Developed Countries

Highlights Fed: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Nominal Treasuries: We project that Treasury securities will still deliver negative total returns, even if Fed liftoff is delayed until December 2022. Investors can protect returns by favoring the 2-year note (long 2yr over cash/10yr barbell) and 20-year bond (long 20yr over 10yr/30yr barbell). TIPS: Investors should short 2-year TIPS outright in anticipation of falling short-dated inflation expectations during the next 12 months. The Taper Is Done, Now Onto Liftoff The Fed announced a tapering of its asset purchases last week and the details of the tapering plan were consistent with what had already been signaled to the public. The Fed will purchase $70 billion of Treasuries this month (compared to $80 billion in October) and $35 billion of agency MBS (down from $40 billion in October). It will then reduce monthly Treasury and MBS purchases by $10 billion and $5 billion each month, respectively, until it reaches net zero asset purchases by June of next year (Chart 2). The Fed didn’t give specific guidance on what will happen with the balance sheet after June, but it’s highly likely that it will follow the pattern of the last tightening cycle and keep the balance sheet flat for a long time, until the fed funds rate is well above the zero bound. The Fed also gave itself the option to increase or decrease the pace of purchases if such changes are warranted by the economic outlook, but it would take a major shock to knock the Fed off its pre-set course. Chart 1The Market's Liftoff Expectations Chart 2Net Purchases Will Reach Zero By June With the tapering announcement out of the way, the Fed can now turn to the more important question of when to start lifting interest rates. Jay Powell made it clear at last week’s press conference that the committee hasn’t yet formally taken up the issue, but that didn’t stop reporters from pressing the Chairman to provide more details about when the Fed will hike. None of that should be too surprising. There’s intense market interest and a great deal of uncertainty about the timing of Fed liftoff. Two months ago, markets were pricing-in no rate hikes at all in 2022. Now, markets are looking for Fed liftoff at the September 2022 FOMC meeting and are discounting a 90% chance of 2 rate hikes by the end of next year (Chart 1). The Fed’s Thinking On Liftoff So, what did we learn from last week’s FOMC Statement and press conference about how the Fed is thinking about the liftoff date? First, we know from previous comments that the Fed would prefer to reduce net asset purchases to zero before it starts lifting rates. This means that the July 2022 FOMC meeting is the first “live meeting” where a rate hike could possibly occur, and the fed funds futures market is already pricing-in a 74% chance that liftoff will occur at that meeting (Chart 1). We aren’t so sure. In fact, we don’t see the Fed lifting rates until December 2022, and Chair Powell’s comments about inflation at last week’s press conference only increased our confidence in that view. On inflation, Powell echoed comments by Fed Governor Randal Quarles that we flagged in a recent report.1 Both Powell and Quarles put less emphasis on the length of time that inflation remains above the Fed’s target and more emphasis on the causes of that inflation and whether it’s appropriate for the Fed to lean against it. Here’s Powell from last week (emphasis added): Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself. Our tools cannot ease supply constraints. Like most forecasters, we continue to believe that our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline to levels much closer to our 2 percent longer-run goal. Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation. Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.2 Essentially, Powell is pointing out that it would be a mistake for the Fed to tighten policy to bring down inflation only to find out that the economy’s natural supply side response was about to do so anyways. The Fed would have dragged down aggregate demand for no reason. So what would cause the Fed to lift rates? We see two potential triggers. The first liftoff trigger would be an assessment by the FOMC that the labor market has reached “maximum employment”. This is the liftoff condition that the Fed has officially set for itself. The second liftoff trigger would be an uncomfortable increase in long-dated inflation expectations. A spike in long-dated inflation expectations would be worrying enough that the Fed would abandon its “maximum employment” goal and tighten earlier. The “Maximum Employment” Trigger Chart 3How Far From "Maximum Employment"? The concept of “maximum employment” brings a whole host of other issues along with it. How will the Fed know if the labor market is at “maximum employment”? We’ve discussed this topic at length ourselves and have come to a few helpful conclusions.3 First, we can infer from the most recent Summary of Economic Projections that the Fed views an unemployment rate of 3.8% as roughly consistent with “maximum employment”. It is therefore highly unlikely that the Fed will even consider declaring victory on its employment goal until the unemployment rate is in the vicinity of 3.8%, down from its current 4.6% (Chart 3). Second, there are good reasons to believe that the aging of the US population and the recent sharp increase in retirements will prevent the labor force participation rate from re-gaining its pre-pandemic level. However, FOMC participants seem to agree that the prime-age (25-54) labor force participation rate should be close to its February 2020 level for the “maximum employment” condition to be satisfied (Chart 3, bottom panel). Chair Powell even specifically referenced the prime-age participation rate at last week’s press conference. We think a declaration of “maximum employment” will only occur once the unemployment rate is near 3.8% and the prime-age (25-54) labor force participation rate is near its February 2020 level of 82.9%, up from its current 81.7%. It’s unlikely that these conditions will be met in time for a July 2022 rate hike. The Appendix to this report updates our scenarios for the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and participation rates by specific future dates. Our scenarios use the overall participation rate (not the prime-age one), but we think the scenarios derived from the New York Fed’s Surveys of Market Participants and Primary Dealers come close to capturing reasonable conditions for “maximum employment”. Based on those scenarios, we calculate that average monthly nonfarm payroll growth of 602k to 733k is required to reach “maximum employment” by June 2022. Conversely, average monthly payroll growth of only 379k to 455k is required to reach “maximum employment” by December 2022. We see the latter as easily achievable and the former as more of a stretch. On the topic of employment growth, it’s worth noting that both monthly nonfarm payroll growth and the prime-age labor force participation rate were dragged down by the spread of the Delta variant during the past few months (Chart 4). With new COVID cases falling, we should see stronger payroll growth and a higher prime-age part rate in the months ahead. Relatedly, falling COVID cases will also help alleviate some the constraints on labor supply as workers grow less fearful of the virus and more confident about re-entering the labor force. This will not only push prime-age participation higher, but it will also take some of the sting out of wage growth. Wage growth has been extremely high recently as the number of job openings has far outpaced the number of new hires (Chart 5). Fading COVID fears should increase the pace of hiring and slow wage growth. This will give the Fed even more confidence that it should stay the course. Chart 5Peak Wage Growth? The Inflation Expectations Trigger Chart 6Inflation Expectations Are Well-Anchored We noted above that the Fed would abandon its “maximum employment” liftoff condition if long-dated inflation expectations rose to uncomfortably high levels. Specifically, we like to track the 5-year/5-year forward TIPS breakeven inflation rate relative to a target range of 2.3% to 2.5% (Chart 6). As long as the 5-year/5-year breakeven rate stays within that range or below, the Fed will be guided by its “maximum employment” goal. However, if that rate were to break above 2.5% for a significant period of time, the Fed would be sufficiently worried about an expectations-driven inflationary spiral that it would abandon its “maximum employment” trigger and bring forward the liftoff date. We don’t expect to see a breakout above 2.5% in the 5-year/5-year forward TIPS breakeven inflation rate anytime soon. The rate has stayed well contained throughout the past few months even as inflation skyrocketed. It would be strange for it to suddenly spike after inflation has already peaked.4 Bottom Line: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Treasury Market Positioning For A December 2022 Liftoff To determine how we should position within the Treasury market, we translate our above views on the timing of Fed liftoff into fair value estimates for different segments of the Treasury curve. Specifically, we assume a scenario where the Fed starts hiking in December 2022 and then lifts rates at a pace of 100 bps per year until reaching a terminal rate of 2.08%. That 2.08% terminal rate is based on an expected target range of 2%-2.25% that is inferred from responses to the New York Fed’s Surveys of Market Participants and Primary Dealers. We assume that the effective fed funds rate will trade 8 bps above the lower-bound of its target range, as it does currently. Table 1 shows expected 12-month total returns for each Treasury maturity, assuming the market moves to fully price-in our expected funds rate path during the next year. Table 1Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.08% Terminal Rate The first observation that jumps out is that, except for the 2-year and 20-year maturities, expected Treasury returns are negative across the board. This justifies sticking with our recommended below-benchmark portfolio duration stance. Second, our expectation that liftoff will be delayed relative to current market expectations gives the 2-year note slightly better expected returns, particularly relative to the 10-year note. As a result, we advise investors to hold 2/10 yield curve steepeners. Specifically, investors should go long the 2-year note versus a duration-matched barbell consisting of the 10-year note and cash. Third, the 20-year bond looks to be priced cheaply on the curve. It offers expected 12-month returns of +79 bps while the 10-year note and 30-year bond are both projected to lose money. We recommend taking advantage of this situation by going long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This proposed trade offers positive carry of 20 bps (Chart 7). Further, the 10/20 slope is stuck in the middle of where it was on the 2015 and 2004 liftoff dates (Chart 7, panel 2). The 20/30 slope, meanwhile, is inverted and well below where it was on the 2015 and 2004 liftoff dates (Chart 7, bottom panel). Our 20 over 10/30 trade will profit as the 20/30 slope re-steepens, even if the 10/20 slope doesn’t move that much. Chart 7Buy 20s Versus 10s30s It could be argued that our recommend trades are all predicated on a fed funds rate scenario that embeds too low of a terminal rate. In fact, the median projection of FOMC participants would place the terminal rate closer to 2.5% than to 2%. If we alter our scenario by increasing the terminal rate assumption from 2.08% to 2.58%, it only improves the outlook for our recommended positions (Table 2). Table 2Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.58% Terminal Rate In the new scenario, expected Treasury returns are more negative – especially at the long-end. However, the 2-year note is still expected to earn a small profit. Our 20 over 10/30 trade performs slightly worse in this second scenario compared to the first one (+1.79% versus +1.95%), but it is still expected to make money.  TIPS Chart 8A Lot Of Upside In Short-Maturity Real Yields We have one final government bond recommendation based on our expectation that Fed liftoff will be delayed until December 2022. That trade is to go short 2-year TIPS. Alternatively, investors could enter 2/10 inflation curve steepeners or 2/10 real yield curve flatteners. Our base case economic outlook is that supply side constraints (both in global supply chains and in the labor market) will loosen during the next 12 months. This will push down short-dated inflation expectations while long-dated inflation expectations stay relatively close to the Fed’s target. If we assume that both the 2-year and 10-year TIPS breakeven inflation rates trend towards the middle of the Fed’s 2.3% to 2.5% target range during the next 12 months and that the nominal 2-year and 10-year yields follow the paths predicted by the fair value scenario presented in Table 1, then we see that the 2-year real yield has a lot of upside (Chart 8). This is true both in absolute terms and relative to the 10-year real yield. We advise investors to short 2-year TIPS outright. Alternatively, 2/10 inflation curve steepeners or 2/10 real yield curve flatteners will also perform well during the next 12 months. Bottom Line: We suggest four different ways that bond investors can profit from the Fed delaying liftoff until December 2022. Investors should keep portfolio duration low, enter 2/10 nominal curve steepeners, buy the 20-year T-bond versus a 10/30 barbell and short 2-year TIPS.  Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 62.7%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +455k in order to hit “maximum employment” by the end of 2022. Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. Chart A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 2 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf 3 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 4 For more details on our inflation outlook please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Rate Hikes Are Coming – O/W Banks And Small Caps: Rampant inflation is changing investor expectations on the timing and speed of rate hikes. At present, the market is pricing in three rate hikes in 2022. Overweight sectors that outperform in a rising rates environment. Shortages Of Goods – O/W Semis: Overweight industries which are upstream in the supply chain, such as semiconductor manufacturers. They enjoy strong pent-up demand and significant pricing power. Transportation Bottlenecks – O/W Airfreight, Road And Rail: While skyrocketing transportation costs are a boost for most, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Pent-Up Demand For Services – O/W Travel Complex: The ISM PMI Non-Manufacturing composite reading indicates that demand for services still exceeds demand for goods. Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services. Underweight Airlines for now. US Consumers Are Feeling Poorer – This Will Weight On Profits: Real wages are not keeping up with prices, erasing American consumer purchasing power, thus putting a lid on corporate pricing power. This will hurt profits in the Consumer Discretionary sector, in addition to causing broad-based margin compression. Fundamentals Are Strong For Now: Companies delivered blockbuster Q3 2021 earnings results and peak margins. However, an unusually high percentage of companies (52.6%) were guiding lower. Rising labor costs, reduced productivity, and loss of corporate pricing power will lead to margin compression as early as 2022. Strong Equity Inflows Into Year-End: Late-in-year catchup pension contributions translate into strong inflows into US equities after the early fall hiatus. Buying on dips still offers downward protection from a major market pullback. Buybacks vs Dividends: Share buybacks are on the rise, seemingly displacing dividends as a means of returning cash to shareholders. For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Reiterating Investment Positioning Overarching Macroeconomic Themes Rate Hikes Are Coming Taper Tantrum 2.0 rotation is running its course: Sectors and styles most adversely affected by rising rates, such as Consumer Staples, Communications, Services and Health Care have underperformed in October (Chart 1), while cyclicals, geared to rising rates, have outperformed. Growth/Technology has benefited from recent rate stabilization. Chart 2Market Is Pricing In Three Rate Hikes in 2022 Market now expects three rate hikes by the end of 2022: Rampant inflation is changing investor expectations on the timing and the speed of rate hikes. A month ago, the probability of two rate hikes in 2022 stood at around 55%. Now, the probability of three rate hikes is roughly 64% (Chart 2). The BCA house view is that the Fed will raise rates once in December 2022 – an outlook much more temperate than the market’s. Investment Implication: Banks, Small Caps and Cyclicals outperform in a rising rates environment (Table 1). Table 1Recent Performance Of Sectors In A Rising Rates Regime Shortages Of Goods   Shortages are ubiquitous. How do we make money from this theme? We choose industries that are positioned upstream in the supply chain; for example, we prefer Semis to Durable Goods (Chart 3). Manufacturers of chips face strong demand and significant pricing power, while durable goods manufacturers face shortages and have to pass higher input costs on to their customers, which constrains demand and sales growth. Of course, there is also another aspect contributing to the underperformance of durables: Purchases of goods have exceeded the pre-pandemic trend and turned. Over the past three months, semis outperformed the S&P 500 by nearly 5%, while durables underperformed by 12%. Investment Implication: Stay overweight Semiconductors and Semiconductor Equipment, underweight Durable Goods (Table 2). Chart 3Demand for Chips Is BoomingTable 2Sectors Affected By Shortage: Recent Performance Pent-Up Demand for Services The ISM Non-Manufacturing PMI for October has come in at a record 66.7 (62 expected) (Chart 4A), and new orders are soaring at 70. These readings exceed the ISM Manufacturing PMI (60.8), suggesting that demand for services still exceeds demand for goods. Furthermore, spending on services is still below pre-pandemic levels, and the rebound is running its course (Chart 4B). We conclude that our “pent-up demand for services” investment theme still has legs. Chart 4AISM Services Is Soaring Chart 4BStill Strong Pent-up Demand For Services Investment Implication: Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services (Table 3). Stay away from Airlines for now. Table 3Travel Complex: Recent Performance Transportation Bottlenecks Shipping costs continue their ascent (Chart 5). Over 100 ships are currently anchored in LA/Long Beach ports compared to almost immediate unloading before the pandemic. While rising transportation costs are denting the profit margins of a wide range of companies, from retailers to manufacturers, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Case in point: A.P. Moller-Maersk, the world’s largest boxship operator, delivered $5.44B in quarterly profits last week – doubling its entire 2020 income, on the heels of the unprofitable years of 2018 and 2019.1 Profits of other freight operators are also surging. Investors take notice: After a stretch of underperformance, the S&P 500 Transportation Index outperformed the S&P 500 by 6.55% in October. Chart 5Shipping Costs Still Exorbitant Investment Implication: Continue overweight of Transportation Services, specifically Air Freight and Logistics, and Road and Rail (Table 4). Table 4Transportation: Recent Performance US Consumers Are Feeling Poorer Consumers are right to worry about inflation: Nominal wages increased by 4.5% Year-on-Year in October, the highest reading over the past 40 years. However, real wage growth is negative, i.e. it is not keeping up with prices, erasing American consumers’ buying power (Chart 6). According to a Gallup survey, upticks in citations of the deficit and inflation are largely responsible for an increase in mentions of any economic issue – from 16% in September to 24% in October.2 According to the Conference Board survey, consumers expect prices to rise by 7% over the next 12 months. Loss of purchasing power is bound to dampen consumer demand, as we have seen with demand for Consumer Durables and Autos which has collapsed due to shortages and sky-high prices. Corporate pricing power is waning: As a result of pressures on consumer purchasing power, US producers are reporting that they find it harder to raise prices. Looking ahead, companies will have to absorb price increases (Chart 7). Chart 6Wage Increases Are Not Keeping Up With Inflation Chart 7Corporate Pricing Power Is Waning Investment Implication: Erosion of consumer pricing power will eventually harm the Consumer Discretionary sector and will lead to a broad-based margin compression. Fundamentals Peak margins are here: The confluence of rising wages, falling productivity, and reduced ability to raise prices translates into an impending margin squeeze. We forecast that the year-over-year margin change will be negative in 2022 (Chart 8). The Q3 2021 earnings season delivered blockbuster results so far with roughly two-thirds of the companies reporting, and results are striking. 83% of companies have beaten the street expectations with the average earnings surprise standing at 11% (Chart 9). Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25%, exceeding an expected 6% contraction. Compared to Q3 2019, EPS CAGR is 12%. These results indicate that street expectations were a low bar to clear. Forward guidance is concerning: Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. Most companies have navigated a challenging economic environment swimmingly so far. However, looking ahead, waning pricing power, falling productivity, and rising costs will weigh on profitability. These factors are the ubiquitous reasons for negative guidance: 52.6% of companies are guiding lower for Q4 2021 (compare that to 32.7% in the previous quarter). Investment Implication: It is likely that the Q4 2021 earnings season disappoints. Sentiment Strong inflows into US equities after early fall hiatus. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines, which many retail investors aim to park in US equities (Chart 10). Furthermore, historically, November and December have been characterized by robust equity inflows: Retail investors wait until the end of the year to reach clarity on their financial situation and to allocate funds to 401Ks, IRAs, and 529s. Investment Implication: Buying on dips still offers downward protection from a major market pullback. Chart 10Strong Inflows Into US Equities: Buying On Dip Is Still En Vogue Uses Of Cash Buybacks Replace Dividends: Share buybacks are on the rise again (Chart 11, Panel 1), seemingly displacing dividends as a means of returning cash to shareholders: The dividend payout ratio is flagging (Chart 11, Panel 2). From a corporate standpoint, dividends require a long-term commitment, while buybacks can be a “one-off,” lending more flexibility to corporate treasurers. Corporations also prefer buybacks as they reduce their share count and inflate earnings per share. Investment Implication: For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Chart 11Buybacks Are Replacing Dividends   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuation And Technicals Chart 19Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals     Small Vs Large Chart 23Macroeconomic Backdrop Chart 24Profitability   Chart 25Valuations and Technicals Chart 26Uses Of Cash       Footnotes 1     WSJ, Supply-Chain Pain Is Maersk’s Gain as $5.44 Billion Profit Dwarfs Amazon, UPS, November 2, 2021. 2     Job Market Ratings Set Record, but Economic Confidence Slides (gallup.com), October 27, 2021.   Recommended Allocation