Financial Markets

Executive Summary EM Credit Spreads Correlate With The EM Business Cycle A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will open up once US Treasury yields roll over and the US dollar begins its descent. US 10-year Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after that. Although we are getting closer to a buying opportunity in EM local currency bonds, it is not imminent. EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle. The near-term outlook for EM currencies and EM/global growth remains unfavorable.   Bottom Line: For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Maintain a defensive tilt within an EM local bond portfolio. Our only outright long has been Brazilian 10-year domestic bonds but we recommend that investors hedge currency risk over the near term. Continue underweighting EM credit relative to US credit, quality adjusted. Feature Bond yields are surging around the world. How advanced are the bond selloffs in the US and in EM? Our short answer is that while the global bond selloff is fairly advanced, volatility will remain high in the near term and yields might rise further. A buying opportunity in EM local bonds and sovereign credit (EM USD bonds) will emerge when US bond yields roll over and the US dollar begins its descent. For now, investors should continue shorting EM currencies versus the US dollar and stay defensive in their EM domestic bond and credit portfolios. US Inflation And Bond Yields Since the top in US bond prices in 2020, US 10-year Treasurys have experienced their second largest drawdown of the past 42 years (Chart 1). The bond rout has pushed net bullish sentiment on US Treasurys to extremely low levels (Chart 2, top panel). From a contrarian perspective, depressed sentiment is positive for the outlook for bonds. Chart 1US 10-Year Treasurys Are Experiencing Their Second Worst Drawdown In 45 years Chart 2Traders Are Very Bearish On Bonds However, the term premium on 10-year bonds is still too low (Chart 2, bottom panel). Extremely high inflation uncertainty warrants a higher risk premium on US bonds. Given that the term premium is a gauge of the risk premium embedded in bonds, it will likely rise further due to inflation and policy uncertainty. Moreover, the tight labor market and surging wages imply that the fundamental outlook for US bonds is also unfavorable. Chart 3 displays that the US labor market has not been this tight since the late 1960s when inflation rose sharply, got embedded in consumer and business expectations and stayed structurally elevated util the early 1980s. The bottom panel of Chart 3 shows the US employment cost index and the Atlanta wage tracker. Both are high and accelerating. Chart 3The US Labor Market Is Very Tight And Wage Growth Is Accelerating Critically, US unit labor costs (ULC) – which have a significant impact on core inflation’s medium-term trends – are accelerating (Chart 4). Productivity growth will not be able to keep up with the pace of wage increases, which implies that unit labor costs will continue to rise at a rapid rate. As a result, any decline in core and headline CPI will be technical and limited in nature. US headline and core inflation rates will drop from the current extremely high levels as transitory forces – which exacerbated price pressures over the past 12 months – ebb. Trimmed-mean core PCE and median core CPI measures suggest that underlying US core consumer price inflation is probably in the 3.5% to 4% range (Chart 5). These two measures strip out outliers like used auto prices. Chart 4Unit Labor Costs Drive Core CPI Chart 5US Core Inflation Will Roll Over But Stay Above 3.5-4%   Thus, core PCE and CPI will drop in H2 this year but will stay above 3.5-4%. That is well above the Fed’s 2-2.25% target range for core inflation. Hence, the Fed will maintain its hawkish stance and continue to tighten monetary policy for now. That is why we have been arguing that the Fed and US stocks are on a collision course. The Fed will adopt a dovish tilt only after financial conditions tighten dramatically, i.e., when the S&P500 is down more than 20% from its January high. Bottom Line: Even though headline and core inflation measures will decline later this year, genuine price pressures will remain intense. US government bond yields might be approaching a turning point. Odds are that US 10-year yields will roll over when they reach 3.3-3.4% (Chart 6). EM Domestic Bonds The current drawdown in the total return of EM domestic bonds is the largest on record in local currency terms, but not in US dollar terms (Chart 7, top and middle panels). The basis is that in the current cycle, EM currencies have depreciated less than they did during previous bond selloffs in 2014-15 and 2020. Chart 6The Next Technical Resistance For 10-Year Treasurys Yields Is Around 3.4% Chart 7EM Local Currency GBI Bond Index: Total Return And Yields   However, historical comparisons do not take into account changes to the composition of the JP Morgan GBI-EM index. Specifically, China was included in 2020 and it now makes up 10% of the index. Chinese onshore government bond yields have been falling and are now very low (comparable with the yields on US Treasurys). Plus, the Chinese yuan is a low beta currency in the EM universe. In brief, Chinese onshore bonds have been supporting the GBI-EM index’s performance over the past 12 months. However, even after considering this favorable compositional change to the GBI-EM index, the recent drawdowns in both local currency and US dollar terms have been significant (Chart 7, middle panel). From a valuation point of view, EM bonds are beginning to offer value (Chart 7, bottom panel). However, risks to ex-China EM local currency bond yields remain to the upside over the near term. First, as long as EM exchange rates depreciate versus the US dollar, EM ex-China central banks will hike their policy rates because weak currencies will aggravate domestic inflationary pressures. Odds are that the greenback’s rally will continue in the near term. Net bullish sentiment on the US dollar is not yet at a peak level (Chart 8). Plus, investors’ net long positions in high-beta EM currencies was elevated as of April 29 (Chart 9). Chart 8Bullish Sentiment On US Dollar Is Not Extreme Chart 9EM Currencies Have Near-Term Downside     Critically, the Chinese yuan’s depreciation versus the US dollar will continue to exert downward pressure on commodity prices and other EM currencies. Besides, EM ex-China currencies have failed to break above the falling trendline (Chart 10). This is a sign that the rebound has been exhausted and a new downleg is in the offing. Second, the pass-through effect of high food and energy prices into core inflation is higher among EM economies than DM ones. Given that food prices are surging and oil prices are elevated, mainstream EM central banks will continue hiking interest rates. Finally, EM local bond yields will not drop until US TIPS yields roll over (Chart 11). TIPS yields are still low, and their path of least resistance would be up. Chart 10Stay Short EM Currencies for Now Chart 11EM Local Yields Correlate With US TIPS Yields   Bottom Line: A buying opportunity in EM domestic bonds will likely occur when US Treasury yields and the US dollar roll over. These are not imminent. EM local currency bond investors should stay defensive for now. EM Credit Spreads EM sovereign and corporate credit spreads fluctuate with their exchange rates and the EM/global business cycle, as was discussed in A Primer on EM USD Bonds and illustrated in Chart 12 and 13. Chart 12EM Credit Spreads Correlate With EM Currencies Chart 13EM Credit Spreads Correlate With The EM Business Cycle     As we discussed above, the outlook for EM currencies remains unfavorable. Risks to EM/global business cycle are also to the downside. China’s growth remains weak. The favorable impact of fiscal and monetary stimulus is being offset by the harsh lockdowns. Copper prices seem to be breaking down in line with China’s economic weakness (Chart 14). This is negative for many EM economies that export raw materials. Domestic demand in many emerging economies is subdued (Chart 15). Monetary tightening and negative fiscal thrust will cause domestic demand in the majority of EM economies to slow further. Chart 14Copper Prices Have Broken Down Chart 15EM Domestic Demand Has Been Very Weak   Finally, global trade volumes will shrink as DM consumption of goods ex-autos declines. Bottom Line: A combination of weakening growth and depreciating currencies will cause EM sovereign and credit spreads to widen further. Investment Recommendations Chart 16EM Credit Spreads Will Widen Further US Treasury yields will likely peak at around 3.3-3.4%. The US dollar will roll over soon after. For now, continue shorting a basket of EM currencies versus the US dollar: ZAR, COP, PEN, PLN, HUF, PHP and IDR. Be patient before buying EM local currency bonds. Our current positions are as follows: receiving 10-year swap rates in China and Malaysia, betting on yield curve inversion in Mexico and Colombia (receiving 10-year/paying 1-year and 6-month swap rates, respectively) and paying Polish/receiving Czech 10-year rates. Our only outright long has been Brazilian 10-year bonds but we recommend that investors hedge currency risk in the near term. EM sovereign and credit spreads will widen further (Chart 16). Continue underweighting EM credit relative to US credit, quality adjusted. Our country allocation for EM domestic bond and sovereign credit portfolios is presented in the tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

In lieu of next week’s report, I will be presenting a webcast titled ‘The 5 Big Mispricings In The Markets Right Now, And How To Profit From Them’. I do hope you can join. Executive Summary Just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes are setting in train a global recession. Demand is already cool, so aggressive rate hikes will take it to outright cold. The risk is elevated because central banks are desperate to repair their damaged credibility on fighting inflation, and it may be their last chance. Inflationary fears and hawkishness from central banks are weighing on bonds and stocks, and it may take some weeks, or months, for inflation fears to recede. But we could be approaching a turning point. By the summer, core inflation should be receding. Furthermore, the fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility that have signalled inflection points. Fractal trading watchlist: 30-year T-bond, NASDAQ, FTSE 100 versus Euro Stoxx 50, Netherlands versus Switzerland, and Petcare (PAWZ). US Inflation Is Hot, But Demand Is Not Bottom Line: Tactically cautious, but long-term investors who do not need to time the market bottom should overweight bonds and overweight long-duration defensive equities versus short-duration cyclical equities – for example, overweight US versus non-US equities. Feature The First World War, the historian AJP Taylor famously argued, was “imposed on the statesmen of Europe by railway timetables.” Taylor proposed that the railways and their timetables were so central to troop mobilisation – and specifically, the German Schlieffen Plan – that a plan once set in motion could not be stopped. “Once started the wagons and carriages must roll remorselessly and inevitably to their predestined goal.” Otherwise, the whole process would unravel, and an opportunity to demonstrate military credibility would be lost that might never come again. Today, could a global recession be imposed upon us by central bank timetables for aggressive rate hikes? Just as it was difficult to unwind the troop mobilisation that led to the Great War, it will be difficult to back down from the aggressive rate hikes that the central banks have timetabled, at least in the near term. Otherwise, an opportunity to demonstrate inflation fighting credibility would be lost that might never come again.  Just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes may set in train  another global recession. Unfortunately, central banks do not have precision weapons. Quite the contrary, monetary tightening is a blunt instrument which works by cooling overall demand. But demand is already cool, as evidenced by the contraction of the US economy in the first quarter. In their zeal to repair their damaged credibility on fighting inflation, the danger is that central banks take the economy from cool to outright cold. Granted, the US economy was dragged down by a drop in inventories and net exports. But even US domestic demand – which strips out inventories and net exports – is barely on its pre-pandemic trend (Chart I-1). Meanwhile, the euro area economy is still 5 percent below its pre-pandemic trend (Chart I-2). To reiterate, by hiking rates aggressively into economies that are at best lukewarm, central banks are risking an outright recession. Chart I-1US Inflation Is Hot, But Demand Is Not Chart I-2Euro Area Inflation Is Hot, But Demand Is Not Our Three-Point Checklist For A Recession Has Three Ticks My colleague Peter Berezin has created a three-point checklist for a recession: The build-up of an imbalance makes the economy vulnerable to downturn. A catalyst exposes this imbalance. Amplifiers exacerbate the downturn. Is there a major imbalance? You bet there is. The post-pandemic 26 percent overspend on durable goods in the US constitutes one of the greatest imbalances in economic history. Other advanced economies also experienced unprecedented binges on durable goods. The catalyst that is exposing this major imbalance is the realisation that durable goods are, well, durable. So, if you overspent on durables in 2020/21, then the risk is that you symmetrically underspend in 2022/23 (Chart I-3). The post-pandemic 26 percent overspend on durable goods in the US constitutes one of the greatest imbalances in economic history. Meanwhile, a future underspend on goods cannot be countered by an overspend on services because the consumption of services is constrained by time, opportunity, and biology. There is a limit to how often you can eat out, go to the movies, or go to the doctor (Chart I-4). Indeed, for certain services, an underspend will persist, because we have made some permanent post-pandemic changes to our lifestyles: for example, hybrid office/home working and more online shopping and online medical care. Chart I-3An Overspend On Goods Can Be Corrected By A Subsequent Underspend... Chart I-4...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend Finally, the amplifier that will exacerbate the downturn is monetary tightening. If central banks follow their railway timetables for aggressive rate hikes, a goods downturn will magnify into an outright recession. So, in Peter’s three-point checklist, we now have tick, tick, and tick. Inflation Is Hot, But Demand Is Not If economic demand is at best lukewarm, then what caused the post-pandemic inflation that central banks are now fighting? The simple answer is massive fiscal stimulus combined with the equally massive shift in spending to durable goods. Locked at home and flush with government supplied cash, we couldn’t spend it on services, so we spent it on goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. For example, airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The causality from stimulus payments to durable goods spending to core inflation is irrefutable. The causality from stimulus payments to durable goods spending to core inflation is irrefutable. The biggest surges in US durable goods spending all coincided with the government’s stimulus checks (Chart I-5). And the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-6). As further proof, core inflation is highest in those economies where the stimulus checks and furlough schemes were the most generous – like the US and the UK. Chart I-5Stimulus Checks Caused The Surges in Durable Goods Spending Chart I-6The Surges In Durable Goods Spending Caused The Surges In Core Inflation What Does All This Mean For Investment Strategy? Our high conviction view is that the pandemic’s inflationary impulse combined with the Ukraine war will turn out to be demand-destructive, and thereby ultimately morph into a deflationary impulse. Yet central banks are all pumped up to demonstrate their inflation fighting credibility. Given that this credibility is badly damaged, it may be their last opportunity to repair it before it is shattered forever. To repeat, just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes may set in train another global recession. That said, a recession is not inevitable. The interest rate that matters most for the economy and the markets is not the policy rate that central banks want to hike aggressively, it is the long-duration bond yield. A lower bond yield can underpin both the economy and the financial markets, just as it did during the pandemic in 2020. But to the extent that the bond market is following the real economic data, we are in a dangerous phase. Because, as is typical at an inflection point, the real data will be noisy and ambiguous. Meaning it may take some weeks, or months, for inflation fears to be trumped by growth fears. On March 10th, in Are We In A Slow-Motion Crash? we predicted:  “On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally” That prediction proved to be spot on! Recession, or no recession, we are still in a difficult period for markets because inflationary fears and hawkishness from central banks are weighing on bonds and stocks, while buoying the US dollar. As such, tactical caution is still warranted. Fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility. But we could be approaching a turning point. By the summer, core inflation should be receding. Furthermore, the fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility that have reliably signalled previous inflection points (Chart I-7 and Chart I-8). Chart I-7The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart I-8The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The advice for long-term investors who do not need to time the market bottom is: Bonds will ultimately rally. Overweight the 30-year T-bond and the 30-year Chinese bond. Equities will be conflicted between slowing growth which will weigh on cyclical profits, and falling bond yields which will buoy long-duration valuations.  Therefore, overweight long-duration defensive sectors and markets versus short-duration cyclical sectors and markets. For example, overweight US versus non-US equities. Fractal Trading Watchlist As just discussed, the sell-offs in the 30-year T-bond and the NASDAQ are approaching points of fractal fragility that have signalled previous turning points. Hence, we are adding both investments to our watchlist. Also added to our watchlist is the outperformance of the FTSE100 versus Euro Stoxx 50, and the underperformance of Netherlands versus Switzerland, both of which are approaching potential reversals. Our final addition is Petcare (PAWZ). After a stellar 2020, Petcare gave back most of its gains in 2021. But this underperformance is now approaching a point of fragility which might provide a new entry point. There are no new trades this week, but the full watchlist of investments at, or approaching, turning points is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions A Potential New Entry Point Into Petcare FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Chart 17US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Stocks Not Linked To Presidential Approval   President Kennedy’s performance in 1962 would be ideal for the Biden administration in this year’s midterm elections – but today the Russian conflict is less likely to help the Democrats.   A threat to the homeland could lift President Biden’s job approval. But most likely inflation and foreign crises will weigh on his approval. A contrarian stock rally would not help Biden’s approval but Biden’s attempts to boost his rating could deliver negative surprises for stocks.    US “peak polarization” and Democratic Party policies are negative for the stock market and investor risk appetite over the next zero-to-six months.   Our quantitative election models suggest Republicans will win the Senate, though uncertainty will rise as a result of the controversy over the Supreme Court and abortion. Democratic odds of keeping the White House in 2024 are 54.6% but eroding. CLOSE Recommendation (Cyclical) CLOSING Level CLOSING Date RETURN Long Municipal Bonds Vs. Duration Matched Treasuries 93.53 2-MAY-22 -1.50%   Bottom Line: Overall Biden policies plus global events are neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months). Feature President Biden is doubling down on his support for Ukraine and thus adopting the John F. Kennedy foreign policy playbook of confronting Russia ahead of the US’s midterm elections. Related Report  US Political StrategyWar Not Helping Biden So Far Biden’s position today is weaker than Kennedy’s in 1962, so his reaction to Russian aggression will create more market hurdles than it removes. Bad news will come before good news, compounding bearish investor sentiment in the near term. Policy uncertainty should decline after the midterm election on November 8, which is positive for equities in 2023.   Democrats Scramble Amid Recession Fear The US economy contracted unexpectedly in the first quarter at an annualized 1.4% rate. The underlying data contained some silver lining – personal consumption grew at 2.7%. But the contraction is bad news for the economy and the ruling Democratic Party. Public approval of Biden’s handling of the economy has fallen to -16.2%. The global economy continues to sputter. Risks to growth are high in Europe and China as well (Chart 1). The US policy response will take shape on the monetary and fiscal level but also on the foreign policy level. First, global risks will not dissuade the Federal Reserve from normalizing interest rates. Chairman Jerome Powell signaled on April 21 that he is willing to hike interest rates 50 basis points at a time to combat core PCE inflation at 5.2%. The market currently expects core inflation to peak at 5.2% while the Fed funds rate will hit 3.3% in 2023 before falling in 2024. The implication is that monetary policy will tighten quickly, even as the economy stutters, which is negative for the US equity market and investor sentiment. However, Fed hawkishness is largely priced. US long-duration treasuries are at or near fair value at 3%, according to our US Bond Strategy. Our US Investment Strategy believes that with the S&P500 already down by 13% so far this year, stocks can begin to grind upward, barring other negative surprises. Chart 1US Slows Amid Global Growth Risks   Second, the White House will scramble to try to limit the damage to the Democratic Party in the midterms – with the unintentional result that negative surprises could arise from fiscal policy and especially foreign policy. On the fiscal front, congressional Democrats will redesign their budget reconciliation bill to try to gain a legislative victory. They will need to make it as close to deficit-neutral as possible to avoid fanning inflation. The odds of passage are higher than consensus expectations (26% on PredictIt). But the stock market does not want more government spending or higher taxes in a stagflationary environment. Fiscal policy is still a significant source of uncertainty in 2022, if not in 2023. On the foreign policy front, the greatest trouble looms. Russian aggression has prompted the US and its NATO allies to double down on their support for Ukraine, providing additional arms and aid. Biden’s Secretary of Defense Lloyd Austin said that the US wants to see Ukraine “a democratic country able to protect its sovereign territory … [and] Russia weakened to the point where it can't do things like invade Ukraine.”1 Finland and Sweden are increasingly likely to join NATO, which will antagonize Russia. Russia’s response is not yet known but it has issued aggressive warnings. By cutting off natural gas to Poland and Bulgaria, Moscow is warning that it may cut off natural gas to all Europe. Meanwhile Germany is embracing an oil embargo. A larger energy shock is increasingly likely. Chart 2More Bad News Before Good News​​​​​ Bottom Line: Monetary policy hawkishness is largely priced whereas additional fiscal uncertainty and America’s reactive foreign policy are not fully priced. This news is neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months) (Chart 2). Biden Can Hurt Stocks, Stocks Cannot Help Biden Before addressing how Biden will try to boost his job approval, we should ask whether approval ratings have any direct impact on financial markets. The answer is largely no – or fleeting at best. During the Trump administration it was easy to get the impression that the president’s approval rating had a substantive impact on the stock market, or at least benefited stocks relative to bonds. After the first year, a correlation developed between presidential approval and the stock-to-bond ratio (Chart 3A, top panel). The passage of tax cuts juiced corporate profits but also suggested that President Trump could get things done, boosting his approval rating. Oddly, however, the relationship continued even after Republicans lost Congress in 2018. Spurious or not, the correlation persisted until Covid-19 erupted. At that point Trump’s approval tanked while the stock market roared on the back of gargantuan monetary and fiscal stimulus. President Biden’s administration started off the same way, with presidential approval falling (the usual honeymoon ended) while stocks rallied relative to bonds (Chart 3A, bottom panel). But Biden’s passage of the American Rescue Plan Act and the bipartisan Infrastructure Investment and Jobs Act in 2021 did not boost his approval rating. Going forward, Biden’s approval rating will probably stabilize at a low level in an inflationary or stagflationary context. Stocks may continue to underperform bonds over a tactical time frame but will not underperform bonds over the cyclical time frame as long as the US avoids a recession. Thus there is not likely to be close correlation between Biden’s approval and the stock-to-bond ratio. From the sector and style perspective, there is also no clear relationship with presidential approval. There may be some basis for seeing Trump’s tax cuts as positive for cyclicals relative to defensives. His term coincided with the second half of a business cycle when growth expanded. But ultimately cyclicals vacillated and went sideways. Moreover growth stocks outperformed value stocks, in accordance with President Obama’s term in office. Yet there was no correlation between Trump’s approval and growth stocks relative to value  (Chart 3B, top two panels). In Biden’s case, presidential job approval has no clear correlation with cyclicals relative to defensives. There may be some relationship with value relative to growth stocks but it is far from convincing. Most likely the underlying macroeconomic dynamics that favored value stocks (i.e. recovery, inflation) coincided with Biden’s honeymoon period and then outlasted it. However, if Biden passes a reconciliation bill with tax hikes, the implication should be positive both for value versus growth stocks and for his approval rating (Chart 3B, bottom two panels). Chart 3AStocks Not Linked To Presidential Approval Chart 3BStocks Not Linked To Presidential Approval From the above data we can draw a few conclusions. On one hand, the stock-to-bond ratio and cyclicals-versus-defensives could rally again on the back of a resilient global economy and yet Biden’s approval rating could fail to recover. The distribution of wealth means that inflation and rising mortgage rates hit low-to-middle income groups who comprise the bulk of voters. Cyclical assets will rise if the global economy improves relative to the US economy, whereas presidential approval may not. Inflation could subside incrementally with limited benefit to the president. On the other hand, if stocks and cyclical sectors continue to underperform, it will probably be due to even worse economic outcomes that will simultaneously prevent Biden’s approval from recovering. If the economy slows further and inflation remains persistent, disapproval will rise. The problem for investors is that the latter is the likeliest scenario based on the energy supply risks in Europe and China’s difficulties stabilizing growth. The US economy cannot entirely avoid the knock-on effects of slower global growth over the next six months. Bottom Line: There is no stable relationship between presidential approval and the stock market, whether regarding bonds, sectors, or styles. There are occasional correlations that reflect coincidences of macro, market, and political cycles or major policy changes. In today’s context a rebound in cyclical assets may not help the president while a further downturn would hurt him. But the president’s attempts to boost his approval rating could hurt stocks. Inflation And Foreign Wars Tend To Hurt Presidents What can Biden do to boost his approval rating and his party’s odds in the midterm election? Not much. Foreign policy is his best option, though he is limited to a defensive or reactive foreign policy and even then the underlying economy will drive voters the most. Looking at presidential approval over time, upswings occur during periods of economic prosperity and peaks occur amid foreign belligerence that threatens the homeland. Presidential approval has slumped since the subprime mortgage crisis and today it is even lower than under President Obama (Chart 4A). Chart 4APresidential Approval Follows Peace And Prosperity, Not War And Poverty Similarly presidential disapproval rises during recessionary and inflationary periods as well as wars and scandals (Chart 4B). The Obama/Trump era saw a rise in disapproval that could resume due to inflation. Foreign wars that do not present a threat to the homeland can increase disapproval. Chart 4BPresidential Approval Follows Peace And Prosperity, Not War And Poverty The takeaway is that a homeland threat from abroad could temporarily lift the president’s approval but it will not last for long unless the underlying economic malaise is cured. The problem for Biden is that the most immediate foreign policy challenges emanate from oil producers whose reactions exacerbate the inflation problem (Russia, Iran). Biden may or may not keep relations steady with China, where disputes could drive up import prices. Bottom Line: A reactive foreign policy could provoke a threat to the homeland that boosts the president’s job approval. But more likely the weakening economy, high inflation, and foreign crises that add to inflation will hurt the president. Biden And The Kennedy Playbook President Kennedy’s experience in 1962 presents the best case for Democrats but the underlying economic and political context are different and damaging for Biden. Comparing today’s situation to comparable midterm election years, the negative outlook for Biden and the Democrats becomes clear. Comparable midterm elections feature high international tensions, high inflation, or low presidential approval on a net basis. Today the “Misery Index” (unemployment plus inflation) is comparable to the minimum levels in midterm years in the 1970s – and higher than the maximum levels in other midterm years (Table 1). The House and Senate losses during periods of high misery and low presidential approval are substantial. Table 1Misery And Midterms The 1962 midterm election is a notable exception. The Cuban Missile Crisis and Kennedy’s handling of it minimized the Democratic Party’s losses that year, with only four seats lost in the House, plus a gain of three seats in the Senate. Compare this to the typical midterm election, with an average of 27 lost seats in the House (31 for Democrats) and four seats lost in the Senate (five for Democrats) (Table 2). Table 2Kennedy’s Cuban Missile Crisis Midterm, 1962 Kennedy’s net approval averaged 55% that year, whereas Biden’s today stands at -11%. A threat to the homeland could boost Biden’s approval but today’s likeliest conflicts would worsen inflation if they occurred. The Misery Index stands at 11% this year compared to 6% in 1962. Most importantly, in the Cuban Missile Crisis, the Russians recognized that America would always care about Cuba’s status more than Russia because it posed a proximate strategic threat. Americans had more at stake and could take greater risks to prevent Cuba from hosting nuclear arms. Today, while the US is not trying to supply Ukraine or Finland with nuclear weapons, NATO membership would expand the US nuclear umbrella. Americans do not seem prepared to recognize that Russia will always care more about Ukraine’s and Finland’s status than Americans will. Russians have more at stake and can take greater risks. Thus while Biden’s foreign policy could easily provoke a crisis with Russia, Biden may not get the better end of the crisis like Kennedy did. Meanwhile financial markets will suffer from the spike in tensions. Bottom Line: Biden’s doubling down on support for Ukraine and NATO enlargement suggest that he does not have an interest in reducing tensions with Russia ahead of the midterm election. Yet Biden is unlikely to get the better of any reactive foreign policy that escalates tensions – at least not in time for the midterms. This dynamic is negative for US and global stocks and risk assets. Election Quant Model Updates The Philadelphia Federal Reserve released a second update to its state-level coincident indicators in April, enabling us to update our quant models for the Senate election in 2022 and presidential election in 2024. The model still predicts that Democrats will lose two Senate seats, producing a Republican majority of 52-48 (Chart 5). Arizona and Georgia are the two states in which Democrats won Senate seats in 2022 but are expected to flip to the Republican side. Arizona and Pennsylvania remain toss-up states (odds of Democratic victory range from 45%-55%) but are inching downward toward likely Republican victories. Chart 5GOP Tipped To Take The Senate (Quant Election Model, April 2022) Democrats shed probability in all states once again. Odds fell the most in Arizona (-1.08 percentage point since the last update in early April) followed by North Carolina (-1.03ppt) and Pennsylvania (-0.98ppt). In seven states the Democratic odds of victory fell by more than 0.5ppts, including Arizona and Nevada (Chart 6). Overall the probability for Democrats retaining control of the Senate now stands at 48.2% (down 0.2ppt). These odds are higher than consensus even though they agree with the consensus on expecting Republican victory. Online betting markets like PredictIt are pricing in Republican control at around 79%, up 3ppt from our last update. This is overstated and the new controversy over the Supreme Court and abortion will fire up Democratic voters, making the Senate race closer to what our model suggests. Chart 6Democrats Falter Across Senate Races: AZ, PA, NC Looking ahead to 2024, our presidential election model still predicts 308 Electoral College votes for the Democratic Party, a number that has not changed since the 2020 election (Chart 7). Democrats have a 54.6% chance overall of retaining the White House. Chart 7Biden Still Tipped For 2024 (Quant Election Model, April 2022) The trend is negative for the incumbent party. North Carolina slipped out of the toss-up category and into Republican category – i.e. Democrats now have only a 44% chance of winning it. Democrats’ odds of winning Florida moved lower – it is now in toss-up territory at 54%, which comes closer to our subjective judgment that Republicans are favored there. The toss-up states have remained well anchored in the range of 40%-60% since 2020 and will play a pivotal role in future predictions. Generally the trend is for falling odds that Democrats will win these states (PA, FL, NC, AZ, and GA). Both Pennsylvania and Florida account for a combined 49 electoral votes and Florida is probably more Republican-leaning than the model says. If the three critical Rust Belt states (Pennsylvania, Wisconsin, Michigan) slip into toss-up territory then the model will be flagging serious trouble for Democrats. But a lot can happen between now and 2024. In the latest update Democrats are shedding probability of winning in all states, although to a lesser degree than the past two updates. Economic data, while still negative for the incumbent party, may be deteriorating less rapidly. Biden’s approval rating improved marginally since our last update and we expect it to stabilize, albeit at a low level. Michigan recorded the largest decline in Democratic odds of victory (-1.07ppt) followed by Minnesota (-0.79ppt) and New Hampshire (-0.78ppt). Democrats shed more than 0.5ppts from their odds of victory in twelve states, nine of which they won in 2022 (Chart 8). Chart 8Democrats Shedding Odds Of Winning States In 2024 Bottom Line: Republicans are favored to take the Senate (as well as the House) in 2022. Democrats are slightly favored to retain the White House in 2024, though the model is optimistic by granting Florida to the Democrats and the election odds look to be razor-thin yet again. Investment Takeaways As we go to press, the unusual leak of a draft opinion of Supreme Court Justice Samuel Alito has roiled US politics. The draft argues that the landmark court case of Roe Versus Wade should be overturned. This incident reflects our “Peak Polarization” theme – that polarization will remain very disruptive in the short term yet subside over the long term. It also suggests an activist effort to escalate the culture wars ahead of the midterm election, which we have argued would be the case and implies that more unrest will follow from this event. Whether the Supreme Court overturns the landmark Roe versus Wade ruling of 1973, the battle for women voters will help sustain election-year policy uncertainty, as women’s approval for Democrats will start to recover  (Chart 9). Investor sentiment will remain bearish in the very near term. A series of hurdles need to be cleared before we close our tactical long DXY trade and defensive sector tilt. We are closing our long municipal bond relative to Treasury trade for a loss of 1.5% (Chart 10). Chart 9Women Are Key Constituencies In The Midterm Chart 10Municipal Trade Fizzled Out Despite Strong Local Government Finance The overall analysis of US politics is neutral or bullish for US Treasuries while neutral or bearish for US stocks over a tactical time horizon (zero-to-six months). If recession is avoided at the critical juncture this year, then 2023 will see a rising stock market as the economy expands and political risks fall.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     Peter Weber, “Defense Secretary Lloyd Austin says U.S. believes Ukraine can win, wants to 'see Russia weakened,'” The Week, April 25, 2022, theweek.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets  

Executive Summary The Economy Will Enter A Slowdown Colombian stock prices and the peso rallied earlier this year, but the rebound is over. Hawkish monetary and tight fiscal policies will slow down domestic demand considerably. Despite high oil prices, the current account deficit will remain wide. This will weigh on the peso. Political risks will rise ahead of the presidential elections which will prove to be a very tight race. Odds of far-left candidate Gustavo Petro winning are not low. His victory would present institutional risks to Colombia’s market-friendly economic model.         Recommendation Inception Date Return A New Trade: Receive 10-Year / Pay 6-Month Swap Rates 2022-05-04    Bottom Line: Colombian financial markets will be buffeted by ongoing monetary tightening, an impending growth slowdown and rising political volatility. Remain underweight Colombian stocks within an EM equity portfolio and continue shorting the currency versus the US dollar. Maintain a neutral allocation to Colombia in both EM domestic bond and sovereign credit portfolios. We are also initiating a new trade: Bet on substantial yield curve inversion. Feature Chart 1Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices This year’s rally in Colombian stocks and the peso has largely been the result of strong domestic demand and a catch up to sky-high oil prices (Chart 1). In the past month, however, alongside other commodity producers such as Brazil and Chile, Colombian risk assets have been buffeted. This is because the outlook for commodity prices has become more uncertain with an ongoing slowdown in the Chinese economy and an impending slump in DM domestic demand for goods. Going forward, Colombian markets will trade on oil price fluctuation, the local business cycle and the presidential elections. The global commodity trade appears to be struggling at present. The business cycle outlook is negative as hawkish monetary and fiscal policies will slow down growth decisively. The political risks have not yet materialized but they could pose a serious menace to financial markets as frontrunner Gustavo Petro presents institutional risks with his plans to upend Colombia’s market-friendly economic model. All in all, we recommend that investors maintain an underweight stance on Colombian stocks and a short position in the currency, while keeping a neutral allocation to domestic bonds and sovereign credit within their respective EM portfolios. We also recommend betting on yield curve inversion by receiving 10-year and paying 6-month swap rates. Cyclical Forces: Growth Slowdown The Colombian economy is overheating: core measures of inflation are reaching their highest point in two decades (Chart 2). Particularly, hairdresser inflation – which we view as a signpost of genuine inflation given that costs are mainly labor and rent – is high and accelerating (Chart 2, bottom panel). Further, nominal wages are rising at 11% in annual terms, the unemployment rate has fallen almost to pre-pandemic levels, and business inflation expectations remain above the central bank’s (Banrep) target of 3% +/- 1% (Chart 3). These are signs that inflation is genuine and broad based in Colombia. Hence, monetary tightening will continue. Chart 2Colombia: Inflation Is Reaching Historic Highs! Chart 3Inflationary Pressures Are Genuine And Broad Just last week, the central bank raised the policy rate by 100 basis points to 6%, while three of the seven board members voted for a larger increase of 150 basis points. Rapidly raising the policy rate from a historical low of 1.75% comes at a cost, however, and it will result in a notable growth slowdown. The top panel of Chart 4 shows that banking credit has been strong but is set to roll over as Banrep raises interest rates significantly. Our marginal propensity to consume proxy and the narrow money impulse are also foreshadowing a growth slowdown in domestic demand (Chart 4, bottom two panels) Regarding fiscal policy, the fiscal thrust is going to be negative this year (Chart 5). Chart 4The Economy Will Enter A Slowdown... Chart 5... And Fiscal Stimulus Will Not Save The Boat   A combination of tight fiscal and monetary policies also presents a notable risk to the credit cycle and to banking profitability. Banks’ EPS in local currency terms has reached a historic high, and their share of non-performing loans (NPLs) and provisions has fallen drastically in the past months. As interest rates rise further and the economy slows down, financial stocks – which make up 47% and 54% of the nation’s COLCAP stock index or the MSCI index, respectively – will experience a soft spot. Banks will have to lift their NPL provisions on the back of rising lending rates and a slowdown in growth (Chart 6, top panel). Any time NPL provisions rise (shown inverted in the top and bottom panels of Chart 6), bank share prices drop. As a result, banks will tighten credit standards and reduce loan origination. This will be a hurdle to both economic growth and banks’ profitability. Chart 6Banks' Share Prices And NPLs Bottom Line: The Colombian economy is facing strong domestic headwinds, which will result in a growth slowdown. The Current Account Deficit: Colombia’s Achilles’ Heel Despite very high oil prices and the rally in commodity plays around the world early this year, the Colombian peso has appreciated only mildly and has given up most of its gains in the past month (Chart 1 above, bottom panel). Odds are the currency will weaken further in the near term (next 3 months), so we are reiterating our recommendation to stay short the peso versus the US dollar: First, it is not certain whether commodity prices will rise significantly in the coming months. While commodity supply constraints remain acute, global demand is deteriorating. In a nutshell, high crude prices are causing oil demand destruction. We elaborated on the outlook for Chinese overall growth and DM domestic demand for goods in our April 21 Strategy Report. This analysis is more pertinent for industrial commodities, less so for oil and has little relevance for agricultural commodities. Second, the chronic massive current account deficit will continue exerting downward pressure on the exchange rate. The current account deficit remains large at $18 billion or 6.2% of GDP as of Q4 2021. Further, even if we assume oil prices will average US $120 per barrel in 2022, the current account deficit will be large in 2022 (Chart 7, top and middle panels). Excluding oil, the current account deficit is also wide. Third, FDI inflows have been meager both in the oil sector and the rest of the economy (Chart 7, bottom panel). There is little chance that FDI will be strong in the coming months given election uncertainty. The front-runner in this year’s presidential elections, Gustavo Petro, has a hardline stance against oil exploration, which would disincentivize foreign investment in the sector. In general, his left-wing policies are not conducive for overall FDI inflows. We elaborate on this topic below. Finally, foreign portfolio flows into local bonds have been a large source of funding for the current account deficit. With the currency depreciating and elevated political risks, net portfolio inflows into domestic bonds could dry up in the near term (Chart 8). Chart 7The Current Account Will Remain In Deficit Despite High Oil Prices Chart 8Colombian Local Bonds Will Underperform Bottom Line: The current account deficit remains wide. Even a marginal decline in foreign net portfolio inflows will lead to currency depreciation. In turn, given the tight correlation between the exchange rate and headline inflation, the central bank will respond by raising interest rates more to curb inflation. Political Risks: Will Colombia Elect A Left-Wing Government? Since June of last year, we have been arguing that Colombian politics would take a left-ward shift given the massive demonstrations demanding higher government expenditures on social programs. In that report, we also flagged the growing popularity of veteran left-wing candidate Gustavo Petro. Presently, Colombia has never been closer to electing a far-left president. Going forward, we expect Colombian markets will trade on two factors: (1) the possibility of Petro winning the election, and (2) his potential to undermine Colombian institutions if he is elected president. Both will insert volatility in Colombian markets from today till the outcome of the second round is known on June 19. First, we believe the contest between the far-left Gustavo Petro and the conservative Federico “Fico” Gutiérrez will be a very close race. While Petro is set to dominate the first round on May 29 (Chart 9), Fico has had a meteoric rise in popularity since last year, which suggests he can possibly bridge the remaining 7% gap between the contenders before the second round on June 19 (Chart 10). Chart 9Petro Will Dominate In The First Round… Chart 10… But The Race Will Be Tight In The Second Round The result of the election largely depends on both candidates’ ability to attract moderate voters, which Fico has been more successful in doing. While Petro has doubled down on his left-wing base by choosing progressive environmentalist Francia Márquez as his running mate, Fico has made conscious steps to separate himself from rightwing leaders (particularly ex-president Álvaro Uribe), in line with the leftward shift in Colombian voters. He has done this by campaigning on a more centrist platform, which includes increasing government spending on infrastructure, pensions, primary education and housing. Further, he has secured the support of the centrist Liberal party, which has a large voter base and holds 17% of seats in congress. So far, we believe the election will be largely a toss-up between Petro and Fico. Second, if Petro does manage to win, investors have reasons to worry. Among his policy proposals, some of the most alarming to the business and financial communities include bypassing congress and legislating freely for the first 30 days, forcing private landowners to dedicate land for agriculture, stripping the central bank’s independence and partly nationalizing funds of private pensions. Further, Petro has promised to outright ban new oil explorations due to environmental concerns, which would largely deter domestic and foreign investment into the sector. This would severely reduce dollar inflows and hurt productivity and oil production in the long run, thereby negating the short-term positive effects of high oil prices.   On the other hand, we doubt Petro will be able to fully implement his left-wing agenda. Congress is fragmented between left, right and centrist parties, but the right and center right faction still holds a majority of 51%. Petro will therefore have to negotiate and water down his most radical proposals. Nevertheless, he can still enact presidential decrees, and his intentions to bypass congress to legislate freely for 30 days and his plan to revoke the central bank’s independence are worrying signs for Colombia’s institutions. All in all, the tight race in the second round and the possibility of Petro winning present large risks that we believe financial markets have not fully priced in. Now that domestic demand is set to decelerate and the outlook for oil prices has become muddled, investors will shift their focus to the presidential race. Petro remains the favorite candidate albeit his lead over Fico has narrowed substantially. While Petro may not be able to fully implement his government plan, Colombian risk assets will trade on the loss of business and investor confidence and institutional risks if he wins the election. Further, while conservative candidate Fico’s rise in the polls has been impressive and could get more votes in the final round as other right-wing and centrist candidates drop out of the race after May 29, his victory in the second round is not assured. Expect more political and financial volatility until then. Investment Recommendations We have the following investment recommendations: Equities: maintain an underweight stance within an EM-equity portfolio. A combination of slowing growth, rising interest rates and political risks will be negative for share prices. We will consider upgrading this bourse to neutral when election risks are priced in and if the right-wing candidate Fico secures the presidential victory. Currency: keep shorting the Colombian peso versus the US dollar. Domestic Bonds: maintain a neutral allocation relative to the respective EM benchmark. Local yields offer value (the 10-year bond yield stands at 10.5%), and the macro policy mix remains fairly orthodox. Nevertheless, given that foreign investors hold 25% of the local bond market, the risk of Petro’s victory would entail large outflows from this asset class. We are initiating a yield curve flattening trade: Receive 10-year and pay 6-month swap rates (Chart 11). As Banrep hikes rates and the economy slows down, chances are high that the yield curve will invert considerably. Sovereign Credit: maintain a neutral allocation within an EM-dedicated credit portfolio. Colombia’s sovereign spreads offer a lot of value: credit spreads are above mainstream Latin American countries (Chart 12). However, the possible election of Petro presents a risk to this asset class. Chart 11Colombia: Prepare For A Yield Curve Inversion Chart 12Colombian Sovereign Credit Is Cheap!   Juan Egaña Associate Editor juane@bcaresearch.com

Executive Summary Indonesia’s Balance Of Payments Will Be Under Pressure Indonesian domestic demand is struggling in the face of tight policy settings. High real borrowing costs are constraining credit growth, and hurting non-financial sectors. Monetary authorities have shown little intention to reduce borrowing costs by any good measure, and remain focussed on exchange rate stability. This is a major policy dilemma that the authorities need to break free from before this bourse can embark on a sustainable bull market. Indonesia’s only bright spot since the pandemic, its external accounts, will be deteriorating. Capital inflows will dwindle at a time when the current account balance is set to slip back into deficit. This will put downward pressure on the rupiah, which in turn raises the risk of policy error as the central bank might be tempted to raise rates in a bid to stabilize the currency. Doing so would hurt economic growth and stock prices.  Bottom Line: Currency investors should stay short the rupiah versus the US dollar. Equity investors should wait for relative weaknesses before considering an upgrade in EM and Emerging Asian portfolios. Investors should stay underweight Indonesia in EM local currency bond portfolios. Sovereign EM credit investors, however, should continue to overweight Indonesia. Feature In the past few months, Indonesian stocks have rallied to a pandemic-era high. They have outperformed their emerging market peers as well, albeit from a very low level (Chart 1). Could this mean that Indonesia’s decade-long underperformance is finally coming to an end? We are not convinced. The nation’s equity index in US dollar terms will find it hard to advance to new highs anytime soon. Absolute return investors, therefore, should not chase this bourse up. In terms of relative performance, odds are that some of the recent gains might be lost. The recent outperformance had more to do with investors fleeing Chinese stocks and Indonesia has been one of the major beneficiaries of this rotation (Chart 2). Meanwhile, Indonesia’s policy setting remains quite restrictive. Its external tailwinds are receding as well, which is making the rupiah vulnerable. Chart 1Indonesian Stocks Are Still Not Geared For A Sustainable Bull Market Chart 2Much of The Indonesian Outperformance Had To Do With Investors Leaving China That said, given Indonesia’s drawn-out equity underperformance since early 2013, this bourse’s relative bear market versus the EM benchmark is late. As such, following near-term weaknesses, asset allocators should consider upgrading this bourse from underweight to neutral in EM and Emerging Asian baskets. Domestic bond investors should stay underweight Indonesian local currency bonds in EM and Emerging Asian portfolios. Sovereign credit investors, however, should remain overweight Indonesia. Persistent Domestic Headwinds The recovery in Indonesian domestic demand has been quite slow over the past two years. The top panel of Chart 3 shows that the economy is still struggling. Two years into the pandemic, consumer confidence and retail sales volume are well below pre-pandemic levels. One reason for the muted consumer sentiment is meagre growth in household income. Nominal wage growth has stalled, sapping consumer demand. Wage growth in real terms (deflated by headline CPI) is shrinking outright (Chart 3, bottom panel). Weakness is palpable on the supply side as well. The capacity utilization rate for both manufacturing and other industries remains well below pre-pandemic levels (Chart 4, top two panels), despite the fact that Indonesia’s manufacturing exports have been very strong over the past year (details to come). This underscores the extent of the weakness in domestic demand. Chart 3Consumer Confidence Is Low As Household Income Is Moribund Chart 4Low Capacity Utilization And Labor Usage Points To Poor Domestic Demand Chart 5Fiscal Support Is In Short Supply In line with low capacity utilization, labor usage has also been consistently below par since the onset of the pandemic (Chart 4, bottom panel). That means hiring has been restrained and workers have had little bargaining power, which explains why nominal wage growth has halted. The restrictive macro policy is also exerting a considerable drag on economic recovery. Indonesia’s fiscal stance is rather tight. The government is planning to rein in the fiscal deficit this year to 4.3% of GDP from a revised 4.7% deficit last year. As such, the IMF estimates that the cyclically adjusted fiscal thrust will be a negative 0.9% of potential GDP this year, and a further negative 0.6% next year (Chart 5).  Monetary policy, as we have repeatedly asserted, has remained extremely restrictive for the past six to seven years. Interest rates are prohibitively high.Banks’ lending rates, for instance, have consistently stayed above nominal GDP growth rate since 2012. That will likely be the case going forward as well given the muted growth outlook. If one looks at real bank lending rates (deflated by core CPI) vis-à-vis real GDP, the picture looks even more grim (Chart 6). Such high borrowing costs, which continued for a decade, have been a major headwind for the country’s non-financial sectors. Stock prices of non-financial firms as well as those of SMEs – which had to endure chronically high financing costs − have been in a decade-long bear market in absolute terms. By contrast, banks benefited from the high lending rates, and their share prices have rallied to their pre-pandemic highs (Chart 7). Chart 6Borrowing Costs Have Been Persistently High Relative To The Economy's Growth Rate... Chart 7...Hurting Stocks Of Non-Financial Firms And SMEs, While Benefitting Banks Chart 8Exorbitant Borrowing Costs Have Led To A Stagnation In Credit Penetration Very high real interest rates is one reason Indonesia’s credit penetration, at 34% of GDP, is unusually low for an economy at this stage of development. The ratio has not risen at all in the past 10 years. In fact, it has headed lower recently (Chart 8). This is not a sign of a healthy, recovering economy. As such, for Indonesian stocks to have a sustainable bull market, one of the macro imperatives is that the real borrowing cost needs to decline considerably. Yet, Indonesian monetary authorities have shown little intention to reduce real rates by any meaningful measure. The main reasons behind this hawkish stance on the part of the central bank has had to do with (i) the country’s persistent current account deficit over the past decade, and (ii) the central bank’s mandate of exchange rate stability. Indonesia needed to offer consistently high real rates to attract enough foreign capital so that it can finance its current account deficits, and thereby have a stable rupiah. Yet, that policy has created distortions elsewhere. Persistently high real rates have led to a steady drop in non-financial firms’ return on equity. That, in turn, discouraged foreign equity inflows but encouraged international fixed-income inflows into Indonesia. This is not surprising as equity investors dislike high real rates, while debt investors prefer it. The reliance on foreign debt inflows, in turn, incentivized the authorities to keep real interest rates persistently high − even in periods when growth was rather timid and inflation undershot the central bank’s target. This is a major distortion that the Indonesian economy needs to break free from before this bourse can embark on a sustainable bull market. Incidentally, a bill to expand the central bank’s mandate to include growth and employment was introduced to parliament last year. If passed, the bill-turned-law would allow Bank Indonesia to set interest rates more in line with domestic economic conditions, rather than just focussing on currency stability. Chart 9Inflation Is Inching Up From Very Low Levels Discussions on the bill, however, have been delayed in  Parliament, and it is not clear when, or if, it will be passed. Meanwhile, Bank Indonesia has begun to tighten policy on the margin by draining excess liquidity from the system. More worryingly, the central bank could begin to raise rates in the next couple of months as it fears inflation will creep up due to rising global commodity prices (Chart 9). Outflows from the bond market might also encourage the central bank to raise rates in an attempt to stem them (details in the next section).   Receding External Tailwinds In contrast to Indonesia’s lack of domestic recovery, the country’s external sector was the star performer over the past year or two. Yet, in the next few quarters, it’s the external sector that will likely be a threat to the nation’s growth. This is because Indonesia’s exports are set to shrink and its balance of payments is set to deteriorate. These factors could threaten the rupiah stability, which would then force the central bank to raise rates / tighten liquidity prematurely in a bid to support the rupiah. Tighter policy would be a major headwind for growth, and would hobble stock prices.  Indonesian exports grew remarkably over the past two years, which helped to push the country’s current account balance into surplus for the first time in a decade (Chart 10, top panel). A closer look, however, will reveal that much of it had to do with surging exports to China – which doubled to $55 billion in two years (Chart 11). Chart 10Indonesia's Balance Of Payments Will Be Under Pressure Chart 11Improvements In The Current Account Were Mostly Due to A Surge In Exports To China           That said, much of the improvements in the current account could unravel going forward: Some of the export windfalls accrued to Indonesia when China banned Australian coal imports in 2020 and switched to Indonesian coal instead.   But more recently, a decelerating economy in China has led to slowing electricity generation. The latter has always had a direct bearing on Indonesian coal exports volume – which is now shrinking (Chart 12, top panel). China’s electricity demand and production will slump further due to COVID lockdowns of enterprises and pending weakness in its exports. Chart 12Export Windfalls Are Ending As Chinese Growth Wanes Chinese thermal coal prices have been falling in recent months from the sky-high levels of late 2021, and could fall further by the end of the year as China keeps increasing its own coal output and its electricity generation drops (Chart 12, bottom panel). All these will weigh on Indonesian export earnings in the months to come. For its part, the Indonesian government has restricted coal exports by mandating that miners set aside 25% of their output for local sales as part of their “domestic market obligation.” The government has also banned shipments of some palm oil ingredients for an indefinite period – in an apparent attempt to check domestic food price inflation. Palm oil is the second largest Indonesian export after coal, and together they make up 22% of total export revenues. Indonesia is a large net crude and refined petroleum importer. Global crude prices will likely stay elevated due to sanctions on Russia. This will be a negative for the country’s trade balance. Chart 13Dwindling Goods Demand In The Developed World Will Hurt Indonesian Manufacturing Exports Moving beyond commodities, Indonesian manufacturing exports − which are as large as its’ commodities exports in US dollar terms − will also likely get hurt. A crucial reason for that is a slowing China. Chinese manufacturing imports are set to weaken in the next several months as that economy is entering a soft patch. That usually is an adverse development for Indonesian exports to China (Chart 13, top panel). In fact, Indonesia’s overall manufacturing exports will also likely slow. Falling household goods demand in developed countries will curtail manufacturing exports from Asia, including Indonesia. Notably, early signs of an impending slowdown in Indonesian manufacturing exports often appear in Chinese data − given the heft of the Chinese economy and its trade links in Asia and beyond (Chart 13, bottom panel). More generally, global trade will likely slow going forward, which is a negative for those economies that have relied on an export windfall over the past couple of years. Essentially, the days of boyant current account balances are numbered for Indonesia.  A slipping current account balance could spell larger problems for Indonesia as the country’s financial account surplus has been steadily eroding. From a high of $37 billion annually in 2019, it dropped to just $12 billion by the end of 2021. Much of that drop is due to a fall in net debt inflows – the type of capital inflows Indonesia strives to attract by keeping real interest rates very high (Chart 10, middle panel). Chart 14Falling Real Bond Yields In Indonesia Will Keep Foreign Debt Investors At Bay Critically, the country has not been able to attract much FDI either despite passing an Omnibus Law to boost new investments and create jobs a couple of years back (Chart 10, bottom panel). Chart 14 shows that foreign investor holdings of Indonesian government debt has shrunk materially from almost $80 billion in early 2020 to less than $60 billion now. In terms of their share in total bonds outstanding, the drop is even more remarkable: from 40% of the total to just 18%. Foreign bond purchases clearly react to the ebbs and flows of Indonesian real yields on offer (Chart 14, bottom panel). Given that Indonesian inflation will likely go up from the current very low levels − putting a downward pressure on the real yields available – foreign investors could continue to shun Indonesian bonds. Indonesian policymakers might also worry as such. That apprehension could prompt Bank Indonesia to raise rates preemptively in a bid to attract debt inflows and stabilize the currency. If so, higher real rates would add to the existing policy headwinds for the domestic economy. Growth will suffer; and markets will sell off.  Investment Conclusions The Currency: The rupiah remains vulnerable as the Indonesian balance of payments is set to deteriorate. A slipping current account balance amid receding capital inflows will be putting downward pressures on the rupiah. Stay short the rupiah versus the US dollar. Domestic Bonds: Indonesian bond yields have fallen massively relative to their EM counterparts, and are at 10-year lows in relative terms. As such, the nation’s local currency bonds have little more room to benefit from relative yield compression. The rupiah is also vulnerable. We went underweight Indonesian domestic bonds in November last year, and that recommendation remains in place (Chart 15). Sovereign Credit: Absolute return investors should reduce their exposure as the rupiah weaknesses going forward could lead to widening credit spreads, and result in negative total returns in US dollar terms (Chart 16). Chart 15Stay Underweight Indonesian Domestic Bonds In An EM Bond Portfolio Chart 16Absolute Return Investors Should Reduce Exposure To Indonesian Sovereign Credit   Asset allocators, however, should stay overweight Indonesia in an EM credit basket. This market has transitioned itself into a defensive one over the past several years – thanks to years of orthodox fiscal and monetary policies and low debt. Hence, given that a period of risk-off is around the corner – during which Indonesian credit tends to outperform as it did in 2015 and 2020 − it makes sense to stay overweight this market. Stocks: Absolute return investors should not chase this bourse up. Asset allocators should wait for relative weaknesses before considering an upgrade from underweight to neutral in EM and Emerging Asian portfolios.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary China's Demand Was Very Weak before Lockdowns The selloff in risk assets is not over. Stay defensive. Stagflation fears will continue gripping financial markets. Global trade volumes are set to contract, but the Fed has little maneuvering room as US core inflation is well above its target. Commodity prices are at an important juncture. The plunge in Chinese material stock prices is a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. The rally in EM commodity plays like Latin America and South Africa is at risk of a major reversal. Bottom Line: Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will be considerable, and the greenback will likely overshoot. A buying opportunity in EM local currency bonds will present itself after EM currencies hit a bottom versus the US dollar. Feature Global and EM risk assets will remain under selling pressure. This Charts That Matter report contains charts that will help investors navigate treacherous financial markets by shedding light on the following key issues: How much more downside in stocks? Chart 1 displays EM share prices in USD terms alongside their long-term moving averages. If EM equities break below the current technical support line, the next one implies that there is 20-25% further downside in EM stocks. For the S&P500, the next technical support is at 3650-3750. Our Equity Capitulation Indicators for both the S&P500 and EM stocks remain above their previous (2010-2020) lows (Charts 5 and 6 below). In addition, equity market breadth is deteriorating. Fundamental problems with financial markets are linked to mounting stagflation fears. Global trade volumes are set to contract in H2 due to a decline in US and European household spending on goods ex-autos and a delayed recovery in China as we discussed in last week’s report. In turn, US wage growth is accelerating, which will push up unit labor costs. US core inflation will likely drop due to base effects, but will remain above 3.5-4%, which far exceeds the Fed’s 2-2.25% target. Chart 1EM Share Prices: Their Long-Term Moving Averages Served As A Support In Bear Markets Chart 2 illustrates that stagflation fears have already gripped financial markets. Global defensive equity sectors have recently been outperforming global non-TMT stocks despite rising US and global bond yields (Chart 2). This is a major departure from the historical relationship between the two and likely foreshadows a period of continuous Fed tightening despite slower global growth. Global equity managers should favor defensive stocks as they will continue to outperform under the two most likely scenarios: (1) either these stagflation dynamics continue; or (2) a growth scare will dominate, during which US bond yields could drop. Chart 2Does This Divergence From A Historic Correlation Signify Stagflation? The US dollar continues to climb, and its strength has recently become very broad-based – extending to commodity currencies and Asian currencies. As we show in Charts 46-48 below, the US dollar has more upside.   Commodity prices are at an important juncture. On the one hand, supply shortages and risks to further supply disruptions could continue to support resource prices. On the other hand, demand will disappoint. Shrinking US and European consumer spending on goods ex-autos, contracting Chinese commodity intake and weakness in EM ex-China demand all suggest that global commodity consumption will decline in the months ahead. In our March 10 report, we noted that commodity prices would be volatile and this view has been validated: commodity prices swings have been extreme over the past two months. More recent evidence points to lower resource prices. Chart 3 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed them to two standard deviations above their time-trend. Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 3 does not include energy, gold and semi-precious metals (the footnote of Chart 3 lists commodities included in this aggregate). Chart 3Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Finally, Chart 4 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. Chart 4Chinese Material Stocks Are Signaling Trouble For Global Materials Investment Recommendations Stay defensive. Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will likely be considerable, i.e., the greenback will likely overshoot. The CNY has broken down versus the US dollar and our target is 6.70-6.75 for now. A depreciating yuan is bearish for Asian and EM currencies. We continue to recommend short positions in the following EM currencies versus the US dollar: ZAR, COP, PEN, HUF, IDR, PHP and PLN. A buying opportunity in EM local currency bonds will present itself when EM currencies hit a bottom versus the US dollar.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   US And EM Equity Capitulation Indicators These indicators have not reached their lows of 2010, 2011, 2018 and 2020. The magnitude of the S&P500 selloffs in 2011 and 2018, were 19.5% and 19.8%, respectively. Hence, our best guess for the size of a S&P500 drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3800-3850. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 5, top panel).  Chart 5 Chart 6 Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Odds are that US share prices will drop further. US equity valuations are still expensive, geopolitical risks are elevated, and inflation and inflation expectations are extremely high, which will limit the Fed’s maneuvering room. Chart 7 Chart 8 Components Of Our EM Equity Capitulation Indicator Similarly, the components of our EM Equity Capitulation Indicator have not reached their previous lows. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above prior troughs. Further downside in EM share prices is likely.  Chart 9 Chart 10 S&P500 Overlays With Previous Geopolitical Crises The most recent examples of geopolitical shocks include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War and the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. Today, the S&P 500 is down only 12.8% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer.  Chart 11 Chart 12 Chart 13 Table 1 Various EM Equity Indexes: Deteriorating Breadth Various EM equity indexes have been in a bear market. The deterioration has been broadening as recent leaders such as commodity producers and Taiwanese stocks have been gapping down. Yet, not all bourses are very oversold. We published a Special Report on semiconductors on April 14 arguing that semi stocks face more downside. Share prices of commodity producers have recently corrected, and, as we argue above, odds of a further drop are non-trivial. What are the odds that the overall EM equity index undershoots? See the next section.  Chart 14 Chart 15 Chart 16 Chart 17 EM Undershoot Is Likely Sentiment towards EM equities has fallen significantly, but it is not yet at previous lows. Similarly, there is still room for EM net EPS revisions by bottom-up analysts to fall further. Finally, platinum prices point to more downside in EM non-TMT share prices.  Chart 18 Chart 19 Chart 20 EM Bond Yields And Share Prices Historically, rising EM corporate USD bond yields and EM local currency bond yields led to a selloff in EM share prices. Unless EM USD and local currency bond yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 21 Chart 22 Rising US Corporate Bond Yields Are Bearish For US Stocks Rising US corporate borrowing costs point to lower US share prices. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Furthermore, bearish US equity market technicals are presently reinforcing this downbeat outlook for US stocks.  Chart 23 Chart 24 Chart 25 The S&P500 EPS Can Contract Outside Of A Recession Let’s recall what happened in 2000-2001 in the US. Real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming. Yet, the S&P 500 operating EPS plunged by 30% and the stock index was down by 50%. In 1966, even though real and nominal GDP did not contract, the S&P500 operating EPS shrank by about 5% and share prices fell by 22%. This episode is the best analogy for US economic and financial market dynamics over the near term.  Chart 26 Chart 27 US Stagflation Scare US wage growth is accelerating, and unit labor costs are surging. The latter will make inflation sticky and hurt corporate profit margins. Besides, US consumer demand for goods ex-autos will shrink following a two-year period of overspending. This combination will produce a stagflation scare – a period when corporate profits are weak, but the Fed has little maneuvering room as core inflation is well above its target.  Chart 28 Chart 29 Chart 30 Chart 31 Global Trade Volumes Will Shrink Taiwanese shipments to China – which lead global exports – have started to contract. Korea’s business survey of exporting companies reveals that business conditions deteriorated substantially in April. Global cyclicals have been underperforming global defensives. Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives. This also points to a slowdown in US growth. Chart 32 Chart 33 Chart 34 Chart 35 China’s Economy Requires Much More Aggressive Stimulus In China, monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus has mainly been for infrastructure spending, and it does not include direct fiscal transfers to households who are losing income due to the lockdown. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has barely bottomed.  Chart 36 Chart 37 Chart 38 Chart 39 China Has Been A Drag On Global Trade Chinese domestic demand was extremely weak even prior to the recent lockdowns in Shanghai. Chinese import volumes of various commodities, machinery, industrials goods and semiconductors were contracting as of March. Lockdowns and associated income/profit losses will further depress domestic demand. Chart 40 Chart 41 Chinese Property Woes Are Worsening Housing floor space sold in April is down by 50% from a year ago. Households are reluctant to borrow and buy, and property developers’ financing has dried up. All these point to shrinking construction activity. Chart 42 Chart 43 Chart 44 Chart 45 The US Dollar Has More Upside Our view on the greenback has played out well, and more upside is likely. The CNY has broken down against the dollar and it will reach at least 6.70-6.75. One exception to a strong US dollar might be the yen, as the trade-weighted yen has fallen to its previous lows. However, a rebound in the yen from current levels requires  a stabilization of US bond yields.  Chart 46 Chart 47 Chart 48 Chart 49 EM Currencies: Do Not Catch A Falling Knife EM currencies remain at risk. They are not cheap, and the recent rebound has faltered with many EM exchange rates unable to break above their technical resistance vis-à-vis the USD. However, we expect the US dollar to top and EM currencies to bottom later this year. Stay tuned.  Chart 50 Chart 51 EM Credit Markets: More Spread Widening Ahead EM and US credit spreads are not particularly wide and will likely widen further. China’s corporate USD bonds remain in a bear market. The two key drivers of EM credit spreads are the business cycle and exchange rates. EM growth will continue to disappoint, and EM currencies will relapse versus the US dollar. Hence, investors should be patient before buying/overweighting EM credit.  Chart 52 Chart 53 Chart 54 Chart 55 EM Domestic Bonds: A Buying Opportunity Down The Road The EM GBI domestic bonds total return index in USD terms has broken down and near-term weakness is likely. Meanwhile, EM local currency bond yields have risen significantly, and they offer good value. That said, a buying opportunity in local currency bonds will transpire only after their currencies bottom. Chart 56 Chart 57 Footnotes    

Special Report

Highlights All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. Feature In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.1 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.2 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1     Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Highlights Several factors point to both an improvement and a deterioration in economic and financial market conditions, underscoring that the 6- to 12-month investment outlook is unavoidably uncertain. On the one hand, the US will likely avoid a recession over the coming year, slowing headline inflation will boost real wages and lower the equity risk premium, bond yields will not move much higher this year, and US services spending will support consumption as the pandemic continues to recede in importance. These are positive factors that will work to support economic activity and risky asset prices. On the other hand, the US will likely experience a recession scare focused on the housing market, the European economy may contract, Omicron’s spread in China threatens a further rise in shipping costs and a trade shock for Europe, and US inflation expectations may unanchor despite a falling inflation rate. For now, investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional stance. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. The US dollar is likely to strengthen over the near term, but we expect it to be lower a year from today. The Scourge Of Harry Truman US President Truman famously lamented the need for “one-handed” economists. His complaint reflected how essential it is for economic policymakers to receive clear advice about the best path forward. Investors understandably have even less tolerance for ambiguity than Truman did about the macro landscape and the attendant investment implications. However, there are times when the economic and financial market outlook is unavoidably uncertain. The current economic and geopolitical environment easily qualifies as one of those instances. Several factors point to both an improvement and a deterioration in economic and financial market conditions, which we review in detail below. The likely avoidance of a recession in the US over the coming year suggests that investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. What Could Go Right The US Will Likely Avoid A Recession Over The Coming Year Chart I-1The Odds Of A US Recession Are Currently Low We downgraded our odds of an above-trend 2022 growth scenario in last month’s report,1 but noted that a stagflation-lite environment of below-trend growth and above-target inflation was a more likely outcome than recession. We based this assessment on our view that the US neutral rate of interest is likely higher than the Fed and investors expect, which we discussed at length in past reports.2 Chart I-1 highlights that our recession probability indicator also supports this view, as it does not yet signal that a recession is on the horizon.3 Table I-1 highlights the components of the model (which is significantly influenced by the Conference Board’s LEI), and shows that the model is not providing a meaningful warning signal. The Fed funds rate component of the model will likely flash red next month following the FOMC meeting, and we have listed it as providing a warning signal in Table I-1. But rising rates themselves have not proven to be a particularly timely indicator of a recession; this is similarly true with rising inflation expectations and oil prices. We noted in last month’s report that a surge in oil prices has not been an especially consistent indicator of a recession since 2000. Table I-1The Components Of Our Recession Model Are Not Yet Flashing A Warning Sign The yield curve component of the model is based on the spread between the 10-year Treasury yield and the 3-month T-bill yield in order to minimize false recession signals, and we agree that the 10-year / 2-year spread has better leading properties. But even the latter curve measure has recently moved back into positive territory (Chart I-2), which will certainly qualify as a false yield curve signal if a recession is avoided over the coming 18 months. Within the components of the Conference Board’s LEI, Table I-1 highlights that there have been signs of weakness from the manufacturing sector, consumer expectations, and the credit market. Chart I-3 aggregates the deviation of six of these components from their trend, and shows that they have indeed been consistent with a significant slowdown in economic activity. Chart I-2The 2/10 Yield Curve Is No Longer Inverted Chart I-3The Weakest Components Of The Conference Board's LEI Are Not Yet Signaling A Recession However, two caveats are warranted. First, part of this weakness reflects the ongoing shift from goods to services spending, unraveling the massive surge in goods spending that occurred during the pandemic (Chart I-4). Second, Chart I-3 highlights that similar weaknesses occurred in the past outside of the context of a recession, most notably in 1995/1996, in the aftermath of the 1994 bond market crisis; in 1998/1999, following the Long-Term Capital Management (LTCM) crisis; in 2015, following the collapse in oil prices; and, finally, in 2018/2019, in response to the Trump administration’s trade war. None of these instances resulted in a contraction in output. Headline Inflation Is Likely To Come Down Headline consumer price inflation is currently extremely high in the US. Rising prices do not just reflect energy, food, or pandemic-related effects. Chart I-5 highlights that trimmed mean CPI and PCE inflation rates have accelerated significantly since last summer, and are currently running at 6% and 3.6% year-over-year rates, respectively. Chart I-4Part Of The Weakness In Manufacturing Activity Indicators Reflects A Shift In Spending From Goods To Services Chart I-5There Is More To High Inflation Than Food, Energy, And Pandemic-Related Effects... However, it seems likely that inflation has peaked in the US (or is about to do so), even abstracting from base effects.Chart I-6 highlights that the one-month rate of change in trimmed mean measures seemingly peaked in October and January, and shows that the level of used car prices also appears to be trending lower (panel 2). The ongoing shift away from goods to services spending noted above will also push core ex-COVID-related consumer prices lower. Finally, BCA’s Commodity & Energy strategy service is forecasting that Brent crude oil prices will average roughly $90/bbl for the remainder of the year, which would likely bring US gasoline prices back toward $3.50/gallon and will lower both headline inflation and energy passthrough effects to core prices (Chart I-7). Chart I-6... But The Rate Of Headline Inflation Has Likely Peaked Chart I-7Our Forecast For Oil Implies US Gasoline Prices Will Fall     A meaningful deceleration in inflation will help reverse some of the recent decline in real wage growth that has occurred, and will likely lower the equity risk premium (see Section 2 of this month’s report).   Long-Maturity Bond Yields Will Not Move Much Higher This Year Chart I-8Our Inflation Probability Model Is Signaling Core Inflation That Is Roughly In Line With The Fed's Latest Forecast Chart I-8 highlights that our inflation probability model is currently signaling core PCE inflation of roughly 4.3% over the coming year. This is only moderately above the Fed’s forecast for this year, suggesting that a moderation in the rate of inflation makes it more likely that the Fed will raise rates in line with, or only moderately above, what was projected in the March Summary of Economic Projections (1.9% by the end of this year, and 2.8% by the end of 2023). By contrast, Chart I-9 highlights that the OIS curve is pricing the Fed funds rate at 80 basis points higher by the end of this year than what the Fed projected in March, suggesting that the bar for further hawkish surprises is quite high. We agree that the Fed will likely front-load a good portion of its planned tightening this year, and we agree that a 50 basis point hike is likely next month and also possibly in June. However, it is quite possible that the Fed will ultimately raise rates over the coming year at a slower pace than investors currently anticipate, which would lower yields at the front end of the curve. Chart I-9The Bar For Further Hawkish Surprises From The Fed Is Quite High If short-maturity yields are flat or trend modestly lower over the coming year, then a significant further rise in long-maturity yields would likely necessitate a major shift in neutral rate expectations on the part of investors or the Fed. We believe that such a shift will eventually occur, as the economic justification for long-maturity bond yields well below trend rates of economic growth disappeared in the latter half of the last economic expansion. However, we noted in last month’s Special Report that a low neutral rate outlook has become entrenched in the minds of investors and the Fed, and is only likely to change once the Fed funds rate rises meaningfully and a recession does not materialize.4 BCA’s fixed-income team currently recommends that investors maintain a neutral duration stance; the Bank Credit Analyst service is more inclined to recommend a modestly short stance. However, the key point for investors is that another significant rise in long-maturity bond yields is unlikely over the coming year, which is positive for economic activity and investor sentiment. The Pandemic Will Recede In Importance, Supporting Services Spending Chart I-10COVID Hospitalizations And Deaths Remain Low In The DM World While the pandemic is clearly not over in China (discussed below), it is likely to continue to recede in importance in the US and other highly vaccinated, and relatively highly exposed DM economies. Despite the fact that confirmed cases of COVID-19 have risen in the DM world in March and April, Chart I-10 highlights that there has been very little increase in ICU patients or deaths. A recent study from the US CDC suggests that 58% of the US population overall and more than 75% of younger children have been infected with the SARS-COV-2 virus since the start of the pandemic.5 When combined with a vaccination rate close to 70%, that signals an extraordinarily high national immunity to severe illness from the disease. Chart I-11 also highlights that deliveries of Pfizer’s Paxlovid continue to climb in the US, a drug that seemingly works against all known variants and has been found to reduce hospitalizations from COVID significantly if taken within the first five days of symptoms. Given that the decline in services spending that we showed in Chart I-4 has been clearly linked to the pandemic, we expect that a slowing pandemic will continue to support services spending. Goods spending is normally a more forceful driver of economic activity than is the case for services spending, but the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-World War II economic environment (Chart I-12). This underscores that a continued recovery in services spending relative to its pre-pandemic trend will provide a ballast to overall consumer spending as goods spending continues to normalize. Chart I-11Paxlovid To The Rescue! Chart I-12Real Services Spending Will Continue To Be A Forceful Driver Of US Economic Activity What Could Go Wrong The US Will Likely Experience A Recession Scare Chart I-13US Housing Affordability Has Cratered, In Large Part Due To Surging House Prices Despite our view that the US economy will avoid a recession over the coming year, it seems likely that investors will experience a recession scare at some point over the coming 6 to 12 months. Even though it has recently moved back into positive territory, the inversion of the 2-10 yield curve has set the scene for a recessionary overtone to any visible weakness in the US macro data over the coming months. We noted above that the manufacturing and goods-producing sectors of the US economy are likely to slow as spending returns to services. More importantly, the extremely sharp increase in mortgage rates will likely cause at least a temporary slowdown in US housing activity, even if that slowdown does not ultimately prove to be contractionary.Chart I-13 highlights that the recent increase in mortgage rates will cause US housing affordability to deteriorate back to 2007 levels. While rising mortgage rates will be the proximate cause of this deterioration in affordability, panel 2 highlights that the real culprit has been a significant increase in house prices relative to income. There is strong evidence pointing to the fact that US real residential investment has been too weak since the global financial crisis (GFC).6 We agree that high prices will likely spur additional housing construction (which will support growth). But over the nearer-term, the sharp deterioration in affordability may imply that house price appreciation will have to fall below the rate of income growth, which would represent a very sharp correction in house price gains that would almost assuredly appear recessionary for a time. The European Economy May Contract We have discussed the risk of a European recession in past reports, and noted that it would be almost certain to occur in a scenario in which Russia’s energy exports to Europe were to be completely cut off. We continue to see this as an unlikely scenario, although the odds have increased significantly of late in light of Russia’s halt of gas supplies to Bulgaria and Poland and Germany’s apparent acceptance of an oil embargo against Russia. However, Chart I-14 highlights that a recession, at least a technical one, may occur in Germany even if its imports of Russian natural gas are not interrupted. The chart shows that the German IFO business climate indicator for manufacturing has deteriorated more than the Markit PMI has, and panel 2 highlights that IFO-reported service sector sentiment is considerably worse than what was suggested by the Markit services PMI. Chart I-15 highlights that European stocks are not fully priced for a European recession, either in relative or absolute terms. This underscores the risk to global equities if real euro area growth falls meaningfully below current consensus expectations of 1.9% this year. Chart I-14German Business Sentiment Suggests A Possible Recession Chart I-15Euro Area Stocks Are Not Fully Priced For A European Recession Omicron Will Continue To Spread In China Table I-2The Ports Of Shanghai and Ningbo Are Quite Important To Chinese Trade Flows Confirmed cases of COVID-19 have surged in China over the past two months, and it is now clear that the country’s zero-tolerance policy will fail to contain the spread of the disease. We initially downgraded the odds of our above-trend growth scenario in our January report specifically in response to the risk that the Omicron variant of the virus posed to China.7 That risk that is now manifesting itself most acutely in Shanghai, but also increasingly in other coastal and northeastern provinces. Chart I-16COVID Restrictions In China Are Causing Significant Delays In Suppliers' Delivery Times China’s COVID surge has two implications for the global economic and financial market outlook. The first is that the surge has led to increased port congestion and shipping delays, which clearly threaten to cause a further rise in global shipping costs. We have noted in past reports that shipping costs from China to the West Coast of the US surged following the one month shutdown of the port of Yantian last year. Table I-2 highlights that the ports of Shanghai and nearby Ningbo handle nearly 30% of China’s total ocean shipping volume. Chart I-16 highlights that road traffic restrictions in the Yangtze River Delta have caused significant delays in suppliers’ delivery times, further raising the risk of bottlenecks that may take months to clear. Chart I-17China's Battle With Omicron Further Raises The Risk Of A Euro Area Recession The second implication of China’s COVID surge is that China’s contribution to global growth is at risk of declining significantly further, at least for a time. If Chinese economic activity slows sharply in response to the lockdowns and a further spread of the disease, we fully expect Chinese policymakers to provide further stimulus to support household income in line with what occurred in DM countries two years ago. In addition, some investors have argued that reduced commodity demand from China is actually desirable in the current environment, as it would further reduce inflationary pressure in the US and other developed economies. However, Chart I-17 highlights that Chinese import growth has already slowed very significantly, which has clearly impacted euro area exports. European exports to China are not predominantly commodity-based, and it is yet unclear whether the form of stimulus that Chinese policymakers will introduce will be particularly import-intensive. As such, China’s failure to contain Omicron further adds to the risk of the European recession we noted above, and threatens our view that US headline inflation will trend lower this year. Inflation Expectations May Unanchor Despite Slowing Inflation We discussed above that US inflation will decelerate this year and that this may allow the Fed to raise interest rates at a slower pace than currently expected by market participants. One risk to this view is the possibility that inflation expectations may unanchor to the upside, despite an easing in inflation. Even though inflation expectations have not trended in a different direction than actual inflation since the GFC, Chart I-18 highlights that this has occurred in the past (from 2001-2006). In our view, the level of inflation that is likely to prevail over the coming two years will be an extremely important determinant of whether inflation expectations break above their post-2000 range. For now, Chart I-18 highlights that the Fed’s expectation for core inflation this year is reasonable, but it remains an open question whether core inflation will decelerate below 3% next year as the Fed is forecasting. This is notable, because US core PCE inflation peaked at a rate of 2.6% during the 2002-2007 economic expansion, which is the period when stable long-dated inflation expectations were prevalent. Chart I-19 highlights that market-based inflation expectations are currently challenging or have risen above their 2004-2014 average. We noted in last month’s report that long-dated household inflation expectations will be historically low, even if inflation decelerates in line with what near-dated CPI swaps are forecasting. Chart I-18Inflation Expectations May Still Unanchor Even If The Inflation Rate Comes Down Chart I-19Market-Based Inflation Expectations May Soon Rise Above Pre-GFC Range   The bottom line for investors is that a slowing of inflation over the coming several months may not be enough to prevent long-term inflation expectations from rising. That raises the risk of an even more aggressive pace of interest rates than currently expected by investors, because the Fed is determined to avoid repeating the mistakes of the 1970s when rising inflation expectations led to a wage-price spiral that required years of comparatively tight monetary policy to correct. By contrast, the Fed will view a temporary income-statement recession stemming from a sharp rise in interest rates as the lesser of two evils. A recession to prevent a long-lasting wage-price spiral would also probably be better for investors over the longer run, but a recession would clearly imply a significant decline in risky asset prices at some point over the coming two years were it to occur. Investment Conclusions Chart I-20Despite The Risks Facing Europe, Euro Area Stocks Are Not A Clear Underweight Candidate From the perspective of allocating to risky assets, the most important question for investors to answer is whether the US is likely to experience a recession over the coming year. As we noted above, in our view the answer is “no”, which implies that US earnings growth will remain positive and that investors should not be underweight stocks within a global multi-asset portfolio. It is true that earnings can decline outside of the context of a recession, but we discuss in Section 2 of our report that this has almost always been associated with a significant contraction in profit margins. The factors that have historically been associated with a nonrecessionary decline in profit margins may occur later this year, but our indicators so far point more to flat margins rather than a significant decline. For now, investors should remain minimally-overweight stocks over a 6 to 12 month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional allocation. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Chart I-15 highlighted that they will underperform further if euro area growth turns negative. It is not clear, however, if that risk warrants an underweight stance today, especially considering the enormous valuation advantage offered by euro area stocks versus their US counterparts and the fact that the euro has already fallen to a five-year low (Chart I-20). Chart I-21Favor A Neutral Stance Towards Cyclical Stocks Versus Defensives Within the dimensions of the equity market, Chart I-21 highlights that the outperformance of cyclicals versus defensives was already late at the onset of Russia’s invasion of Ukraine, and that the uptrend in relative performance has seemingly ended. Still, a moderately overweight stance toward stocks overall does not especially support an underweight stance toward cyclicals; therefore, we recommend a neutral stance over the coming year. We continue to recommend that investors (modestly) favor value stocks over growth stocks on the basis of better value and as a hedge against potentially higher long-maturity yields, although we acknowledge that most of the outsized outperformance of growth stocks during the pandemic has already reversed. Despite their recent underperformance, we continue to favor global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have seemingly already priced in a likely recession scare in the US later this year (Chart I-22). Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. We are wary of recommending a neutral duration stance given the possibility that investors or the Fed may upwardly revise their neutral rate expectations earlier than we anticipate; however, investors are also likely to see long-maturity yields come down for a time in response to a housing market slowdown over the coming several months. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. Finally, while we are bearish toward the dollar on a 6- to 12-month time horizon, it is likely to strengthen over the near term. Chart I-23 highlights that our composite technical indicator for the US dollar is now clearly in overbought territory. We expect that a downtrend will begin once the war in Ukraine reaches a durable conclusion and clarity about the economic impact of the spread of Omicron in China – and the likely policy response – emerges. Chart I-22The Selloff In Small Caps Seems Overdone Chart I-23US Dollar And Indicator The Dollar Is Ripe For A Major Pullback Beyond Likely Near-Term Strength   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 28, 2022 Next Report: May 26, 2022 II. The US Equity Market: A Fundamental, Technical, And Value-Based Review All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.8 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.9 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts As discussed in this month’s Section 2, BCA’s equity indicators do not paint an optimistic picture for stock prices. Our monetary indicator is at its weakest point in almost three decades, our valuation indicator continues to highlight that stocks are overvalued, and both our sentiment and technical indicators have broken down. An eventual easing in the latter two measures will ultimately prove positive for equities, but this will likely happen only once they reach extremes. Investors should be at most modestly overweight stocks versus bonds over the coming year. Forward equity earnings are likely pricing in too much of an increase in earnings per share over the coming year. Net earnings revisions and net positive earnings surprises have rolled over considerably, although there is no meaningful sign yet of a decline in the level of forward earnings. Earnings growth is more likely than not to be positive over the coming year, but will be modest. Within a global equity portfolio, we recommend a neutral stance towards cyclicals versus defensives, as well as a neutral regional equity stance. Euro area stocks are not a clear underweight candidate despite the risk of a European recession. Within a fixed-income portfolio, the 10-Year Treasury Yield has very little further upside over the coming year, arguing for a modestly short duration stance. We do not believe that the Fed will end up raising rates to a level higher than investors are forecasting over the coming year. Commodity prices continue to rise in a broad-based fashion following Russia’s invasion of Ukraine, and our composite technical indicator highlights that they remain significantly overbought. We expect oil and food prices to come down over the coming year, but there is a risk to that assessment. Russia aggression has very likely sped up Europe’s decarbonization timeline, suggesting that investors should be tactically, cyclically, and structurally bullish on industrial metals prices. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Leading and coincident indicators remain decently strong, and we do not expect a recession in the US over the coming year. However, the odds of a stagflationary-lite outcome of above-target inflation and at-or-below-trend growth have increased because of the war. 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 Gabriel Di Lullo Research Associate Footnotes 1     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 2     Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, and "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3  Please see US Investment Strategy/ US Bond Strategy Special Report "Gauging The Risk Of Recession: Slowdown Or Double-Dip?" dated August 16, 2010, available at usbs.bcaresearch.com 4    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 5    Clarke, KE, JM Jones, Y Deng, et al. Seroprevalence of Infection-Induced SARS-CoV-2 Antibodies — United States. September 2021–February 2022. 6    Please see The Bank Credit Analyst "Global House Prices: A New Threat For Policymakers," dated May 27, 2021, available at bca.bcaresearch.com 7     Please see The Bank Credit Analyst "January 2022," dated December 23, 2021, available at bca.bcaresearch.com 8    Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 9    Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Executive Summary Allies Still Have Faith In USD The Biden administration’s use of sanctions has prompted market speculation about the longevity of the dollar. Yet the DXY has hit 100 and could break out, in the context of rising interest rates and safe-haven demand. The US’s increasingly frequent recourse to economic sanctions is a sign of growing foreign policy challenges. US rivals will continue to diversify away from dollar-denominated reserves. However, from a big picture point of view, there is no clear case that the dollar suffers from US sanctions. When global growth reaccelerates, the dollar can weaken. But until then it will remain resilient. Recommendation (Tactical) Inception Level Inception Date Return Long DXY 96.19 23-FEB-22 5.8% Bottom Line: Tactically stay long DXY and defensives over cyclicals. Feature The US’s aggressive use of sanctions against Russia, in response to its invasion of Ukraine, has prompted market speculation about the future of the global financial and monetary system. Related Report  US Political StrategyBiden's Foreign Policy And The Midterms               It is helpful to begin with facts – what we really know – before launching into grandiose predictions for the future. For example, while some analysts are predicting the demise of the US dollar’s position as the leading reserve currency, so far global investors have bid up the dollar in the face of rising policy uncertainty (Chart 1). In this report we conduct a short overview of US sanctions policy and draw a few simple investment conclusions. Chart 1US Political Risk And The Dollar US Extra-Territorialism Not Yet Hurting The USD The DXY is now trading at 101.2, above the psychological threshold of 100, suggesting that it could break out above its 2016 102.2 peak. The drivers are an expected sharp rise in real interest rates, in both absolute and relative terms, as the Federal Reserve starts on a rate hike cycle that is expected to add 225 basis points to the Fed funds rate this year alone to combat core inflation of 6.5%. This monetary backdrop must be combined with extreme global political and economic instability to explain the dollar’s potential breakout. The global situation is growing less stable, as EU-Russia energy trade breaks down while China imposes lockdowns to stop the spread of Covid-19. Over the past twenty years, the US has struggled to maintain its global leadership. Washington became distracted by wars in the Middle East and South Asia, a national property market crash and financial crisis, and a spike in political polarization and populism. The US public grew war-weary, while the US faced growing challenges from large and powerful nations that it could not confront militarily. Therefore US policymakers turned to economic tools to try to achieve their objectives: namely sanctions but also tariffs and export controls. Many economists and political scientists have warned that the US’s expanding use of economic sanctions – and broader trend of international, extra-territorial, law enforcement – would drive other countries to sell the US dollar and buy other assets, so as to reduce their vulnerability to US tools. This reasoning is sound, as we can see with Russia, which has reduced its dollar-denominated foreign exchange reserves from 41% to 16% since 2016, while increasing its gold holdings from 15% to 22% over the same period. Other major countries vulnerable to US sanctions could follow in Russia’s footsteps. However, so far, the dollar is not suffering excessively from such moves. On the contrary it is rising. The US started using sanctions aggressively with North Korea in 2005, Iran in 2010, and Russia since 2012. The dollar has fluctuated based on other factors, namely rising when the global commodity and industrial cycle was falling (Chart 2). Chart 2TWUSD And DXY Since 2000 Sanctions are a limited prism through which to examine the dollar. But if there is any observable effect of the US’s turn toward sanctions against major players like Russia in 2012 and China in 2018, it is that it has boosted the dollar rather than hurt it. Obviously that trend could change someday. But for now, as the Ukraine war dramatically heightens the US struggle with its rivals, investors should observe that the dollar is on the verge of a breakout. If the dollar continues to rise, it suggests that the US’s structural turn toward more aggressive economic and financial sanctions is not negative for the dollar. It may be neutral or positive. Cyclically the trade-weighted dollar is nowhere near its 2020 peak and could still fall short of that peak, especially if global tensions subside. But the collapse in the euro has caused the DXY to break above its 2020 peak already. Bottom Line: Stay tactically long DXY while watching whether it can break sustainably above 100 to determine whether our cyclically neutral view should be upgraded. US Sanctions On North Korea In this century, the US began to turn more aggressive in its use of sanctions when it confronted the “Axis of Evil” following the terrorist attacks on September 11, 2001. North Korea withdrew from the Nuclear Non-Proliferation Treaty in 2003 and began to pursue a nuclear and ballistic missile program more intently. The US responded by levying serious sanctions on that state beginning in 2005. Gradually tougher US sanctions never caused a change in the North Korean regime or foreign policy. On the contrary North Korea achieved nuclear weaponization and is today outlining an expansive nuclear doctrine.  US sanctions on North Korea were never going to drive global macro trends. However, they could have had an impact on South Korean trends. Initially none of the US sanctions reversed the dollar’s decline against the Korean won. After the global financial crisis in 2008, when the dollar began an uptrend against the won, we observe periods of significant new sanctions in which the won rises and the dollar falls (Chart 3, top panel). The same can be said for the outperformance of US equities relative to South Korean equities – if sanctions had any impact, they simply reinforced the flight to US assets in a globally disinflationary context. The trend was mirrored within the US equity market by the rise of tech versus industrials (Chart 3, bottom panel). Chart 3US Sanctions On North Korea Since Covid-19, the outperformance of US tech is now being overturned by high inflation, which has triggered a vicious selloff in tech. In 2022, global growth is slowing, stagflation is taking shape, and the odds of a recession are rising. Stagflation is negative for both industrials and tech, but more so tech. However, South Korea is still suffering from a deteriorating global macro and geopolitical backdrop, as globalization falters, US-China competition rises, and the US fails to contain North Korean ambitions. Sanctions are a symptom rather than a cause.  Bottom Line: US sanctions on North Korea pose no threat to the US dollar. Tactically US industrials can continue to outperform tech but both sectors will suffer in a stagflationary context. US Sanctions On Venezuela The US has slapped sanctions on Venezuela since the early 2000s but these sanctions kicked into high gear in 2015 after President Nicolas Maduro took power and eliminated the last vestiges of democratic and constitutional order. The US recognized the opposition as the legitimate government so sanctions relief will not be easy or convenient. Sanctions have not changed the regime’s behavior, but the regime has all but collapsed and major changes could happen sooner than people expect. Moreover any short-term sanction relief prompted by high oil prices will not be sustainable: the Republican Party will oppose it, hence private US corporations will doubt its durability, and Venezuela’s failing oil industry cannot be revived quickly anyway (Chart 4, top panel).    The US has strong relations with Venezuela’s neighbor Colombia. Yet Colombia faces the greatest economic and security risks from Venezuelan instability. The US dollar vastly outstripped the Colombian peso over the past decade, consistent with the US energy sector’s underperformance (Chart 4, bottom panel). Chart 4US Sanctions On Venezuela With Covid-19, this trend reversed because of the global energy squeeze and inflationary environment. The implication was positive for the Colombian peso as well as global (and US) energy sector relative performance. But the peso only marginally improved against the dollar, while US energy outperformance is now stretched.  Bottom Line: Energy sector still enjoys macro tailwinds but it is no longer clear that US energy stocks will outperform the broad market for much longer. Favor energy by staying long US energy small caps versus large caps. Also stay long oil and gas transportation and storage sub-sector relative to the broad market. The Biden administration is unlikely to give sanction relief to Venezuela. If it does, it will be ineffective at reducing oil prices in the short term. Either way, there will be little impact on the US dollar. US Sanctions On Iran US policy toward Iran is critical to global stability and energy prices in 2022 and the coming years. US sanctions did not change Iran’s behavior alone, but in league with the P5+1 (the UK, France, China, Russia, plus Germany) sanctions forced Iran to accept limit on its nuclear program in 2015. However, the Trump administration withdrew from that agreement and imposed “maximum pressure” sanctions on Iran in 2018, leading to a sharp depreciation in the market exchange rate of the Iranian toman (Chart 5, top panel). The Saudi Arabian riyal, by contrast, is pegged to the dollar and remains steady except when oil prices collapse (Chart 5, middle panel). The Saudis still rely on the Americans for national security so they are unlikely to abandon the dollar, though they may marginally diversify their foreign exchange reserves. The Biden administration wants to rejoin the 2015 deal but first is trying to extract concessions from Iran. Iran feels limited pressure: while its currency is still weak and inflation high, Iran has not succumbed to social unrest. Iranian oil production and exports are rising amid global high prices (Chart 5, bottom panel). Ultimately Iran wants to continue to advance its nuclear program in line with the North Korean strategy. Hence Biden can rejoin the deal unilaterally if he wants to avoid Middle Eastern instability ahead of the midterm elections. But it would be a short-term, stop-gap agreement and the reduction in oil prices would be fleeting. By contrast, if Biden fails to lift Iran’s sanctions, then the risk of oil disruptions from the Middle East goes way up. Tactically investors should expect upside risks to the oil price, but that would kill more demand and weigh on global growth. Over the past decade the outperformance of US equities relative to Saudi and Emirati equities falls in line with the outperformance of US tech relative to energy sectors. As mentioned, this trend has largely run its course, although it can go further in the short run. But there is a broader trend related to growth versus value styles. The UAE’s stock market is heavily weighted toward financials, while the US is heavily weighted toward tech. The US tech sector has collapsed relative to financials (Chart 6).  Chart 5US Sanctions On Iran Chart 6US Sanctions On Iran Bottom Line: US energy and financials sectors can fare reasonably well in a stagflationary context but their outperformance relative to tech is largely priced from a cyclical point of view. US maximum pressure sanctions on Iran never hurt the US dollar. US Sanctions On Russia The US’s extraordinary sanctions against Russia in 2022 – including freezing its dollar-denominated foreign exchange reserves – have sparked market fears that countries will divest from US dollars to protect themselves from any future US sanctions. To be clear, the US has confiscated foreign enemies’ property and foreign exchange reserves in the past. True, Russia is qualitatively different from other countries, such as Iran, because it is one of the world’s great powers. Yet the US closed off all economic and financial linkages with Russia from 1949-1991 because of the Cold War, the very period when the US dollar rose to prominence as the global reserve currency. In 2022, sanctions on Russia have primarily hurt the Russian ruble, not the US dollar (Chart 7). The Russians divested from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. But they were not able to divest fast enough to prevent the 2022 sanctions from pummeling their financial system and economy. Chart 7US Sanctions On Russia Going forward Russia will be much more insulated from the US dollar but at a terrible cost to long-term productivity. The lesson for other US rivals may be to diversify away from the dollar – but that will be a secondary lesson. The primary lesson will be to take economic stability into account when making strategic security decisions. Economic stability requires ongoing engagement in the global financial system and US dollar system. US sanctions on Russia have benefited US equities and dollar relative to Russian assets as one would expect. Russia’s invasion of Ukraine exacerbated the trend. The takeaway for US investors is that the energy sector’s outperformance sector’s outperformance can continue in the short run but is becoming stretched from a cyclical perspective. Bottom Line: Investors should expect oil and the energy sector to remain strong in the short run, while tech will suffer in an inflationary and stagflationary environment. But energy may not outperform tech for much longer. US Sanctions On China US policy toward China is the critical question today. China holds $1 trillion in dollar-denominated exchange reserves and must recycle around $200 billion in current account surpluses every year into global assets. The US has imposed sweeping sanctions on Iran since 2010, Russia since 2012, and China since 2018. China began diversifying away from dollar-denominated foreign exchange reserves in 2011 in the wake of the Great Recession. The US-initiated trade war in 2018 solidified the change in China’s foreign reserve strategy. The US sanctions against Russia will further solidify it. There are some signs that US punitive measures affected the USD-CNY exchange rate but global economic cycles are far more powerful. The yuan appreciated from 2005 until the global financial crisis, during the height of US-China economic and diplomatic engagement. It depreciated through the manufacturing slowdown of 2015 and the US-China trade war. It appreciated again with the pandemic stimulus and global trade rebound. The yuan was affected by US sanctions and tariffs on the margin amid these larger macro swings (Chart 8, top panel). Still, the overarching trend since 2014 points to a rising dollar and falling yuan. Globalization is in retreat and US-China strategic competition is heating up. As with South Korea, these trends are negative for Chinese assets. US sanctions are a symptom rather than a cause of the underlying macro and geopolitical dynamics. The same point can be made with regard to US equity performance relative to Chinese – and hence US tech outperformance relative to US industrial stocks (Chart 8, bottom panel). However, as with Korea, the cyclical takeaway is to favor industrials over technology in a stagflationary environment. Chart 8US Sanctions On China Bottom Line: Tactically favor US industrials over tech until the world’s stagflationary trajectory is corrected. US-China relations are one area where US sanction policy can hurt the dollar, as China will seek to diversify over time. But so far the evidence is scant. US Sanctions And Foreign Holdings Of Treasuries Having examined US sanctions on a country-by-country basis, we should now turn toward holdings of US dollars and Treasury securities. Are US economic sanctions jeopardizing the willingness of states to hold US assets? First, Americans hold 74% of outstanding treasuries. Foreigners hold the remaining 26% (Chart 9, top panel). This is a large degree of foreign ownership that reflects the US’s openness as an economy, as well as the size of the treasury market, which makes it attractive to foreign savers who need a place to store their wealth. Of this 26%, defense allies hold about 36%. Theoretically up to 17% of treasuries stand at risk of rapid liquidation by non-allied states afraid of US sanctions. But a conservative estimate would be 6%. Notably the share of foreign-held treasuries held by non-allies has fallen from 40% in 2009 to 23% today. Non-allies are reducing their share fairly rapidly (Chart 9, middle panel). What this really means is that China and Hong Kong are reducing their share – from 26% in 2008 to 16% today. Brazil and India have maintained a steady 6% of foreign-held treasuries. Notably the offshore financial centers see a growing share, suggesting that trust in the dollar remains strong even among states and entities that wish to hide their identity. Some of the divestment that has occurred from non-allied states may be overstated due to rerouting through these third parties. Looking at the data in absolute terms, only China – and arguably Brazil – can be said with any certainty to be pursuing a dedicated policy of divesting from US dollar reserves (Chart 10). This makes sense, as China, like Russia, is engaged in geopolitical competition with the US and therefore must take precautions against future US punitive measures. But these measures are not so far generating a worldwide flight from the dollar, either at the micro level or the macro level. Chart 9Foreign Purchases Of US Treasuries Chart 10Foreigners With Large Treasury Holdings In fact, the biggest competitor to the US dollar is the euro. This is clear from looking at the share of global currency reserves – the two are inversely proportional (Chart 11). And yet it is the European Union, not the US, that could suffer a long-term loss of security, productivity, and stability as a result of Russia’s invasion of Ukraine. The euro is losing status as a reserve currency and the war could exacerbate that trend. Chart 11Global Reserve Currency Basket Europe does not provide protection from US sanctions. The EU, like the US, utilizes economic sanctions and the two entities share many similar foreign policy objectives. Europe is also allied with the US through NATO. When the US withdrew from the Iran nuclear deal, the EU did not withdraw, yet EU entities enforced the sanctions, as their economic linkages with the US were much more valuable than those with Iran. In the case of Russia, the two have imposed sanctions in league, as they will likely do toward other small or great powers that attempt to reshape the global order through military force. The next competitors to the dollar and euro are grouped together in Chart 11 above because they are the US’s “maritime allies,” such as Japan, the United Kingdom, and Australia. These countries will pursue a similar foreign policy to the United States and they do not offer protection from US sanctions during times of conflict or war.  The true competitor is the Chinese renminbi. The renminbi will grow as a share of global reserves. But it faces serious obstacles from China’s economic policy, currency controls, closed capital account, and geopolitical competition with the United States. Washington’s sanctions have already targeted China yet the US dollar has remained resilient.  Bottom Line: The US’s erratic foreign policy in recent decades has potentially weighed on the US’s commanding position as a global reserve currency, with its share of reserves falling from 71% in 2000 to 59% today. But US allies have mostly picked up the slack. And the dollar’s top competitor, the euro, is likely to suffer more than the dollar from the Ukraine war. Still it is true that US sanctions are alienating China, which will continue to diversify away from the dollar.  Investment Takeaways Tactically stay long the US dollar (DXY). The combination of monetary policy tightening and foreign policy challenges is driving a dollar rally that could result in a breakout.  US sanctions policy is not a convincing reason to sell the dollar in today’s context. Over the medium term dollar diversification poses a risk, although the dollar will still remain the single largest reserve currency over a long-term, strategic horizon. For further discussion see the Special Report by our Foreign Exchange Strategy and Geopolitical Strategy, “Is The Dollar’s Reserve Status Under Threat?” Given US domestic policy uncertainty in an election year, and foreign policy challenges, stay long defensive sectors, namely health care, over cyclical sectors.   Tactically our renewable energy trade has dropped sharply. But cyclically it remains attractive, as our recent Special Report with our US Equity Strategy team demonstrates. If Congress fails to succeed in promoting its new climate and energy bill, then this trade could suffer bad news in the near term. Tactically US industrials can continue to outperform the tech sector, given the stagflationary context that is developing. Energy’s outperformance, especially relative to tech, is becoming stretched, at least from a cyclical point of view. But geopolitical trends suggest oil risks are still to the upside tactically. For now, maintain exposure to high energy prices by staying long energy small caps versus large caps and O&G transportation and storage.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary A housing slowdown has begun and it will proceed in three stages. First, rising mortgage rates will lead to slowing demand. Second, weak demand will push inventories higher and cause home prices to decelerate. Finally, construction activity will trend down signaling a peak in the fed funds rate. We are at least one year away from housing signaling a peak in interest rates. Agency MBS returns will improve going forward, but the sector is still not sufficiently attractive to increase exposure. Housing Starts Are A Useful Fed Indicator Bottom Line: Maintain an underweight allocation to agency MBS within US bond portfolios and favor low coupons (1.5%-2.5%) over high coupons (3%-4.5%). Feature Chart 1The Highest Mortgage Rate Since 2011 The biggest question for investors continues to be how the economy and financial markets will react to the Federal Reserve’s hawkish pivot, a pivot that has led to sharply higher bond yields and a much flatter yield curve. However, it’s not just this re-shaping of the Treasury curve that has changed the economic landscape. The Fed’s hawkish pivot has also sent the mortgage rate back above 5% for the first time since 2011 (Chart 1). This week’s report considers what an elevated mortgage rate means for the future path of Fed rate hikes. It also updates our view on Agency MBS.   Housing Is Critical For Fed Policy Housing is probably the most important channel through which monetary policy impacts the economy. This is simply the result of the fact that monetary policy directly influences mortgage rates and mortgage rates are a major determinant of housing demand. Not only that, but empirical research has shown residential investment to be an excellent leading indicator of recession.1 Related Report  Global Fixed Income StrategyGlobal Bond Yields Take A Breather From these facts we can draw two conclusions. First, monetary policy works in large part through its influence on housing activity. Second, trends in housing activity can send important signals about the stance of monetary policy. For example, we observe that periods of Fed tightening tend to occur when the 12-month moving average of housing starts is above the 24-month moving average. Meanwhile, periods of Fed rate cuts tend to occur when the 12-month moving average of housing starts is below the 24-month moving average (Chart 2). This is a fairly reliable relationship going back to the early 1970s, the sole exception being the late-1980s when the Fed delivered a series of rate hikes as housing activity trended down. Chart 2Housing Starts Are A Useful Fed Indicator Chart 2 shows us that housing starts are currently trending higher, consistent with a period of Fed tightening. However, it also tells us that we should start to anticipate the end of the tightening cycle when the 12-month moving average of housing starts falls below the 24-month moving average. While the elevated mortgage rate will certainly slow housing activity going forward, we expect that we are still at least one year away from receiving that signal from the housing starts data. A Housing Slowdown In Three Steps We see the coming housing slowdown proceeding in three steps. First, higher mortgage rates will crimp demand. This is already starting to occur. New and existing home sales have both dipped in recent months, and mortgage purchase applications are down off their highs (Chart 3). Chart 3Phase 1: Weaker Demand Demand weakness will continue until the housing slowdown reaches its second phase. The second phase will be characterized by rising home inventories and decelerating home prices. This has still not occurred. The total inventory of new and existing homes is near its all-time low and home prices were up 18% during the 12-month period ending in January (Chart 4). The second phase of the housing slowdown is critical because builders will be incentivized to add supply as long as inventories remain low and prices remain elevated. That is, the housing slowdown will not reach its third phase – declining housing starts – until weak demand pushes inventories up and prices down, making new construction less attractive. Presently, while homebuilder equities have sold off as mortgage rates have risen, homebuilder confidence is still extremely high (Chart 5). This tells us that we are still quite far away from seeing a trend reversal in housing starts. Chart 4Phase 2: Falling Prices Chart 5Phase 3: Less Construction Bottom Line: A trend reversal in housing starts, as indicated by the 12-month moving average dipping below the 24-month moving average, will send a strong signal that the Fed is near the peak of its tightening cycle. Given that the housing slowdown is still in its early stages, we view this development as at least one year away. Agency MBS: The Rout Is Over, But It’s Still Too Soon To Buy Chart 6Poor MBS Performance Agency Mortgage-Backed Securities (MBS) have performed terribly during the past year (Chart 6). Not only have the securities drastically underperformed duration-matched Treasuries, but they have also performed worse than investment grade corporate bonds and Agency-backed Commercial Mortgage-Backed Securities. The chief reason for the poor performance has been the surge in bond yields and the resulting increase in Agency MBS duration. It became less attractive for homeowners to prepay their mortgages as mortgage rates rose. This caused MBS duration to extend, meaning that every further increase in yields led to a more severe drop in price. Chart 7 shows that the average duration of the conventional 30-year Agency MBS index was around 3.0 at the beginning of 2021. It is now above 6.0! The good news is that this is probably about as high as the index duration will get. The refi option on most mortgages is already out-of-the-money. That is, close to 0% of the amount outstanding of the conventional 30-year MBS index can profitably refinance with the mortgage rate at its current level (Chart 7, panel 2). We also observe that the average price of the index has fallen to well below par (Chart 7, panel 3) and the average convexity of the index is close to zero (Chart 7, bottom panel). The key point is that there is now very little convexity risk in the MBS index, so further movements in bond yields will lead to much smaller changes in index duration. Low convexity risk means that the worst of the MBS duration extension has already passed. MBS returns should be somewhat better going forward, though we still don’t recommend increasing exposure to the sector. At this juncture, the main reason to stay defensive on Agency MBS is that spreads simply don’t offer sufficient value. The average index spread versus Treasuries is close to its lowest level since 2000 (Chart 8). Interestingly, dramatic MBS underperformance didn’t lead to spread widening during the past year because MBS yields kept getting compared to longer and longer duration Treasuries as the MBS index duration extended. Chart 7The Extension Trade Is Over Chart 8MBS Spreads Are Too Tight MBS value is also relatively poor compared to investment grade rated corporate bonds. The option-adjusted spread differential between Agency MBS and investment grade corporates is close to its median since 2000 (Chart 8, panel 2). MBS value looks slightly more expensive if we adjust for index duration by using the 12-month breakeven spread (Chart 8, bottom panel). With value relative to investment grade corporates either at its historical median or slightly more expensive, we don’t see a compelling case for favoring Agency MBS over investment grade corporates. Bottom Line: MBS index duration extension has likely run its course. We therefore expect MBS returns to improve somewhat during the next 6-12 months. That said, we continue to recommend an underweight allocation to the sector as current spreads don’t justify favoring MBS over Treasuries or investment grade corporates. Take A Look At Low Coupons We think investors should consider favoring low coupons (1.5%-2.5%) within an overall underweight allocation to agency MBS. We view this recommendation as a way to position for a drop in Treasury yields between now and the end of the year. In prior reports we noted that long-dated forward Treasury yields are elevated relative to survey estimates of the long-run neutral fed funds rate, and also that we expect inflation to trend down in the coming months.2 While we continue to recommend keeping portfolio duration close to benchmark on a 6-12 month horizon, a low-coupon bias within Agency MBS is a good way to position for the possibility that falling inflation will push bond yields down. To see why, we need to simply consider that low coupon mortgages are the least likely to refinance and thus low-coupon MBS have the highest durations (Chart 9). With convexity currently close to zero for the entire coupon stack (Chart 10), MBS relative coupon positioning can really be boiled down to a play on rates and duration risk. Chart 9Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 10Agency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity A further rise in bond yields will cause higher coupon MBS (3%-4.5%) to outperform lower coupon MBS (1.5%-2.5%), while a drop in bond yields will lead to low-coupon outperformance. Given our current macro outlook, we think it makes sense to bet on the latter. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.nber.org/papers/w13428 2 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns