rental, lodging and in-person entertainment. Chart 1Inflation Seems To Have Peaked Chart 2A Stunning Reversal On Used-Car Lots The semiconductor-driven production squeeze pushed up new car prices and took used car prices along for the ride as consumers turned to them as a ready substitute. Used car prices then rose even more as rental car companies frantically reversed 2020’s culling of their fleets to meet revived 2021 demand (Chart 2). By July, however, several of those categories had come off the boil and began to make more modest contributions to month-over-month core CPI growth. In August, they turned into headwinds, limiting core CPI’s sequential gain to just 0.1%. While the core index grew at its slowest rate since February, the segments that weren’t as heavily affected by the pandemic – the gray portion of the stacked bars in Chart 3 – experienced their largest price increases of the year. Those core categories less sensitive to transitory pandemic factors have eased a bit on a year-over-year basis (Chart 4, bottom panel) but the leading month-on-month measure suggests they will turn higher going forward. Chart 3Passing The Baton Shelter costs account for 41% of the core CPI basket and though spiking hotel rates (Chart 5, second panel) have made an outsized contribution to their bounce off the bottom (Chart 5, top panel), the much weightier owners’ equivalent rent and primary residence cost measures have begun to hook up (Chart 5, third panel). Series that impact the supply and demand balance for residences, like the prime-age employment-to-population ratio (Chart 5, fourth panel) and the National Multifamily Housing Council’s measures of apartment market activity (Chart 5, fifth panel), suggest that the key rent series will continue moving higher. Chart 4Transitory Factors Are Abating ... Chart 5... But Rents Are Rising The bottom line is that the August CPI report, like much of the economic data in this particularly uncertain time, offered evidence to support opposing interpretations. We will simply have to wait and see how the data evolve over the rest of the year to gain a good read on its future trajectory. We expect that inflation will continue to come down from its summer peak while remaining comfortably above the Fed’s effective 2.3-2.5% core CPI target. Such a move will underscore that its inflation criteria have been met and focus investor attention squarely on the labor market’s progress toward regaining full employment. Much Ado About Nothing The bond market has cottoned on to the fact that the labor market, not consumer price inflation, is the swing factor for monetary policy settings, and the 10-year Treasury note has essentially ignored the core CPI breakout (Chart 6). Equities have evinced little concern, reflecting the causal relationship we noted last week. High inflation by itself is not kryptonite for stocks; the restrictive monetary policy measures the Fed eventually imposes in response to high inflation are. Inflation’s market importance thus turns on the tipping point at which it heralds restrictive monetary policy. Chart 6Treasuries Are On Board With The Transitory View A Fed that believes elevated inflation readings are transitory is a Fed that will wait to restrain the economy to contain them. A Fed that is determined to let the economy run hot so as to nurture broad-based strength in the labor market is a Fed with a less sensitive inflation reaction function than has prevailed since Paul Volcker’s tenure. The same goes for a Fed that has made no secret of its desire to reset inflation expectations higher. Putting it all together, the Fed appears determined to wait until it sees the whites of inflation’s eyes before it takes action that will undermine economic growth. Our view that the Fed’s inflation reaction function has become less sensitive is independent of the identity of the chair. The revised statement on longer-run goals and monetary policy strategy was issued by the entire FOMC, and investors should not be distracted by the quadrennial reappointment parlor game, which has settled on a contest between chair Powell and board member Brainard. Although Brainard has won progressives’ admiration for her advocacy of tighter bank supervision, policy would not be materially different under her stewardship than it would be under Jay Powell’s. Monetary policy will be accommodative for a long time regardless of who is chairing the FOMC on February 1st and the Biden administration’s nomination decision will not have lasting market implications. Could A Messy Evergrande Unwind Trip Up The US Bull? The financial press last week was filled with stories about the dire condition of Evergrande Property Group (Chart 7), one of China’s largest property developers. As noted in several of last week’s reports, Evergrande is the world’s most indebted developer and its leverage burden is not news to dollar bond investors, who have increasingly required outsized yields to lend to the company.1 All three major credit rating agencies have downgraded it to the equivalent of CC, reflecting their view that default is imminent. Though a technical default may be certain, per reports that Evergrande will fail to make scheduled interest and principal payments due this week, the ultimate ripple effects are unknown. As our Emerging Markets Strategy team has noted, a broad range of outcomes are possible. At the most benign end of the continuum, the event could mark a crescendo of concerns that have been weighing on sentiment and activity, and trigger policy stimulus that produces economic and market inflections. At the other end, Evergrande could intensify the existing credit crunch, sparking a wave of self-reinforcing defaults and bankruptcies, culminating in a systemic event on the order of Lehman Brothers’ bankruptcy. Absent government intervention, the defaults will be messy. Most of the company’s assets are in the form of unfinished properties that will require additional capital and know-how before they can be monetized. Even its portfolios of completed properties may not be easy to sell in a residential market that was already slowing (Chart 8). The pall its troubles have cast over the property market will make things worse by prodding other liquidity-constrained developers to slash prices to move their own inventories. Chart 7Boom And Bust Chart 8Not Exactly A Seller's Market Our China strategists believe that the government wants to make an example out of Evergrande to impose some discipline on investors and developers. Despite repeated warnings, it has remained on the wrong side of the three red lines policy makers recently established to rein in property market excesses. Some onshore investors may be bailed out, but party officials will have no qualms about leaving offshore investors holding the bag. As China goes, so too do small neighboring economies reliant on its appetite for imports. Resource economies like Brazil, Chile and Australia that export iron ore, copper and other base metals to feed the China construction and infrastructure juggernaut could slow. Suppliers of machinery and specialized manufactured components like Japan and Europe could also feel a bit of a chill. While the US is not immune to disruptions in the rest of the world, it is a comparatively closed economy that is generally less susceptible to external troubles and has minimal financial links with the Middle Kingdom. A review of the 2020 10-Ks for the SIFI banks and Goldman Sachs and Morgan Stanley confirmed that the American banking system has minimal direct exposures to China and Hong Kong. Only Citigroup, which operates a meaningful commercial banking franchise in Hong Kong, has direct cross-border exposures that amount to as much as 1% of assets (Table 1). Table 1SIFI Exposures To China And Hong Kong The bottom line is that we do not view Evergrande as China’s Lehman. Policymakers may want to make an example of it but not to the point that they will stand by in the face of a broad contagion. Even if it did produce a credit event that rippled across Asian EM markets and tempered investors’ enthusiasm for risk assets more generally, US markets would benefit in a relative sense befitting the dollar’s status as a defensive currency, Treasuries’ status as the predominant risk-free asset and the S&P 500’s low-beta nature. The fall of an overextended Chinese property developer is unlikely to push the US out of Goldilocks and into too-cold territory. Investment Implications Inflation will trigger a policy change once it stays high enough for long enough to trigger the Fed’s recalibrated reaction function. Markets will sniff out a policy change ahead of time and could even catalyze a policy change if the bond vigilantes awaken from their long hibernation. When we reiterate our constructive view on markets and the economy over a three-to-twelve-month timeframe, we are reiterating our assessment that markets will not begin to prepare for the policy change within the next twelve months and that growth will appear as if it will remain on an above-trend trajectory for some time beyond. We are confident that the next twelve months will remain “safe” from a policy and a growth perspective. We have much less conviction about the next six to twelve months following next September and are acutely aware that the outlook for the second half of 2022 and the first half of 2023 will exert a meaningful influence next summer. We will adjust our views based on the incoming data, but we do think the first three to six months of our cyclical timeframe will be conducive to risk asset outperformance and therefore reiterate our recommendation to overweight equities and credit while sharply underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Per Evergrande’s annual reports, its average annual interest rate on outstanding debt on 12/31/20 was 9.49%, up from 8.99% on 12/31/19, 8.13% on 12/31/18 and 8.09% on 12/31/17.

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. I will also address the topics that our clients are most concerned about, including China’s regulatory developments, inflation, and policy direction. The webcasts will be held on Wednesday, September 22 at 10:00 am EDT (English), and Thursday, September 23 at 9:00 am HKT (Mandarin). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, September 29. Best regards, Jing Sima, China Strategist Highlights China is facing cyclical inflationary pressures more than disinflationary ones. Prices of mining, raw materials and manufacturing goods have been rising at record rates. Chinese manufacturers are operating at close to full production, which suggests that there is little slack in demand. Despite soft headline readings in consumer prices, the costs of goods and services have rebounded to pre-pandemic levels. Prices for home durable goods, fuel and utilities have surged to multiyear highs. Measures to boost domestic demand will be limited as long as inflationary pressures continue and manufacturers produce at close to full capacity. Near-term policy support will likely focus on reducing costs for manufacturers and improving wage growth for lower-income households. We are initiating a trade: long industrial stocks/short A-shares.  Feature China’s Producer Price index (PPI) registered a 13-year high in August, at the time when the domestic economy continued to slow. On the other hand, consumer prices (CPI) - both headline and core CPI - have been lackluster. The acceleration in producer inflation and the demand dynamics raise the question whether China is in a stagflation, a situation in which prices climb but wages and demand do not follow. Consequentially, economy policy faces a dilemma between boosting demand and containing inflation. Inflationary pressures have been driven by pandemic-related factors and the supply-side constraints will likely continue into Q1 next year. These inflationary pressures, and more importantly, undercurrents in the inflation prints, will constrain Chinese policymakers’ efforts to reflate the economy. The recent rebound in Chinese infrastructure stocks is overdone. Material stocks are also vulnerable to price setbacks. Global commodity prices will soften, although from very elevated levels. Meanwhile, we are initiating a trade: long Chinese industrial stocks relative to the A-share market. Despite falling profit growth in recent months, China’s leadership is increasing its support, both cyclically and structurally, to the manufacturing sector. Inflation Or Deflation? The details in both the PPI and CPI readings indicate that China is facing more inflationary pressures than disinflationary ones. Producers are raising prices across the board. Although consumer prices will likely remain well below the PBoC's 3% inflation target for the year mainly due to low food prices, prices in some of the key consumer goods segments are rising at an alarming pace. The inflationary pressures will continue for producers, at least through the first quarter of 2022. The strength in August’s PPI was concentrated in mining and raw materials (Chart 1, top panel). Robust global demand and tight supply conditions supported high oil and base metals prices, while pushing up coal prices. Chart 1Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chart 2Commodity Prices Held Up Despite A Slowing China We do not expect China’s infrastructure investment growth to pick up and support industrial metal prices. However, this year’s unsynchronized recovery in global demand and severe supply shortages have delayed the global commodity market’s price reaction to slowing Chinese demand (Chart 2). Moreover, as China’s environmental policy remains stringent during the upcoming winter, supply-side constraints from production cuts will partially offset the slowdown in China’s demand for mining and raw materials (Chart 3A and 3B). Chart 3ASupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Chart 3BSupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Manufacturing goods inflation registered its topmost annual growth since data collection started in 1996 (Chart 1, bottom panel). Moreover, capacity utilization rates in the industrial and manufacturing sectors are at the highest levels since 2007, well above their means (Chart 4). Changes in manufacturing capacity are highly correlated with China’s export growth and tightly linked to PPI (Chart 5). Therefore, manufacturing goods prices will remain lofty as long as external demand stays robust and China’s manufacturers continue to produce near maximum output. Chart 4Chinese Manufacturers Are Producing Near Their Max Capacity Chart 5Robust Exports Have Been Supporting Strong Chinese Manufacturing Output The PPI’s weakest component has been consumer goods, which inched up by a mere 0.3% from a year ago (Chart 6). However, consumer goods only account for 25% of PPI, whereas industrial and manufacturing producer goods are 75%. In addition, the underlying data shows that among the four sub-components in the PPI’s consumer goods, only food prices have remained below their pre-pandemic levels (Chart 7, top panel). Prices in durable goods have rebounded strongly since March last year and clothing and daily sundry articles have recovered to their end-2019 rate of growth (Chart 7, mid and bottom panels).  Chart 6Producer Prices For Consumer Goods Remain Soft... Chart 7...But Food Prices Have Been The Main Drag The PPI’s price forces are consistent with the CPI, in which food has been the main drag. Core CPI, along with prices for consumer goods and services, have returned to pre-pandemic growth rates (Chart 8). Durable goods prices, such as home appliances, increased to a multiyear high in August. Fuel and utilities costs have also risen. This suggests that despite the soft CPI readings, inflation has flowed from producers to Chinese consumers through manufacturing goods. The passthrough will likely intensify into Q4 when domestic COVID-cases have been largely brought under control and the September – October holiday season will boost consumption for both goods and services. Chart 8Prices For Other Consumer Goods Categories Have Recovered Table 1A Look At China’s CPI Basket – Food Dominates We still expect that headline CPI will remain below the PBoC’s 3% inflation target for the year. Consumer durable goods prices are lightly weighted in China’s CPI, therefore, an acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates (Table 1). Chart 9Prices For Healthcare And Education Services On A Structural Downshift In addition, there are some structural headwinds that will affect prices in the education and healthcare and medical services components, which together account for about 15% of the CPI. Healthcare prices have been on a policy-driven structural downshift since late 2017 and recent regulatory changes in the education industry will depress pricing power in that sector (Chart 9). Despite sluggish aggregate consumer prices, climbing prices in consumer durable goods, services and particularly, fuel and utilities, will likely force China’s leadership to take action on policy. Bottom Line: Price pressures for Chinese producers remain intense and consumers will feel the heat of escalating prices in durable goods, fuel and utilities. Inflation is threatening domestic demand, which is already slowing from its peak earlier this year. Implications On Policy Response Inflation readings –even though they are lagging economic indicators –bear significant forward-looking market implications because changes in inflation dynamics herald various policy responses. Despite slower economic growth, higher inflation coupled with accommodative monetary and fiscal policies may indicate that the economy is in a “goldilocks” stage and corporate profits can still benefit (Chart 10). Chinese onshore stocks reached record high recently (Chart 11). Chart 10Are Chinese Corporates In A 'Sweet Spot'? Chart 11Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 However, underlying trends in China’s producer and consumer inflation prints raise the risks that policymakers may not deliver the ingredients needed for a “just right” scenario. Even though China has kept a loose monetary policy that we expect to extend into next year, inflationary pressures may force policymakers to either delay or reduce the magnitude of stimulus. Recent policy moves show that the authorities are focused on reducing input cost burdens and bumping up support for small- and medium-sized enterprises (SMEs), which are highly concentrated in mid- to downstream manufacturing and services sectors. In our view, the recent rhetoric from policymakers further reduces the odds of any broadly based stimulus to boost demand. Our view is based on the following observations: The elevated global input costs and limited price passthroughs to consumers are depressing Chinese manufacturers’ profit margins and incentives to expand production capacity. Despite strong exports and production, manufacturing investment has lagged that in infrastructure and real estate this year (Chart 12). Consumers, particularly lower-income households, are bearing most of the burdens; rising costs and slow wage growth are weakening their propensity to spend (Chart 13). Chart 12Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Chart 13Slow Wage Growth Limits The Pace Of Consumption Recovery The inflation prints came at the time when China’s top leadership shifted its structural policy goals to reduce income inequality and stabilize manufacturing share in the aggregate economy. The structural goals will likely be reflected in policy responses to the cyclical challenge.  Moreover, this year’s manufacturing production volume was growing twice as fast as producer prices, a reversal from 2017 when price increases outpaced production (Chart 14). Price changes are much more important to corporate profits than volume changes. A strong RMB and sharply escalating shipping costs have also reduced exporters’ pricing power and profits (Chart 15). In contrast, mounting prices across various commodities have allowed the upstream industrial sectors, which are dominated by SOEs, to deliver much stronger profits than the downstream and private sector (Chart 16). Chart 14Growth In Manufacturing Output And Prices Starting To Converge Chart 15Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability   It is unsurprising that authorities are increasing support to the private sector in order to maintain manufacturing share in the economy and keep the export sector competitive (Chart 17). A boost in infrastructure investment, on the other hand, would exacerbate upward pressure on commodity prices and mostly benefit upstream SOEs. Chart 16Upstream Industries Disproportionally Benefited From Surging Commodity Prices Chart 17Private Sector: Lower Profit Margin, Higher Costs Furthermore, stimulating the traditional sectors would not revive household consumption. The subdued recovery in consumption and prices for consumer staple goods is due to slow growth in lower-income household wages and a disrupted recovery in the services sector. Ramping up infrastructure investment can support headline GDP growth, but will do little to provide jobs and wages since China’s private sector provides 80% of all jobs and 90% of annual job creations. Lower-income households have a higher marginal propensity to consume. We expect the government to accelerate fiscal support measures to fortify wages among lower-income households. Bottom Line: Ongoing inflationary pressures and the underlying forces will likely thwart policymakers from stepping up their efforts to stimulate the old economy sectors. Investment Conclusions Chart 18Rebound In Infrastructure Stocks Should Be Short-Lived Chinese onshore stocks in the infrastructure, materials, and industrial sectors recently advanced strongly in the expectation that policymakers will ramp up their fiscal support in the old economy sectors, particularly infrastructure. Although we agree that infrastructure investment will improve, we maintain our view that a sizable rebound is highly unlikely this year. Hence, we do not expect that the rally in infrastructure stocks will be long-lasting (Chart 18).  We are probably too late in the cycle to re-initiate our long material/broad market trade in the onshore and offshore equity markets (Chart 19). We closed the trade in December last year when Chinese policymakers started pulling back stimulus, and in expectations that raw material prices would tumble. However, we underestimated the intensity of China’s de-carbonization efforts and protracted global supply-side constraints. Although global commodity prices will remain elevated into 2022, the price rallies from this year are not sustainable on a cyclical (6- to 12-month) basis. Therefore, we do not recommend material stocks as a cyclical play.  Chart 19Price Rally In Materials Stocks Unlikely To Sustain Chart 20Industrial Stocks May Be On A Structural Upcycle Instead, we recommend a long industrial/broad A-share market trade (Chart 20). Even though China is in a late business cycle and the upcoming stimulus will be mediocre at best, we think that the industrial sector will benefit from policy support for investment in the manufacturing sector and a faster pace in the sector’s capacity expansion.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes Market/Sector Recommendations Cyclical Investment Stance

Highlights Economy – A partial undoing of 2017’s Tax Cuts and Jobs Act is in the works as Congress takes up the Biden Administration’s infrastructure agenda: A modest increase in the marginal corporate tax rate to help fund infrastructure investment is being discussed on Capitol Hill. We do not expect the ultimate agreement will meaningfully impact output. Markets – Equities appear to have taken little note of the tax-hike debate, and there are worries that investors are being overly complacent about the potential implications: Earnings estimates do not seem to reflect the impact of higher taxes on companies’ bottom lines. Based on the proposals that are reportedly being discussed, however, we think the impact on S&P 500 earnings will be modest. Strategy – A tax hike alone does not justify broad asset allocation shifts, though adjusting positions within equity portfolios could have promise: The effects from a marginal rate increase will be felt most strongly at the individual stock level, based on differences in effective tax rates. Feature We have shown that bear markets (light red shading) and recessions (gray shading) tend to coincide, while stocks generally march higher during economic expansions (Chart 1). We have also shown that the S&P 500 performs considerably better when monetary policy is easy (the fed funds rate is below our estimate of equilibrium) than when it is tight (fed funds exceeds our equilibrium estimate). While an investor could do a lot worse than mechanically tie his/her equity positioning to the state of the business cycle and/or the monetary policy cycle, it is not easy to recognize the onset of a recession in real time or accurately assess the equilibrium fed funds rate. We are confident, however, that a recession will not occur in time to sour the twelve-month outlook unless a vaccine-resistant strain of COVID emerges and that monetary policy is at least a couple years from turning restrictive. Chart 1Bear Markets Coincide With Recessions There is more to asset allocation than monetary policy settings and the state of the business cycle, but they currently call for a default equity overweight in multi-asset portfolios. Per our process, an investor must have a very good reason for overriding that default. A blow to earnings from a corporate tax hike that has not been discounted could provide that reason, especially when valuations are extremely elevated. Although it is difficult to know exactly what markets are discounting at any given moment, it seems clear that equity analysts have not put a great deal of effort into estimating the impact of a tax hike on the earnings of the companies in their coverage universe. The good news is that our base-case scenario suggests that the tax changes most likely to make it through Congress will deal the bull a glancing blow rather than a knockout punch. We estimate that a statutory increase in the corporate tax rate from 21% to 25% would clip S&P 500 earnings by about 5%. Against a backdrop of unusually conservative four-quarter earnings expectations, the lagged effects of extraordinarily accommodative monetary and fiscal support, and a paucity of alternatives, the equity bull market appears to be capable of weathering a modest tax hike. The Gap Between Marginal And Effective Tax Rates The byzantine nature of the United States tax code creates myriad opportunities for the spectrum of companies subject to its provisions. Tailored tax advice is a thriving cottage industry that employs hundreds of thousands of well-paid accountants, attorneys and specialists in structuring transactions to minimize clients’ outlays. The upshot of the various incentives embedded in the code is that the marginal tax rate – the tax owed on an additional dollar of earnings – may diverge from the effective tax rate – the share of an entity's aggregate earnings that are paid in taxes. Based on the relative favoritism the code bestows upon a particular activity, or the disparate way it treats domestic and foreign operations, effective tax rates can vary widely at the industry level. Of the 392 S&P 500 constituents that owed income tax in their last full year of operations, 60% had an all-in effective tax rate that fell below the 21% statutory federal rate.1 After allowing for state and local income tax levies, the distribution of effective rates shows that a considerable majority of companies manage to pay less than the marginal rate (Chart 2A). The potential for reducing the effective rate is directly related to a company’s size (presumably because the biggest companies are most likely to have multinational activities): the 30 largest tax-paying constituents, accounting for over one-half of the index's tax-paying market-cap, were even more adept at staying below the all-in marginal rate (Chart 2B). Chart 2AS&P 500 Constituents Pay Less Than The Stated Tax Rate ... Chart 2B... Especially If They're Mega-Caps If every S&P 500 constituent’s effective tax rate equaled the marginal tax rate, an increase to 25% from 21% would result in a 5.1% decrease in S&P 500 earnings, as net income would fall from 79 cents of every dollar of pre-tax income to 75 cents. The income decline would be permanent, assuming no further tax-rate changes, and would merit an equivalent decline in the index. Changes in long-run fundamental prospects are not reflected instantaneously in stock prices, however, and it is uncertain just when the market would account for it. There are additionally some near-term buffers to declines in forward four-quarter estimates that might mask any drag from a tax hike. If A Long-Term Tree Falls, Will It Make A Sound? The future is unknowable, but we have at least a puncher’s chance of anticipating what’s to come over short segments like a quarter or a year. The ecosystem of publicly held companies largely operates within that one-to-four-quarter timeframe: companies report quarterly results, as do asset managers, and nearly everyone professionally involved with public equities is subject to compensation structures with annual performance incentives. A share of stock may entitle its owner to a proportional share of earnings in perpetuity, but the next four quarters loom large in the market’s calculus, even to the point of obscuring nearly everything that may come after them. It follows, then, that surprises affecting the outlook for the next year may muffle the market’s reaction to tax negotiations on Capitol Hill. We repeat that consensus analyst expectations for the coming four quarters are modest relative to history and the current macroeconomic backdrop. Now that the second quarter is in the books, analysts are calling for a slight earnings retrenchment, with earnings falling nearly 7% in the third quarter before rising 4% and 1% in the next two quarters, respectively, to settle in the first quarter of 2022 at a level 2% below the quarter just ended. They are not projected to top last quarter’s high-water mark until the second quarter of 2022 (Table 1). Table 1A Low Bar It is possible that earnings will grow that slowly – the pandemic is not over, corporate profit margins may narrow if companies are unable to raise prices enough to cover their rising input costs, fiscal support for the economy is waning, and financial conditions may tighten as the Fed dials back monetary accommodation at the margin – but it would be unlikely on two counts. First, it would counter the empirical record. Earnings have tended to grow, quarter-on-quarter, during expansions (Chart 3). Chart 3That's Why They're Called Expansions Second, it would fly in the face of the red-hot macroeconomic backdrop. The lagged effects of extraordinarily accommodative monetary and fiscal policy settings have real US GDP poised to grow at a pace well above its long-run potential trend through the end of 2022. The equity market is indifferent to quarterly GDP releases, which come out every 63 trading days with a one-month lag and are subject to two revisions that arrive after 21-session intervals, but trailing four-quarter GDP is highly correlated with trailing four-quarter sales (Chart 4, top) and earnings per share (Chart 4, bottom). We of course prefer forward-looking models to backward-looking data but the persistence of economic cycles, especially as they have lengthened across the postwar era, confers some useful predictive properties on trailing data. Chart 4GDP Growth Influences Revenue And Earnings Growth Earnings are a function of revenues (units times price per unit) and margins (per-unit profitability) and robust GDP growth would seem to be tied only loosely to the latter. Over the last three decades, however, growth in S&P 500 earnings per share has been as correlated with GDP growth as growth in revenue per share. Margins are already elevated (Chart 5) and rising cost pressures threaten to squeeze them unless companies can pass on costs to their customers, but the volume pickup embedded in potent real GDP growth will mitigate some of the downward pressure. Chart 5Elevated For Longer? We will have to wait and see how much pricing power companies have, as it will probably take several months before a clear picture begins to emerge. If they can make price hikes stick, margins will hold up, earnings will keep rising and the S&P 500 should power through the meager year-end 2021 and 2022 targets offered by a panel of buy- and sell-side strategists in last week’s Barron’s. We think it is plausible that households, flush with found money from pandemic fiscal transfers and/or financial and housing market appreciation, may prove to be relatively price-insensitive until they work down their windfalls. Vibrant demand could push companies to increase capacity, boosting hiring and capex, stoking more demand in a self-reinforcing post-pandemic honeymoon. The boom would not go on forever, but such a scenario would yield more upside for financial markets and the economy than the increasingly wary consensus projects. Revisiting Lower Fifth Avenue’s Retail Corridor To landlords’ chagrin, businesses’ real estate costs are a source of margin relief. We returned to lower Fifth Avenue to update our retail rental survey and found that little changed between Memorial Day and Labor Day. Two storefronts that were vacant at the end of May have since been rented by pandemic winners Tonal (interactive home gyms) and Hoka (high-performance running shoes), filling two corner locations in the northern half of the corridor (Figure 1). Four storefronts that were occupied by apparel retailers on our last tour – Gap, Gap Kids and Gap Body, and Rigby & Peller, a specialty purveyor of lingerie and swimwear – are vacant now (Figure 2). The net two-store decline has reduced the retail occupancy rate on Fifth Avenue between 14th Street and 23rd Street to 60% from 63%. Figure 1Fifth Avenue Storefronts, 19th Street To 23rd Street Figure 2Fifth Avenue Storefronts, 14th Street To 19th Street According to the Real Estate Board of New York (REBNY), average and median asking rents along the corridor have fallen by 3% and 21%, respectively, since Fall 2020. The excess of storefront supply over demand is a modest inflation corrective in an economy in which the partial release of pent-up demand has exceeded the uneven restoration of supply across several categories. REBNY’s semi-annual rental research survey left no doubt that retail tenants have the upper hand in Gotham and we’d suspect that office tenants do as well. The current market offers tenants ample availability and reduced leasing costs. Some firms recently capitalized on the conditions[,] … includ[ing] [upscale British furniture] retailer … Timothy Oulton [which leased over 7,000 square feet of space across three levels at 20th and Broadway, a block east of Fifth Avenue]. Additionally, an array of smaller service-oriented retailers such as dry cleaners, dance studios and barber shops are locking in favorable terms or shifting to better locations.2 Investment Implications The investment implications of the equity market’s seeming nonchalance regarding looming corporate tax hikes will probably be most keenly felt at the sector, sub-industry or individual stock level. Though we do not see meaningful asset allocation consequences, the disparity in effective tax rates at the sector level (Table 2) hints at disparities across sub-industries and individual stocks. With input from equity analysts, it should be possible to assemble baskets of stocks based on their sensitivity to a higher marginal income tax rate. Table 2One Size Does Not Fit All As Barron’s September 6th Fall Investment Outlook feature highlighted, buy-side CIOs and sell-side strategists have adopted a measured tone. Year-end 2021 S&P 500 targets hover around the index’s current level and top-down 2022 projections offer no more than grudging upside. Tightening margins are a leading fundamental concern, along with rising inflation pressures, and elevated valuations contribute to the sense of unease. A chorus of “This won’t end well” intonations suggests that stocks may have a wall of worry to scale before the spoilsport consensus can claim validation. Regarding inflation concerns, asset allocators should bear in mind that stocks are an inflation hedge relative to cash and bonds. They should also recognize that high inflation does not derail equities; tight monetary policy in response to high inflation, which involves higher interest rates as part of a deliberate effort to throttle an overheating economy, derails equities. Investors conditioned to a predictably rapid Fed response may view this as a distinction without a difference. Per our house view that the fed funds liftoff date is over a year away and the sustained series of rate hikes required to tighten policy is well more than another year out, however, TINA's influence may become even more pronounced before this bull market ends. We remain vigilant, but we think it is too early to head for cover.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The term “all-in” recognizes that US corporations uniformly incur tax liabilities at the state level in addition to their federal obligations. The average marginal 2021 state income tax rate is 6.6%. 2  REBNY_Manhattan_Retail_Spring_2021.pdf

Highlights Economy – Goldilocks remains our base-case macro backdrop for the next twelve months: The transitory inflation narrative is still intact, despite persistently high consumer price increases, suggesting that the economy will not overheat. The Delta wave has roiled many communities, but COVID is unlikely to spark a growth outage unless a vaccine-resistant variant emerges. Markets – Above-trend growth and extraordinarily accommodative monetary policy is a sweet spot for risk assets: As long as the Fed’s novel policy of adding monetary stimulus to an economy growing way above trend doesn’t give rise to unnervingly high inflation, the combination will be conducive to continued equity and credit outperformance. Strategy – Continue to overweight risk assets within multi-asset portfolios: There’s more to investment returns than the state of the business, credit and monetary policy cycles but they make a powerful case against turning defensive in the near term. Feature We had several virtual meetings with clients in August and inflation, the Fed and the growth outlook were frequently recurring themes. In this week’s report, we share some of the most common questions, along with our take on them, so that all clients can see what we’ve been discussing with their peers. In the interest of space, we confine the discussion to our base-case scenarios, but future outcomes appear to be even more uncertain than they normally are against a backdrop of unprecedented policy settings. We advise investors to remain vigilant and be prepared to hold positions for shorter-than-usual durations in the event circumstances change. Inflation prints remain high, pressuring the Fed’s transitory narrative. What will happen to markets if investors reject it? Chart 1Losing Steam? Inflation prints do remain high, with headline CPI rising 0.5% month-over-month and 5.3% year-over-year in July and core CPI rising 0.3% and 4.2%. Both series modestly exceeded expectations, though they recorded their smallest sequential gains since February and their year-over-year increases came in just below the peaks recorded in June (Chart 1). It is possible that consumer price increases have begun to decelerate though it will take more data to confirm the existence of a new trend. Reports of continued bottlenecks driven by component shortages, transport challenges and the Delta infection wave suggest that even if the factors that have pushed inflation higher are beginning to abate, they may linger in some form for longer than initially expected. The transitory narrative remains intact, however. Drilling into the components of the elevated core CPI reveals that a handful of categories that have been particularly impacted by the pandemic are exerting outsized influence over the index. When we published the initial version of Table 1 in late May, nine categories powered April’s reported core inflation. This time there are eight, as the five shaded components have come off the boil and the four components shown in an indented font have newly begun to run hot. Table 1Temporary Irritants Excepting historically volatile recreational services and water, sewer and trash services, which have been increasing in price far faster than other goods and services for a while, the hot categories’ moves have been extreme relative to their own history. Unless their spaces have undergone lasting structural changes, we expect their two-plus standard deviation moves will not be sustained. The biggest outliers, lodging and new vehicles, can be explained entirely by the pandemic and once hotels are able to return to full capacity and an end to the semiconductor shortage allows automakers to resume normal production levels, they will come back to earth. The turnover among the outliers supports the transitory narrative, as price spikes in categories that have long lagged the overall basket, like airfares and used cars, or have experienced long deflationary skids, like furniture and bedding, appear to have been fleeting. Chart 2Back To The Early Nineties Markets would experience considerable disruption if investors became convinced that elevated inflation readings were not transitory. Bond yields would rise sharply; the dollar would weaken, stoking further price increases; and the technology sector would come under pressure, threatening the S&P 500. Worst of all, the Fed would be forced to begin hiking the fed funds rate sooner than expected, on its way to setting it at a higher terminal level than expected, sending rates higher across all maturities and weighing on equities generally. The sizable potential market impacts have us monitoring inflation closely, even if the inflation debate won’t likely be resolved until we have several more monthly data points. So you’re watching inflation closely, but you’re not all that worried about it? That’s the gist of it, yes. We’re watchful but not worried. Part of the reason that respective year-over-year core and headline CPI prints over 4% and 5% give everyone such a start is that inflation hasn’t been so high since the beginning of the nineties (Chart 2). But the structural factors that have helped keep inflation in check for decades didn’t suddenly disappear when the pandemic arrived. While BCA’s house view holds that investors are complacent about inflation’s longer-run trajectory, we expect that it will take a few years for prices to move sustainably higher. Table 2Inflation Checklist We developed our inflation checklist to keep tabs on when inflation is poised to rise enough to impact monetary policy and provoke a market inflection. We check the same three boxes that we have in our previous reviews: Labor demand is still red-hot, year-over-year changes in marquee inflation indexes are still well above the Fed’s target and BCA’s pipeline inflation indicator remains very elevated (Table 2). Wages have not yet broken out in response to the worker shortage, however (Chart 3), and it is as if idle workers are abstaining from working rather than using their leverage to command higher wages. The more refined trimmed-mean measures of the CPI and the PCE Index remain relatively well behaved (Chart 4). Chart 3Wages Have Risen, But They Haven't Broken Out Yet     Chart 4More Refined Inflation Measures Continue To Lag Their Marquee Peers Even if our pipeline inflation indicator has crested, it remains at an extremely high level consistent with above-target consumer price gains (Chart 5). As measured by the DXY Index, the dollar has twice bounced convincingly off support at 90 this year, helping to keep imports from adding fuel to the fire. Core consumer prices in the Eurozone and China are only rising a little more than 1% annually in any event, so the two largest economies outside the US are not yet exporting inflation stateside (Chart 6). Chart 5Inflation Pressures May Finally Be Easing Chart 6Eurozone Prices Are Rising, But They're Not Yet Elevated If we had to pick just one indicator to determine whether inflation will become problematic, it would be the shape of the inflation expectations curve. High inflation becomes self-sustaining when economic actors – workers, businesses, consumers and lenders – begin to expect it will persist into the future and change their behavior to align with their expectations. When inflation is expected to be high over the long term, individual workers or their unions insist on higher wages to maintain purchasing power, businesses at all points of the supply chain demand higher prices to protect their margins, consumers accelerate their big-ticket purchase decisions to get the most bang for their buck and lenders require higher nominal pro forma returns. The resulting feedback loops help inflation become entrenched in the same way that expectations of falling prices have paved the way for a deflationary mindset to grip Japan. As long as investors (Table 3) and households (Chart 7) expect inflation to decelerate from the short term to the intermediate term, and again from the intermediate term to the long term, the inflation genie has not gotten out of the bottle. Table 3Investors' Inflation Expectations Curve Is Inverted, ... Chart 7... And So Is Consumers' Where do you get the idea that upward S&P 500 earnings revisions are in store? Analysts are already penciling in double-digit year-over-year gains over the next four quarters and growth is plainly decelerating. In our view, the dislocations imposed by COVID-19 across all of 2020 distorts year-over-year earnings comparisons so much that they are of little use. To sidestep that distortion, we have been calculating expected growth by comparing forward four-quarter earnings projections to the annualized run rate of the last reported quarter. As an example, at the beginning of the second quarter earnings season in July, we multiplied the first quarter’s $49.13 EPS by four to get $196.52 and then compared it to the $193.25 sum of expectations for 2Q21 through 1Q22, discovering that analysts were calling for a nearly 2% decline in S&P earnings based on 1Q21's run rate. We also observed that the 2Q21 projection of $45.21 indicated that analysts expected an 8% quarter-over-quarter decline (Table 4). Table 4Expectations At The Start Of The 2Q Earnings Season Were Too Low Looking through modest seasonal effects, S&P 500 EPS tend to grow from quarter to quarter during expansions. An 8% quarter-on-quarter contraction would have been very surprising when nominal GDP, a sound proxy for S&P 500 revenue growth, was projected to grow by at least 2.25% (7% real annual growth plus 2% inflation). Assuming S&P 500 earnings could match GDP growth, we figured that 2Q index EPS would be at least $50, 2% above 1Q and 10% above analyst estimates. With nearly all constituents having reported at press time, it looks like they will settle at $52.74. Chart 8Predicted Declines In Forward Four-Quarter S&P 500 Earnings Are Rare Table 5S&P 500 Earnings BCA does not make point estimates, but a sequential perspective yielded a useful insight that pandemic-distorted year-over-year analysis missed: consensus 2Q earnings estimates were glaringly low when compared to actual 1Q results and the next three quarters’ estimates looked like they had room to rise as well. As Chart 8 shows, forward four-quarter earnings are rarely projected to fall below the most recent quarter’s annualized run rate. With quarterly earnings not projected to exceed 2Q21 until 2Q22 (Table 5), the expectations bar appears to be set low for the next four quarters, especially given 2H21 real annualized GDP growth expectations of around 6% (9% nominal, if inflation declines to no less than 3%) and 1H22 real GDP growth expectations of 3 to 3.5% (5.5 to 6% nominal, if inflation declines to no less than 2.5%). ​​​​​​​The bottom line is that earnings estimates are quite modest from a sequential perspective when viewed against S&P 500 earnings’ tendency to rise during expansions. While we expect that earnings growth will decelerate, we do not foresee that it will spite history and contract, especially given the extraordinarily accommodative monetary and fiscal policy backdrop. Investment Implications As the foregoing discussion suggests, we remain comfortable with our base-case scenario that the Goldilocks strong-growth/accommodative policy backdrop will remain in place and support risk assets over the next twelve months. Neither the too-hot right-hand tail, in which monetary policy is projected to turn restrictive soon enough to weigh on twelve-month returns, or the too-cold left-hand tail, in which growth disappoints despite copious accommodation, looks particularly likely. But as we keep highlighting in discussions with clients, we are mindful that our conviction levels are necessarily lower than usual given the unprecedented backdrop. We are bullish, but vigilantly so, and we urge investors not to let their guard down. We take heart from what we view as a powerful bias for the Fed to err on the side of providing too much accommodation. It was nothing new when Chair Powell explicitly drew a distinction between tapering asset purchases and hiking the fed funds rate in his Jackson Hole speech a week and a half ago, but it was nonetheless comforting for an investor in risk assets to have the Fed reiterate its dovish default position. A zero fed funds rate is conducive to corporate earnings growth and risk asset outperformance and it will help hold off the start date of the next recession. So too will the lagged effects of massive fiscal transfers that bolster households’ ability to consume. The path of least resistance is for risk assets to continue generating excess returns.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com