Economy

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Biden Can Take Risks Ahead Of Midterms News reports suggest House Speaker Nancy Pelosi will travel to Taiwan and meet with Taiwanese President Tsai Ing-wen in the coming days. China has promised military counter-measures if she visits. Structural factors suggest US-China tensions over Taiwan could explode: China’s reversion to autocracy and hawkish foreign policy, Taiwan’s assertion of autonomy, and the US’s political instability and foreign policy reactiveness. Cyclical factors also suggest that tensions could escalate: China’s instability in the wake of Covid-19, the ramifications of Russia’s invasion of Ukraine, the budding Russo-Chinese alliance, the Biden administration’s domestic political vulnerability, and the Xi administration’s domestic political vulnerability. In particular, Xi cannot back down. A diplomatic crisis or military showdown is likely in the short run but not yet a full-scale war. Taiwan is harder to invade than Ukraine, the US is not attempting a radical boost to Taiwan’s military, Taiwan is not moving toward formal independence, and the Chinese economy is not yet collapsing beyond all hope. However, over the long run we fear that a Taiwan war is more likely than not. Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Investors should short Chinese and Taiwanese currencies and assets. Tactical Recommendation Inception Date Return LONG US SEMICONDUCTOR & SEMI EQUIPMENT / TAIWAN EQUITIES 2022-06-23 14.6% LONG KOREA/ SHORT TAIWAN EQUITIES 2020-03-27 -23.5% Bottom Line: Tactically investors should buy safe-haven assets and await a resolution of the US-China confrontation over Taiwan, which could cause a dramatic escalation in strategic tensions. Feature A fourth Taiwan Strait crisis is likely upon us. Speaker of the US House of Representatives Nancy Pelosi will visit Taiwan during her travel around Asia Pacific this week, according to the Wall Street Journal on August 1. Chinese President Xi Jinping warned US President Joe Biden in a phone conversation on July 28 that “those who play with fire will eventually get burned,” referring specifically to US relations with Taiwan. Chinese foreign ministry officials have threatened “forceful” countermeasures if Pelosi visits the island, explicitly saying that the People’s Liberation Army would respond in some way.   There is still some uncertainty over whether Pelosi will go. She delayed the trip in April. Rumors emerged over July that she would resume but President Joe Biden suggested on July 20 that US military officials opposed the trip, believed the timing to be inappropriate. Taiwan was not mentioned in Pelosi’s official itinerary published on July 31, which includes Singapore, Japan, South Korea, and Malaysia. But the Wall Street Journal report has been corroborated by US and Taiwanese officials. Assuming Pelosi goes, China will respond with some military show of force. The US may pretend that one hand (the White House, the Department of Defense) does not know what the other hand is doing (the House of Representatives). But China will not be convinced. There are three major reasons that we have predicted a fourth Taiwan Strait crisis: 1.   China’s reversion to autocracy and foreign policy hawkishness: After the Great Recession, China was forced into a painful downshift in potential economic growth, stemming from a contracting labor force, excessive debt, and changes in the international economy (Chart 1). As economic growth has slowed, China has pursued political centralization, economic mercantilism, military modernization, and foreign policy assertiveness, offering nationalism as a distraction from the disappointments of the new middle class. While China may not be ready to launch a full-scale invasion of Taiwan, it is willing to do so if the Communist Party regime’s survival is at stake. Chart 1China's Slowdown Leads To Hawkishness 2.   Taiwan’s reassertion of autonomy: Taiwanese people began to sour on mainland China with the Great Recession and increasingly developed an independent identity (Chart 2). China’s growing economic influence, combined with Xi Jinping’s re-centralization of power across Greater China, provoked a backlash in Taiwan beginning in 2013 that culminated in the nominally pro-independence Democratic Progressive Party gaining full control of the island in 2016. The US-China trade war, China’s imposition of control over critical buffer spaces (including the South China Sea and Hong Kong), and US export controls on advanced technologies thrust Taiwan into the middle of a strategic confrontation. While Taiwan is not seeking war or formal political independence, it is seeking closer ties with the US and democratic allies to protect against Beijing’s encroachment.     3.   US political instability and foreign policy reaction: The Great Recession brought the US’s latent political instability from a simmer to a boil. The Washington establishment withdrew from the war on terrorism only to face discontent at home and strategic competition from China and Russia. China intensified its acquisition of US technology while North Korea obtained a nuclear arsenal under China’s watch. A surge in populism led the US to initiate a trade war against China and to impose restrictions on critical technologies to slow China’s modernization. While the US political factions bickered over domestic policy, they both tapped into a popular consensus on economic nationalism and hawkishness toward China (Chart 3). While the US is struggling to curb Russia and Iran, its greatest long-term challenge stems from China and it is increasingly focused on containing China’s economy and strategic ambitions. Chart 2Taiwanese Souring On China Chart 3US Hawkish Consensus On China In addition, there are important cyclical reasons why investors should take very seriously the risk of a major geopolitical crisis emanating from Taiwan in the short run: The Covid-19 pandemic intensified US (and global) distrust of China and accelerated the divorce of the US and Chinese economies. It also threw the Chinese economy into a downward spin, threatening Xi Jinping’s personal security and the Communist Party’s regime security. Hypo-globalization reduces critical economic constraints on military conflict. The Ukraine war highlighted the willingness of ambitious strongman regimes to go to war to prevent neighboring countries from allying with the United States. Taiwan is critical to Chinese security just as Ukraine is critical to Russian. Taiwan, like Ukraine, lacks a mutual defense treaty with the US and yet is attempting to create a de facto treaty through political, economic, and military cooperation – a scenario that will incentivize Chinese military action if it ever believes the US will take irrevocable steps to increase its commitment to defend Taiwan. At the same time, the US will try to deter China more effectively, since its deterrence failed in the case of Ukraine, which entails upgrading the Taiwanese relationship. Hence China will feel threatened and accuse the US of altering the status quo. Russo-Chinese alliance prevents US-China reengagement. Russia threw itself into China’s arms by cutting off natural gas to Europe. China cannot reject Russia’s overture because it needs Russia’s alliance to break through American strategic containment in the coming years. China needs Russia’s natural resources and its cooperation in gaining economic access to Central Asia and the Middle East. The US cannot pursue strategic détente with China if China is allying with Russia, since a Russo-Chinese alliance poses an unprecedented threat to American global influence and security (Chart 4). The Democratic Party is desperate to mitigate looming election losses. President Biden’s approval rating has fallen to 39%, while headline inflation hits 9% and the economy slips into a technical recession. The Republican Party is lined up for a victory in the midterm elections, yet Democrats view the populist Republicans as an existential threat. Hence Biden and Democratic leaders like Pelosi are willing to take significant risks to salvage the election, including provoking foreign rivals. The administration is contemplating tougher export controls on China’s access to semiconductor manufacturing equipment and Congress is passing bipartisan legislation to make the US more competitive against China. Any major confrontation abroad would generate a patriotic rally among voters, as did the Cuban Missile Crisis in 1962, which saved the Democrats from heavy losses in the midterms that year (Chart 5). China’s domestic politics support a foreign confrontation. As Xi attempts to cement another five-to-ten years in power at the twentieth national party congress this fall, the pandemic restrictions, political repression, property bust, and economic slowdown ensure that he has little good news to celebrate at home. He could benefit from taking an aggressive stance against the imperialist Americans over Taiwan – and he cannot afford to back down or lose face. Ultimately China’s regime legitimacy is at stake in Taiwan so it is willing to take greater risks than the United States.   Chart 4US Cannot Engage With Russo-Chinese Behemoth Chart 5Biden Can Take Risks Ahead Of Midterms All of the above demonstrates that investors should not be complacent but should take risk off the table until the Pelosi trip blows over. A major diplomatic or geopolitical crisis will occur if Pelosi indeed visits Taiwan, for China will be required to react to uphold the credibility of its warnings, and Beijing will have a national and political interest in overreacting rather than underreacting. The Americans will then have a national and political interest in preserving their own credibility. This dynamic could lead to a major escalation in strategic tensions. Could a crisis lead to full-scale war? Yes it could but most likely it will not – at least not yet. Here are some important limitations, which investors should monitor closely. If these are reduced or overcome, then a larger conflict becomes more probable: Taiwan is harder to invade than Ukraine. Taiwan is an island and islands that are politically unified can only be subdued with enormous cost of blood and treasure even by the most powerful armies. Taiwan is critical to the global economy, unlike Ukraine. While it lacks defense treaties, it has stronger strategic partnerships than Ukraine did. The Chinese military has not fought an expeditionary war since Vietnam in 1979. The US sent aircraft carriers to the Taiwan Strait in each of the previous three crises since the 1950s, signaling that it is willing to defend Taiwan, and currently has at least two aircraft carriers in Asia Pacific (Map 1). China needs to be prepared for potential American and Japanese intervention if it is to attack Taiwan, which requires an advanced triad of nuclear arms.    Map 1US Aircraft Carriers Suggest Taiwan Risk Is Substantial The US is not sending any game-changing offensive weapon systems. Instead the US is sending a mere politician. China opposes anything resembling state-to-state relations but Taiwan’s defensive capability would not be improved. Hence China would not be forced to take aggressive military action. Instead China is attempting to set a very low bar for intervening in US-Taiwan political relations. Beijing can intervene in a way that enforces the new line but remains beneath the threshold of war. Going forward, US arms sales to Taiwan will be a much riskier affair and the delivery of a weapons system could trigger conflict (Chart 6). Chinese economy is not (yet) beyond help. China still has authoritarian powers to manipulate the domestic economy, suggesting that policy makers will intervene to slow down the property bust and stimulate activity. After Xi Jinping consolidates power, we expect a pro-growth strategy to be unveiled that will lead to a stabilization of growth in 2023. This is necessary for Xi to maintain domestic stability, which is existential to the regime and its long-term security. If stimulus and interventions fail utterly and China collapses into a full-blown financial crisis, then China will lose the ability to improve its security over the long run and the risk of conflict with foreign powers will rise. But as long as China’s economy is not collapsing, China maintains the prospect of building its influence and power over time and conquering Taiwan through absorption rather than extremely risky armed conflict (Chart 7). Chart 6US Arms Sales Could Trigger A Real Conflict Chart 7More Economic Stimulus Is Coming Taiwan is not moving toward formal independence. The Tsai Ing-wen administration is nominally in favor of independence but has chosen rhetorical sleight of hand over any formal change to Taiwan’s status. Taiwanese people support the status quo knowing that they will live in a war zone if they declare independence. The long-term problem stems from the fact that a clear majority opposes unification with the mainland (Chart 8). Taiwan and the US face elections in 2022 and 2024. If the Kuomintang stages a comeback in Taiwanese politics, or the Democrats win reelection in 2024, then China still has the ability to pursue its aims through diplomacy. Whereas if the Democratic Progressive Party remains in full control of Taiwan, and the Republicans regain the White House, Beijing may conclude that little can be gained through diplomacy. Especially if these US and Taiwanese parties proceed to press their interests aggressively. Chart 8Taiwanese Not Declaring Independence Hence the most likely outcome if Pelosi visits Taiwan is a US-China geopolitical crisis of some sort but not a full-scale war. A crisis short of war could establish a new set of red lines over Taiwan that could govern the US-China relationship in the medium term with reduced uncertainty. But it would bring very bad news in the short run and lead to a permanent deterioration in US-China relations and global stability over the long run, which markets must price first.   Bottom Line: Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Stay short Chinese and Taiwanese currencies and assets. While semiconductor stocks stand at risk, investors should favor US semiconductor companies over Chinese and Taiwanese (Chart 9). Chart 9Investors Should Seek Safe Havens Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Dear client, There will be no regular bulletin from the European Investment Strategy team next week to allow us to take some time off. We will return to our regular publishing schedule on August 15, 2022. Kind regards, The European Investment Strategy team   Executive Summary Global Headwinds For Europe Ahead of our summer break, we review our EIS main themes for the remainder of the year. We expect European growth to be poor in the latter half of 2022, but a recession toward the new year will be shallow. European inflation is set to crest in the fall. While the ECB will only modestly underwhelm the current €STR curve pricing, the TPI will be activated. European equities have entered a bottoming process, but cyclicals will continue to underperform defensive equities in the short-term. European investment grade credit is more attractive than local equities and US investment grade debt. The euro is also in a bottoming process, but near-term downside risk remains considerable. Bottom Line: European stocks are in the process of forming a bottom; yet, the economic softness will prevent cyclical shares from outperforming their defensive counterparts. Additionally, European IG debt offers more attractive risk-adjusted returns than equities in the near-term. Finally, the euro still faces potent front-loaded headwinds, despite a seductive long-term outlook.   The month of August is starting, which often corresponds to a period of lower volumes on the markets, since a large percentage of the financial industry goes on vacation for the summer. This year, those vacations are even more merited than usual, as the first seven months of the year have been particularly tumultuous. Chart 1Deteriorating European Growth So far, the European economy has experienced a rare set of consecutive shocks. First, inflation has jumped to its highest level since the euro was introduced 23 years ago. This inflationary shock, however, does not reflect booming demand, as it is accompanied by a sharp economic growth slowdown and thus has a strong connotation of stagflation. PMIs have fallen below the 50 boom/bust line and the growth expectations component of the Ifo survey is now firmly at recessionary levels (Chart 1). Ultimately, what Europe faces is an inward shift in the supply curve caused by a sudden curtailment of energy flows from Russia. Chart 2A Tough First Half of 2022 Second, and largely because of this inflationary shock, the policy backdrop is in upheaval. On July 21, 2022, the ECB increased interest rates for the first time in eleven years and delivered its first 50 bps hike in more than two decades. At last, negative interest rates are not the determinant feature of Eurozone rates. Yet, despite the end of this longstanding policy distortion, the euro cannot catch a break and has tested parity. Meanwhile, German yields hit 1.9% in June, inflicting a YTD loss of 13% on their holders, and Italian spreads have blown up, raising the specter of financial fragmentation in Europe (Chart 2). Third, the environment has also been rough for equity investors. The pan-European Euro STOXX and the Eurozone Euro STOXX 50 have entered into bear markets, falling 23% and 24% respectively from their January 5 peak to their trough on July 5, 2022 (Chart 2, bottom panel). At this juncture, we will review our main themes for the remainder of the year, which also gives us an opportunity to align our recommendations with our core views.  Key Views For The Remainder Of The Year We continue to expect European growth in the latter half of the year to be weak, probably around 0%. Too many hurdles are mounting. We continue to witness signs that global growth is deteriorating. The slowdown in manufacturing activity is not a phenomenon unique to Europe. Global inventories are rising in the manufacturing and retail sectors, which is likely to reduce global industrial production in the coming quarters. As a result, global trade and European exports are set to weaken further (Chart 3). Moreover, the global credit impulse is contracting rapidly in response to tightening monetary conditions. This, too, will weigh on global trade, and thus, on export-oriented nations like Europe. Chart 3Global Headwinds For Europe Chart 4Households Aren't Alright Inside Europe, the household sector’s malaise is deepening further, as highlighted by crashing consumer confidence (Chart 4). This degeneration reflects the hit to real income caused by elevated inflation, but it has been compounded by rising borrowing costs and falling financial asset prices. Chart 5Running Out Of Gas Meanwhile, the risks from the energy market remain most salient and could even force a contraction in output somewhere between Q4 2022 and Q1 2023. Russian natural gas flows are minimal and are unlikely to rebound enough to allow for the hoped-for build-up in natural gas inventories by the winter (Chart 5). As a result, to keep the lights on, European countries will have to rely on a combination of coal power and energy cuts. Nonetheless, BCA’s commodity and energy strategists estimate that the 14GW of coal-fired generation capacity announced so far and the 15% cut in demand pushed by the European Commission will allow Europe to limp along this winter and avoid the nightmare scenarios delineated by the Bundesbank four months ago.   Ultimately, we expect European economic activity to rebound rapidly in the second quarter of 2023. European governments will not sit idly by when their economies are suffering from a major drag caused by a conflict. Households and the sectors that will be most affected by energy rationing (industrials, such as chemicals and cement) will receive help. Thus, fiscal policy will remain accommodative. Moreover, any production curtailed during the winter will be postponed, which means that activity will likely rebound sharply once the weather warms up. On the inflation front, we continue to see a peak in inflation in the coming months. Commodity inflation is peaking and supply-side constraints are ebbing, which will lessen overall inflation (Chart 6). Additionally, the current weakening demand in Europe, tighter financial conditions, and slowing money supply growth are all consistent with a slowdown in inflation (Chart 7). Chart 6Weaker Commodity Inflation Chart 7Domestic Conditions Becoming Disinflationary Regarding monetary policy, the ECB wants to hike — and hike it will. Our base case scenario calls for a 50bps hike in September, but risks are skewed to the downside because of the weakening economic activity. We also expect two 25bps interest rate increases in October and December, which is somewhat under the €STR curve pricing, but only marginally so (Chart 8). However, we do expect the Transmission Protection Instrument (TPI) to be activated in the fall to facilitate higher policy rates because of the vast difference in r-star between Germany and the periphery.  Chart 8A Tad To High For government bonds, since we foresee a small dovish surprise by the ECB as well as lower inflation, we anticipate slightly more downside for German Bund yields for the rest of the year. Italian government bonds remain risky in the near-term as market participants test the ECB’s resolve regarding the TPI and Italian politics remain in a state of flux. However, the eventual ECB purchases render them an attractive bet in medium- to long-term portfolios. Despite the slowdown in activity, European equities have already entered a bottoming process. They are cheap and their multiples are already consistent with deep stagflation fears (Chart 9, top panel). Moreover, earnings revisions are already contracting (Chart 9, bottom panel). The collapse in the euro, however, is providing a potent counterweight to economic weaknesses and is allowing European firms to beat analyst expectations. This positive view on the aggregate stock level does not translate yet into an overweight stance on cyclical equities versus defensive ones. Lower inflation and potentially lower global yields help defensive stocks, not cyclical ones. Meanwhile, the Chinese economy continues to struggle with the impact of Beijing’s zero-COVID policy and the disarray in the housing market. These forces suggest that European cyclicals could suffer further underperformance in the coming months (Chart 10), especially if European activity and global trade remain under stress. Additionally, the risks caused by the energy market will continue to warrant a discount in European cyclical equities. Chart 9The Bottoming Process For Stock Has Begun Chart 10Cyclicals Are Still Handicapped Chart 11IG Prices In A Recession Already European credit, especially investment-grade corporate, offers more appealing risk-adjusted returns than equities. Valuations in the IG space are clearly discounting a severe recession, with the 12-month breakeven spreads in their 80th historical percentile (Chart 11). Meanwhile, the combination of shallower than-once-feared recession with continued fiscal support and further ECB buying will help spreads narrow. As a result, we continue to favor IG to increase risk exposure in Europe. We also favor European IG debt over their US counterparts, especially on a USD hedge basis. The euro remains at a complex juncture. As we wrote three weeks ago, EUR/USD is increasingly attractive for long-term holders. It is cheap and a turnaround in growth next year will help this pro-cyclical currency. However, in the near-term, the euro must cope with the negative impact of China’s growth weakness, Europe’s more pronounced recession risk relative to the US, and the evolving threat of a severe energy crunch. As a result, we continue to see a very fat left tail in EUR/USD in the near-term and prefer the CHF to other European currencies as a vehicle to garner exposure to Europe. Bottom Line: European growth will remain challenged in the near-term, but a severe recession will be avoided. With inflation also peaking this fall, European stocks are in the process of forming a bottom; yet, economic softness will prevent cyclical shares from outperforming their defensive counterparts. Additionally, European IG debt offers more attractive risk-adjusted returns than equities in the near-term. Finally, the euro still faces potent front-loaded headwinds, despite a seductive long-term outlook. Consequently, investors should favor the CHF to gain exposure to European currencies. House Cleaning We take this opportunity to restate our view for the remainder of the year, and to clean up our recommendation and focus on those most aligned with the aforementioned views. The trades from our rotation framework are not impacted, as they are not linked to our key views. Tactical Trades We keep the following tactical trades on the books: Neutral stance on cyclicals relative to defensives: This trade is aligned with our worries that weak global growth will continue to hurt the performance of cyclical equities. Long German / short Italian industrials: This is an uncorrelated trade that benefits from the extreme valuation discount of German industrials relative to their southern counterparts. Moreover, the German economy is faring better than that of Italy, while German financial and monetary conditions are looser than those in Italy. Long Swiss equities / short Eurozone defensives: This is another uncorrelated trade. Swiss stocks are pricey and defensive. However, they are less exposed to the energy rationing this winter than their Eurozone counterparts. Moreover, this position is an implicit bet on a weaker EUR/CHF. Long / short basket based on Combined Mechanical Valuation Indicator: This is another uncorrelated trade, based strictly on the most extreme signals from our CMVI methodology. It is a risk averse approach that focuses on buying assets discounting the worst outcome and buying those pricing in some excessively optimistic scenarios. Short European tech firms / long European healthcare shares: This is a defensive trade that seeks to avoid taking a directional bet on the performance of high duration stocks relative to the market. It corresponds to our worry about cyclicals relative to defensives Combined Mechanical Valuation Indicator Top 20: This position is similar to our country-selected CMVI trade, but here, it picks the most extreme signals in terms of valuation among 2,000+ sectoral trades across nine European countries. Short European consumer discretionary / long telecom services: This is another defensive trade that is supported by valuations and that benefits from the negative impact on real household income of inflation. It will also gain if energy prices additionally increase and further hurt discretionary spending. Overweight Spanish and Italian bonds: This position has now become a cyclical bet. Italian and Spanish bonds could suffer some additional near-term volatility; however, the upcoming activation of the ECB’s TPI will cause these spreads to widen, offering investors the opportunity to enjoy a much higher yield than Bunds and capital gains as well. Long Eurozone Investment Grade corporate: We are moving this position to become a cyclical trade. It is a direct bet on our positive stance on European IG corporates. Sell EUR/JPY: This trade is a play on the near-term downside risk to the euro. Cyclical Trades: We keep the following cyclical trades on the books: Underweight French consumer discretionary stocks relative to the French equity benchmark: The overbought and expensive status of the entire French stock benchmark comes from the consumer discretionary sector. These stocks are treated as growth stocks; however, the decline in global consumer confidence is historically associated with a vanishing premium for this sector. Long Swedish Industrials / short Eurozone and US industrials: This is a sector neutral trade that avoids overexposure to cyclicals. Instead, it takes advantage of the fact that Swedish industrials have a higher return on assets and profit margins than that of their competitors in the Eurozone and the US. Moreover, the SEK is particularly cheap, which boosts the competitiveness of Swedish industrial equities. Favor Eurozone aerospace & defense stocks relative to the benchmark: Defense stocks are our favorite sector at the moment. They benefit from both European re-armament and from the need for power projection in a multipolar world. Favor Eurozone aerospace & defense stocks relative to industrials: Industrials are likely to see their valuation premium diminish once inflation recedes. They currently trade as an inflation hedge because of their comparatively robust pricing power. Meanwhile, defense equities benefit from the structural tailwind described above. Favor Spanish over Italian equities: Spain’s competitiveness has improved considerably relative to the rest of the Eurozone, notably relative to Italy. Importantly, Spain’s political risk is currently lower than that of Italy. Underweight German Bunds within European fixed-income portfolios: This trade is similar to our overweight stance on Italian and Spanish bonds. Overweight Gilts within European fixed-income portfolios: The British economy is weak, which constraints the ability of the BoE to push up rates as much as what is priced into the SONIA curve. Short EUR/SEK: This trade is being move to a structural position. The Swedish economy is more cyclical than that of Europe, but Sweden is less at risk than the Eurozone from Russia’s energy curtailments. Moreover, Swedish returns on assets are superior to those of the Euro Area, which is positive for the currency on a long-term basis. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Reporters at last week’s post-FOMC press conference were consumed by the prospect of a recession. Their questions about the economy echoed the analysts’ on bank earnings calls and Chair Powell’s answers echoed the CEOs’ and the CFOs’: while it has clearly slowed, it remains stronger than it would be in a recession. Although the Econ 101 definition of a recession – two or more quarters of contracting real GDP – is embedded in the public’s mind, the NBER’s recession criteria are more involved and do not appear as if they have yet been met. With a little over half of index constituents (~70% of market cap) having reported, S&P 500 earnings have surprised to the upside. Despite a rampaging dollar and a sharp backup in corporate bond yields, margins are down less than 60 basis points from 2Q21 and are unchanged from 1Q22. We are constructive on equities and credit over a three-to-twelve-month timeframe because we believe markets have priced in the impact of the next recession too soon. We expect the Fed will eventually induce a recession, but not for at least another year. Earnings Haven't Stumbled Yet Bottom Line: Continue to overweight equities in multi-asset portfolios with a twelve-month timeframe because markets have gotten ahead of themselves by selling off so sharply. A recession will not arrive before underweight investors judged on their relative quarterly performance are forced back into stocks. Feature And we thought investors were preoccupied with recession. The questions sell-side analysts asked on big bank earnings calls in mid-July revealed that the shadow of a recession loomed large in their institutional investor clients’ minds. The questions markets and economics reporters asked Chair Powell at his post-FOMC meeting press conference last week demonstrated that the media is positively obsessed with it. If it bleeds, it leads is no longer just the local TV newscast’s mantra. We have been trying to steer the discussion away from are-we-or-aren’t-we toward questions that we think are more productive for investors. How bad will the next downturn be? What is its current estimated time of arrival? Have markets under or overreacted to our best guess about severity and ETA, assuming the marginal price setter has a timeframe of twelve months or less? Are-we-or-aren’t-we is manifestly Topic A in the financial and general media, however, so the body of this week’s report is given over to why we think we are neither in a recession nor on the cusp of one. We will turn to financial markets and investment strategy in the concluding section. What Is A Recession? In Econ 101 three-plus decades ago, I learned that a recession was defined as back-to-back quarters of economic contraction as measured by real GDP. For all the time that has passed since, I remember that definition clearly. Apparently other graduates do, too, and the definition taught in central Virginia was the standard in Economics departments across the nation. Alas, life is more complicated than it seemed in those halcyon student days. Business cycle inflections are not always apparent to the naked eye and the NBER’s Business Cycle Dating Committee has been tasked with assessing when downturns are sufficiently deep, diffuse and persistent to constitute a recession. The committee monitors a broad range of indicators and moves deliberately, announcing its determinations only after enough subsequent data have arrived to support its assessment of peaks and troughs. For the six recessions since 1980, the committee has announced cycle peaks with an average lag of seven months and cycle troughs with an average lag of fifteen months (Table 1). Table 1Long And Variable Lags Equity and credit portfolio managers and analysts spend a lot more time on corporate earnings than GDP, so the recession debate would seem to be of interest mainly within the ivory towers of academia, think tanks and the bureaucracy. The topic is relevant for investors, however, because equity bear markets tend to coincide with recessions. As bear markets (Chart 1, light red shading) typically begin before NBER-designated recessions (gray shading) and always end before them, it is worth investors’ time to try to anticipate their onset. Since a significant portion of bear market drawdowns occur after the recession is deemed to have started, there is also value in the humbler (and more attainable) aim of recognizing a recession once it’s begun. Chart 1Bear Markets And Recessions Tend To Travel Together So Has It Begun? At the risk of sounding like Jay Powell before a skeptical pool of reporters, we do not think the economy is in a recession, primarily because the labor market is so strong. Recessions always follow one-third percentage-point increases in the three-month moving average of the unemployment rate, but it has yet to begin moving upward (Chart 2). Leading indicators like small business hiring intentions (Chart 3, second panel), temporary employment (Chart 3, third panel) and initial jobless claims (Chart 3, bottom panel) point to continued payroll expansion (Chart 3, top panel). The economy is unquestionably slowing, and labor demand will slow with it, but the record backlog of job openings (Chart 4, top panel) and unabated stream of job quits (Chart 4, bottom panel) suggest that the labor market has a sizable cushion that will allow it to endure a few blows. Chart 2Unemployment Has Not Turned Yet Chart 3The Employment Outlook Is Still Good ...​​​​​ Chart 4... As There Is Still A Shortage Of Workers Like Chair Powell, we would venture that the labor market’s cushion extends to the overall economy. We believe that households’ excess pandemic savings will buffer the largest component of aggregate demand from inflation pressures, though the eventual fate of those savings is hotly debated within BCA. Related Report  US Investment StrategyA Difference Of Opinion We expect that a meaningful share of the $2 trillion-plus that households have amassed will eventually be spent; our Counterpoint team does not. The matter is not yet settled, but we are encouraged that the savings rate dipped below its February 2020 level of 8.3% in the fourth quarter and has been less than 6% every month this year, reaching a low of 5.1% in June. If the savings rate is mean-reverting, and if households don’t circle the wagons en masse as they might if recession prophecies become self-fulfilling, households have quite a bit of catching up to do (Chart 5). If consumption continues to lead business investment in line with the empirical record, fixed investment should be able to keep its head above water. Even a downshift in consumption and investment ought to be enough to offset the modest fiscal drag that may ensue if gridlock becomes even more constraining after November’s elections, as our US Political Strategy colleagues expect, and keep the expansion going for a few more quarters. Chart 5These Squirrels Have Stored Up A Lot Of Nuts For The Winter Okay, But What About Earnings? S&P 500 earnings are where the rubber meets the road for investors. Befitting the one-step-forward, one-step-back course the macro data releases have followed, second quarter earnings have been mixed.1 In the aggregate, however, they’ve been solid, with the 56% of index constituents (~70% of market cap) that have reported so far beating earnings expectations by 5.2%. That’s in line with the typical underpromise-and-overdeliver earnings season theater but feels like a reprieve for investors who’ve been subjected to a steady drumbeat of recession talk. Profit margins have narrowed – earnings per share have grown 7.7% year over year, well shy of revenue per share’s 12.1% growth – but by less than expected, as the 5.2% earnings surprise has swamped the 1.6% revenue surprise. S&P 500 operating profit margins observed a tight range after the crisis before jumping by more than a percentage point when the top marginal corporate tax rate was lowered beginning in 2018 (Chart 6). They then made another percentage-point leap in 2021, as companies seemed to find another efficiency gear as they adjusted to the pandemic. The reasons for the pandemic leap aren’t clear – shrinking office footprints, lower utility bills and reduced travel and entertainment don’t seem like candidates to move the needle so far on their own – but according to Refinitiv, the owner of I/B/E/S, the definitive source for earnings estimates, it has persisted through the first two quarters of 2022.2 The contraction in real compensation since 2021 (Chart 7, second panel) has likely been the primary driver, but the backup in corporate bond yields (Chart 7, third panel) and the surging dollar (Chart 7, bottom panel) have been margin headwinds so far this year. Chart 6Profit Margins Remain Elevated Chart 7Falling Real Wages Have Been Great For Margins We expect that the interest expense and currency translation headwinds will largely disappear in the second half, leaving real wages as the critical swing factor. Our benign take on wages (from employers’ perspective) is not unanimously held within BCA and could be a crucial determinant of our more bullish recommendations’ outcome. Our view is predicated on an analysis of US labor relations history positing that employers have achieved formidable structural advantages over employees that cannot be unwound by a few years of a cyclical boost and one term of the determinedly labor-friendly Biden administration. Our interpretation runs counter to the prevailing view but we believe it is well supported and can provide a lengthy source bibliography for those inclined to check our work. Investment Implications There are no absolutes in financial markets. No asset is good or bad in itself; its merit is solely a function of its relative probability-adjusted risk-reward profile. The recession debate doesn’t matter much in itself; the key is whether this year’s market declines have gone too far in pricing in the severity, breadth, duration and proximity of the next downturn. We add proximity to the list of the NBER’s criteria because it is a critically important factor when most professional money managers, who exert outsize influence in setting prices, are judged on their relative quarterly and annual performance. We are not perma-bulls or attention-seekers. We are more bullish than our colleagues and the investor consensus purely because we think the equity market has gone too far in discounting the impact of a recession that we estimate will not begin before the second half of 2023 and may not be particularly deep in the absence of imbalances that make the real economy vulnerable to a metastasizing downturn. Inflation pressures have not been building unopposed across four presidencies (LBJ through Carter) while corporate management teams nearly indifferent to shareholder interests rolled over at the feet of the UAW and other formerly potent labor unions, entrenching the wage-price spiral. The Powell Fed has begun to hike the funds rate aggressively, but it will not have to smother the economy like the Volcker Fed to round up a fugitive inflation genie and force it back into the bottle. Chart 8It Is Not A Spiral When Prices Rout Wages Levered capital has not been cascading into commercial real estate for better than a decade to exploit tax loopholes which were closed by the 1986 Tax Act, leaving savings and loans holding the bag and imperiling a sizable swath of the banking system. Stocks are expensive and there are plenty of pockets of silliness, but financial markets have not replayed the dot-com mania, no matter how promiscuously the term "bubble" is applied or how thoroughly the post-crisis rise in asset values has driven Austrian School devotees up the wall. Malinvestment has not occurred on anything close to the scale of the subprime crisis, when lenders, ratings agencies, regulators, banks and investors collectively failed at their duties, spawning a global crisis. American households have modest debt loads and a mountain of savings. Nonfinancial corporations are well heeled after a frenzy of pandemic debt issuance at laughably favorable terms. The banking system is doubly and triply reinforced with the biggest banks hemmed in by excessive capital requirements and stifling risk limits. The economy is likely to be on a better footing at the start of the next recession than it has been in any of the recessions of the previous 40 years (ex-the flash COVID recession). Although he wouldn’t answer the question directly, we thought Chair Powell made it abundantly clear that the Fed is willing to induce a recession if that’s what it takes to bring inflation to heel. We ultimately think the Fed will have to squash the economy to get inflation back down to its 2% target, but we don’t think it will happen over the timeframe that matters to the institutional investor constituencies that have a huge say in setting marginal prices. That view is at risk if inflation does not show signs of peaking soon or if longer-run inflation expectations rise to uncomfortable levels. For now, neither has happened and the latest run of data did not break one way or the other. Final July long-run inflation expectations of 2.9% from the University of Michigan consumer sentiment survey were down from June’s final 3.1% reading and meaningfully below the 3.3% preliminary June false alarm that jarred the FOMC. The second quarter employment cost index grew by more than 1% for the fourth straight quarter, extending its nominal rise (Chart 8, top panel) even while it continues to contract in real terms (Chart 8, bottom panel). A growth shortfall is a threat as well, though it failed to materialize in second quarter earnings, forcing the S&P 500 to unwind some of the weak growth expectations it had already discounted. If our base-case scenario holds, more such unwinding is in store. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      As we worked on this report after Thursday’s market close, Amazon delighted investors, Apple pleased them and Intel, as per a barrons.com headline, “missed by a mile.” 2     Per Standard & Poor’s, the index’s operating margin fell by a percentage point in the first quarter. Though S&P has tended to define operating earnings less favorably than Refinitiv/I/B/E/S, the two series moved together directionally until 1Q22 and only Refinitiv’s data facilitates comparisons between past results and future expectations.