Equities

Highlights The combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency for the Fed to raise interest rates. The central bank’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, and it will move forward with a rate hike at its March meeting. We expect that the Fed funds rate will rise to 1% by the end of this year. The Fed’s asset purchase reductions will not have a direct impact on economic activity, but they could have an indirect effect by prompting a faster rise in US Treasury yields towards their fair value levels. The US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year, rather than by the end of 2022 as we previously expected. Part of the generalized rise in risk premia this month relates to the potential Russian invasion of Ukraine, but the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates. Rising long-maturity bond yields are being driven by the short end of the curve, which we see as a sign that the generalized selloff in the US equity market is uncalled for. Investors should buy the US stock market at current levels on a 6-12 month time horizon. It is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. A Russian invasion of Ukraine has become a likely event, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but investors should gird for a risk-off reaction over shorter-term time horizons. Omicron, The Supply-Side, And The Fed January was a poor month for the global equity market, which sold off 10% from its high at the beginning of the year. Chart I-1 highlights that in the US, the S&P 500 has now fallen below its 200-day moving average, in contrast to global ex-US stocks which have fared somewhat better in US$ terms. Equities have declined this month because of a combination of imminent Fed tightening and a geopolitical crisis, both of which we will discuss in detail below. On the pandemic front, the number of confirmed cases of COVID-19 has surged globally (Chart I-2), which is likely an underestimation of the total number of infections given capacity limits on testing in many countries. Panel 2 highlights that services PMIs fell sharply in January in several economies because of the Omicron wave, reflecting both renewed pandemic control measures in some countries as well as precautionary changes in behavior amongst consumers in countries where widespread “non-pharmaceutical interventions” (“NPIs”) were not reintroduced. Manufacturing PMIs, on the other hand, held up quite well, even in Europe where natural gas prices remain high. Chart I-1A Significant Correction In US Stock Prices Chart I-2Omicron Is Impacting Services, Not Manufacturing   Some positive signs have emerged from the hospitalization data in advanced economies, as they appear to be pointing to a cresting wave of patients with COVID-19 both in hospitals overall and specifically in intensive care units (Chart I-3). The evolution of the pandemic remains highly uncertain, and the development of new variants continues to remain a risk. But incoming data on hospitalizations, the rapid increase in the number of vaccine booster doses administered in many advanced economies, and the sheer speed at which the disease has recently been spreading all point to a possible imminent peak in the impact of the Omicron variant on the demand side of the economy – at least in the developed world. However, Chart I-4 highlights that there is no sign yet of a waning impact of the pandemic on the supply side of the economy. The chart shows that rising European natural gas prices are having less of an impact on our supply-side pressure indicator, but that the indicator remains flat excluding this effect. We noted in last month’s report that the Omicron variant posed a significant risk of more frequent or longer lockdowns in China, because of the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to provide any protection against contracting Omicron. Panel 2 of Chart I-4 highlights that shipping costs between China/East Asia and the west coast of the US have started to tick higher again, suggesting that the impact of ongoing lockdowns as well as mandatory quarantines and testing in key areas such as Shenzhen, Tianjin, Ningbo, and Xi’an may already be having an effect. Chart I-3Hospitalizations From Omicron Appear To Be Peaking Chart I-4Pandemic-Related Supply-Side Pressures Remain Severe   From the Fed’s perspective, a combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency to raise interest rates. The Fed’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, which is being partially driven by demand (even if supply-chain factors are also materially boosting global goods prices). Chart I-5The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year Chart I-5 shows that our inflation momentum model is signaling falling odds of 4% or higher core PCE inflation, but the model’s probability remains above the 50% mark. Thus, while it is possible that US inflation will soon peak in year-over-year terms, the Fed will move forward with a rate hike at its March meeting. For now, we believe that the Fed will move at a pace of four quarter-point rate hikes per year (regardless of how they are sequenced), suggesting that the effective Fed funds rate will rise to 1% by the end of this year. Quantitative Tightening And Financial Markets Investors continue to wrestle with the Fed’s recent hawkish shift and the implications that it may have for economic activity and financial markets. Investors are not just concerned about the pace and magnitude of Fed rate hikes, but also the potential impact of quantitative tightening as the Fed moves to slow the pace of its asset purchases over the coming few months. Chart I-6The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one In our view, investors should be more concerned with the former rather than the latter. Chart I-6 highlights the reason that investors were so focused on the magnitude of the Fed’s balance sheet during the first half of the last economic expansion. Panel 1 of the chart shows that the level of the S&P 500 correlated almost perfectly with the Fed’s total holdings of securities from 2008 to 2015. However, panel 2 highlights that this relationship broke down from 2016 to early 2020, only to correlate positively again as the Fed’s holdings of securities surged higher during the pandemic. To us, the experience of the past decade highlights that the correlation between the Fed’s balance sheet and the equity market is mostly a spurious one. The two are indirectly related; periods when the Fed’s security holdings increase reflect periods of monetary easing, which is typically positive for risky asset prices. But we do not agree that the impact of asset purchases on long-maturity bond yields can be effectively separated from the direct impact of changes in short-term interest rates, which are typically falling as the Fed’s balance sheet rises. In addition, asset purchases signal important information by the Fed about the future path of short-term interest rates when it changes the pace of its purchases. And finally, the 2016-2019 period strongly underscores that there is no direct link between Fed asset purchases and the stock market. It is possible that periods of rising Fed asset purchases are associated with a low government bond term premium or more dovish investor sentiment about the future path of interest rates than is projected by the Fed. If so, that could imply that the Fed’s asset purchase reductions will have some impact on financial markets over the coming months. Chart I-7 suggests that the term premium on 10-year Treasurys is no longer low, but these series are based on surveys of primary dealers and fixed-income market participants, and thus may not reflect the aggregate views of investors. Chart I-8 highlights that 10-year government bond yields are 40 basis points below the fair value implied by the Fed’s interest rate projections, and panel 2 highlights a similar conclusion based on a regression of the 10-year yield on the 2-year yield and 5-year/5-year forward CPI swap rates. Thus, it is possible that the Fed’s rapid reduction in the pace of its asset purchases will cause bond yields to converge quickly with these estimates of fair value, implying that the US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year rather than by the end of 2022, as we previously expected. Chart I-7Surveys Suggest The Term Premium Is No Longer Deeply Negative... Chart I-8...But 10-Year Treasury Yields Are Lower Than They Should Be The Stock Market, Interest Rates, And Value Versus Growth Chart I-9The US Equity Market Selloff Has Been Driven By Tech Stocks The fact that the global equity selloff had been concentrated in the US prior to the escalation in tensions over Ukraine reveals the root cause of the decline. Chart I-9 highlights that the Nasdaq has fallen more than the S&P 500, as have US growth stocks compared with value stocks. As such, the recent selloff in the stock market reflects some of the major themes that we presented in our 2022 annual outlook. We highlighted in our outlook, as well as several previous reports, that the relative performance of global growth versus value since the pandemic has been driven primarily by changes in valuation that could reverse if bond yields rose. Chart I-10 highlights that this is exactly what has occurred over the past month, which also explains the underperformance of US equities given how heavily-weighted the US market is toward broadly-defined technology stocks. However, the underperformance of US growth stocks has occurred within the context of a nontrivial decline in the overall US market, which was somewhat beyond our expectation. We anticipated a period of elevated financial market volatility in advance of the Fed’s first rate hike, and we warned investors that 2022 was likely to be a year of meaningfully lower total returns (mid-to-high single digits) compared with the past two years. The fact that equity multiples for growth stocks are falling in response to higher long-maturity bond yields is not surprising to us. But investors have punished both growth and value stocks as bond yields have risen, behavior that we do not think is justified given the large difference in valuation between the two. Chart I-11 highlights that our (standardized) proxy for the equity risk premium (ERP) is above its 2003-2021 average for value stocks, whereas it is quite low for growth stocks. Had the ERP for value stocks fallen to its historical average this month value stocks would have risen between 1-4% in January despite rising real 10-year government bond yields. And the historically average levels shown in Chart I-11 might themselves be too high, given that other ERP estimates like the ones we showed in our annual outlook highlight that the 2003-2021 period was one in which the US ERP was historically elevated. Chart I-10Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Chart I-11The ERP For Value Stocks Does Not Need To Rise Chart I-12The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks As noted, part of a generalized rise in the ERP this month relates to the potential Russian invasion of Ukraine, an event that we now see as likely (discussed below). But the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates, particularly given the (mistaken) perception amongst investors that Fed hawkishness is entirely driven by elevated inflation. We acknowledge that the Fed’s hawkish shift has been a rapid one, and that this has led US government bond yields to rise quickly. Both the level and change in interest rates matter for economic activity and financial market sentiment, but our view is that the former is more important. Changes in interest rates are mainly significant because they create uncertainty about where rates will ultimately settle, and whether that level would be sustainable for economic activity and the valuation of financial assets. In this respect, Chart I-12 should be encouraging for investors. The chart shows that the 10-year Treasury yield recently reached a new pandemic high, but that this rise was driven by yields on shorter-maturity bonds. 5-year/5-year forward Treasury yields remain 50 basis points below the Fed’s long-term Fed funds rate projection (2.5%), suggesting that the rapid move in US Treasury yields simply reflects a revised pace of rate hikes – not ultimately a higher level. This underscores that the generalized selloff in the US equity market is uncalled for, and that investors should buy the US stock market at current levels. Chart I-13Recession Fears May Rise Early Next Year Chart I-13 highlights that an accelerated pace of rate hikes will likely cause the yield curve to be flatter at the end of the year than would have otherwise been the case, which may eventually be interpreted by investors as a sign that a recession is drawing nearer (potentially implicating both value and growth stocks). We discussed this risk in last month’s report, but for now we maintain the view that this is more likely to occur in 2023 rather than this year. The chart highlights that the S&P 500 did not sell off in response to growth/recession concerns in 2018 before the 2/10 yield curve had flattened to 20-30 basis points, which isn’t likely to occur until 1H 2023 according to fair value calculations derived from the FOMC’s rate projections. The Dollar, Chinese Policy, Commodities, And Global Ex-US Stocks Chart I-14Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Despite the recent surge in US interest rate expectations, and up until last week, the US dollar had behaved in a somewhat strange fashion since late November– even as the Omicron variant spread rapidly around the globe. Chart I-14 highlights that the dollar had traded counter to both relative interest rate differentials and the intensity of the pandemic, both of which appear to have strongly explained the dollar’s trend in the first three quarters of 2021. As we go to press, the US dollar is rallying again, although at least some of the rise is being driven by the prospect of imminent war in Ukraine. We argued in our annual outlook that the dollar was likely to fall this year, and that it was both technically stretched and expensive according to our PPP models. Chart I-15 highlights that the prior weakness in the dollar may also be explained by slowing net foreign purchases of US equities, as the impact of global equity investors flocking to the tech-heavy US market during the pandemic begins to wane. However, we suspect that two additional factors may have been impacting the broad dollar trend before this week’s surge in geopolitical risk. The first is a possible reversal in the correlation between the number of COVID-19 cases and the dollar (from positive to negative). For most of the pandemic, investors have treated new waves of the pandemic as an indication that global growth will slow, which certainly occurred in the services sector this month. But the sheer speed at which the Omicron variant is spreading, in combination with the fact that it causes less severe disease than previous variants, has likely prompted some investors to expect that Omicron has shortened the amount of time to COVID-19 endemicity. An endemic disease, while still a public health issue, would imply less transmission and much less COVID-19-related hospitalization and death. Correspondingly, it would also likely be associated with a significant increase in services spending alongside stronger international travel, which would be positive for global growth (and thus negative for the dollar). Second, it is apparent that China-related assets have caught a bid, as illustrated by our market-based China growth indicator and its accompanying diffusion index (Chart I-16). While the indicators shown in Chart I-16 remain below the boom/bust line, they are rising quickly, and in a manner that suggests investors are reacting to new information. Chart I-15Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Chart I-16Since November, Optimism Towards China Has Also Likely Weakened The Dollar Chart I-17China Bulls Are Probably A Bit Too Early We doubt that investors would be upgrading their outlook for Chinese economic growth based on expectations of COVID-19 endemicity, given the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to prevent transmission of Omicron. Therefore, we conclude that investors have become more optimistic about the pace of easing from Chinese policymakers, potentially sparked by a recent pickup in the pace of special purpose local government bond issuance (Chart I-17). We agree with investors that Chinese monetary policy is becoming easier at the margin. For example, the PBoC recently reduced its one-year loan prime rate (LPR) by 10 bps and five-year rate by 5 bps, following last week’s 10bps cut in the 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rate. This is on top of December’s 50 bps drop in the reserve requirement ratio (RRR). But we do not think that China’s credit data is yet heralding a meaningfully stronger growth impulse. Panel 2 of Chart I-17 presents the 12-month flow of China’s ex-equity total social financing as a share of nominal GDP, both including and excluding local government bond issuance. The chart highlights that the significant pickup in local government bond issuance has led to only a slight uptick in China’s overall credit impulse. Excluding local government bonds, China’s credit impulse continues to decline, reflecting an impaired monetary policy transmission mechanism and slowing bank loan growth. The implication is that it is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. At least some of the pickup in our market-based indicator reflects passive outperformance of some China-sensitive assets; Chart I-18 highlights that global ex-stocks and industrial metals prices have risen relative to US stock prices over the past month, but mostly because US stocks sold off in reaction to Fed hawkishness. Chart I-19 highlights that industrial metals prices continue to advance in a fashion that is not explained by the pace of China’s credit growth (as has generally been the case over the past decade), suggesting that metals are being somewhat supported by investment demand that is likely being driven by inflation hedging. We noted in our November Special Report that industrial commodities performed well during the stagflationary period of the 1970s,1 and over the past 40 years during months in which stock and bond returns are both negative. This makes metals an ideal portfolio hedge in the current environment, and we suspect that this factor – in addition to global inventory drawdowns last year – have kept prices elevated. Chart I-18Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Chart I-19Metals Prices Are Higher Than What Chinese Economic Growth Would Imply However, this also implies that metals prices could sell off at some point over the coming few months if US inflation fears begin to peak and Chinese monetary policy has not yet turned decisively reflationary. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. Similarly, while we believe that investors should maintain global ex-US stocks on upgrade watch, we would prefer to see more evidence of a likely acceleration in Chinese economic activity before upgrading. In addition, we would also recommend that investors wait for the Ukrainian situation to play out, given the recent selloff in European stocks in response to the deepening crisis. A Likely War In Ukraine Last week, US President Joe Biden publicly predicted that Russia would likely invade parts of Ukraine, and implied that the sanction response from Western countries might be muted if the invasion were “minor”. Biden’s remarks have since been described as a gaffe, but in our view they were likely accurate. When combined with reports that the White House is warning domestic chipmakers of potential export restrictions to Russia in the event of an invasion, Biden’s remarks suggest that the US government does not believe that a diplomatic solution is likely and that Russia will probably send troops into Ukrainian territory. A full-scale invasion of Ukraine is very unlikely, as it would unite the Western world in delivering crippling economic sanctions towards Russia. The question for investors is whether the economic consequences of a minor incursion have significant enough implications to change one’s 12-month asset allocation stance. The extent of the rise in energy prices following a minor Russian incursion into Ukraine would be the key determinant of the impact that Russian military action would have on financial markets. Russia could withhold natural gas or oil exports to punish Europe if the Nord Stream II pipeline were cancelled. Oil prices would likely rise, even if retaliatory action was limited to the natural gas market, because oil consumption would rise as a substitute. This would further exacerbate the European energy crisis, although as we noted above, the PMI data continues to point to COVID as a more serious near-term threat to European economic activity than energy prices. Our geopolitical strategy team recently upgraded the odds of Russia invading Ukraine from 50% to 75%, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but it is likely to have a near-term impact on the performance of some assets. While some of the risk of this event has already been priced in, on a 0-3 month time horizon, the US dollar would likely rally even further in response to an invasion and we suspect that the recent outperformance of global ex-US stocks would reverse (with the US outperforming). Our sense is that global equities may underperform government bonds for a short period following a minor incursion, but that a more aggressive Russian invasion would likely be needed to cause a persistent rise in the US dollar, US equity outperformance, and stocks to underperform bonds on a 12-month time horizon. Investment Conclusions Chart I-20We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio Relative to the investment positions that we presented in our annual outlook report, we see no compelling reason to alter any of our recommendations on a 6-12 month time horizon. Over the nearer-term, a minor Russian incursion of Ukraine is now likely, and may further roil financial markets for a period of time. But the bar for the Ukrainian situation to durably impact returns on a 12-month time horizon is high, and implies a degree of conflict that we do not currently expect. US equities have sold off because of a rise in the discount rate and in the equity risk premium. We do not believe the latter is justified for the market as a whole. Our view that US equities have overreacted to the Fed’s hawkish shift and that long-maturity US bond yields have roughly another 50 basis points of upside this year strongly point to an overweight stance towards stocks versus bonds and a short-duration stance as still justified. We continue to expect that growth stocks will underperform value stocks over the coming year, but in the context of a rising rather than falling overall market (Chart I-20). It is too early to position aggressively toward China-sensitive commodities and global ex-US stocks, but investors should maintain these assets on upgrade watch. The US dollar may continue to reverse some of its recent decline over the coming 3 months in response to military conflict in Ukraine or if investors dial back their expectations for Chinese economic growth, but we expect a lower dollar in a year’s time. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2022 Next Report: February 24, 2022 II. The US Productivity Surge: Less Than Meets The Eye The current surge in US measured productivity looks very unlike what occurred in the mid-to-late 1990s. A detailed breakdown of labor productivity growth points to atypical labor market compositional effects – namely a significant decline in services employment – as being responsible for the apparent rise in productivity. In addition, technological disinflation, a major ingredient of the late 1990s “disinflationary boom”, is absent today. A cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the crisis. US output per worker surged compared to other countries, but the US fiscal response also generated a significant amount of excess income to support economic activity – unlike in the euro area, UK, and Japan. Micro-level arguments and some academic studies argue against the idea that work from home arrangements will ultimately be productivity-enhancing. Remote work makes it more difficult for firms to train the next generation of senior employees, which will raise the staffing risks for many businesses. While the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. If inflation remains significantly above target after the pandemic is over, the Fed’s long-term interest rate projections may rise. US stocks would suffer potentially large losses in a scenario where 10-year US Treasury yields rise towards the potential growth rate of the economy. Investors should consider reducing their equity exposure if 5-year, 5-year forward US Treasury yields break above 2.5%. We do not expect that to occur this year, which for now justifies an overweight stance towards risky assets. Chart II-1A Pandemic-Driven Productivity Surge? The behavior of US labor productivity during the COVID-19 pandemic has raised several questions among investors. As defined by output per hour worked, US productivity accelerated significantly over the first six quarters of the COVID-19 pandemic, but then fell sharply in Q3 2021 (Chart II-1). While some market participants have questioned the cause of the recent decline, investors have generally been more interested in the question of whether the US is in the middle of a long-lasting productivity surge that will help alleviate inflationary pressure – akin to what occurred in the second half of the 1990s. In this report, we review the recent surge in US labor productivity in contrast to what occurred in the late-1990s, and then compare it with what has occurred globally. While we are not pessimistic about the pace of technological advancement and its potential to drive long-run productivity, we conclude that the US is not likely experiencing a sustained productivity boom driven by technological adoption during the pandemic. This underscores why investors should not expect a significant increase in potential output owing to the pandemic or its effects. It also highlights that, if elevated inflation in response to strongly positive output gaps were to occur over the coming few years, it would likely be met by significantly tighter fiscal or monetary policy. Today Versus The 1990s: Total Factor Productivity Versus Capital Intensity Chart II-2The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event A technologically-driven surge in productivity growth in the second half of the 1990s was a highly significant macroeconomic event. Chart II-2 highlights that US labor productivity surged to over 3% from 1995 to 2000, alongside a significant deceleration in core PCE inflation and a sizeable acceleration in potential GDP growth. Given the acceleration in measured productivity during the pandemic, and the accompanying rapid adoption (or broader use) of technology, it is easy to see why some investors have questioned whether a 1990s-style productivity boom is underway. However, a detailed breakdown of the 2020 rise in labor productivity growth highlights substantial differences between the current environment and that of the late 1990s, which points instead to compositional effects as the main driver. Improvements in labor productivity can come from smarter workers, an increase in the amount of capital employed per worker, or from technological innovations and better working practices. The US Bureau of Labor Statistics provides a breakdown of the annual change in labor productivity that attempts to capture these three components: The contribution from shifts in labor composition: This measures the productivity impact of changes in the age, education, and gender structure of the labor force. The contribution from capital intensity: This measures the productivity impact of shifts in the amount of capital equipment available per worker. Total factor (or “multifactor”) productivity: This measures the changes in output per hour that cannot be accounted for by the above two factors. Thus, it includes the effects of technological changes, returns to scale, shifts in the allocation of resources, and other changes in operating procedures. Examining the 2020 rise in labor productivity growth along these three factors underscores key differences between the current environment and that of the late 1990s. The first point for investors to note is that the acceleration in labor productivity in 2020 occurred alongside a contraction in total factor productivity (TFP) growth, in contrast to the 1990s when TFP drove labor productivity (Chart II-3). The fact that TFP growth fell in 2020 means that the increase in labor productivity must have occurred either because of labor composition or capital intensity effects. In 2020, labor composition contributed somewhat to accelerating labor productivity, but that most of the increase was caused by a sharp increase in capital intensity. Some of the increase in overall capital intensity occurred because of an increase in the intensity of information processing equipment and intellectual property products (supporting the idea of an increase in pandemic-driven capital deployment), but this was outstripped by the contribution of “other” capital services (Chart II-4). Chart II-3Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Chart II-4The Surge In US Capital Intensity Reflects A Rapid Compositional Shift In The Labor Market The concept of capital intensity refers to the amount of capital available per worker, but in practice it is measured as the ratio of the amount of capital used relative to the amount of labor hours used to produce output. Thus, a surge in capital intensity that is not accounted for by an increase in the amount of tech-related capital available to workers points to a rapid compositional shift in the economy from relatively low capital-intensive industries to relatively high-intensive industries. Under less extreme economic circumstances we would be more inclined to search for other potential causes of a rapid increase in measured capital intensity, but a shift in employment from less to more capital-intensive industries is exactly what has occurred during the pandemic. Services jobs tend to be much more labor-intensive than goods-producing jobs; Chart II-5 highlights that the former fell far more than the latter during the pandemic, in sharp contrast to what normally occurs during a recession (Chart II-6). This phenomenon is also reflected in a highly unusual decline in services spending compared with very strong goods spending relative to their pre-pandemic trend. Chart II-5Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Chart II-6The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The takeaway for investors is that the nature of the pandemic and its unique impact on the economy has created the appearance of an acceleration in productivity, when in reality true productivity has fallen and the standard measure of productivity is being flattered by enormous changes in the composition of the labor market. Today Versus The 1990s: IT Investment, And Technological Disinflation The trends in IT investment and prices highlight another major difference between the current environment and that of the late 1990s. Charts II-7 and II-8 highlight recent trends in comparison to those of the 1990s, with the following notable points: Chart II-7There Are Major Differences Between IT Investment And Prices Today Versus The 1990s Chart II-8A One-Off Move The recent pace of real investment in total IT does not point to the pandemic as a sustained source of productivity growth. Real investment in IT has already slowed significantly, in contrast to the 1990s when it accelerated on a sustained basis for years. IT investment as a % of GDP and of total plant and equipment spending has already stopped rising (or is now falling), exhibiting clear signs of a one-off shift and thus undermining the view that IT investment has significantly raised potential output. In pronounced contrast to the mid-1990s when IT equipment prices were collapsing, computing equipment inflation has recently risen into positive territory – to the highest levels recorded since the data became available in 1959. Higher prices for IT equipment clearly reflect, at least in part, pandemic-driven pressure on global supply chains and the production of semiconductors. So we do not expect sustained increases in the price of computing equipment. But the key point for investors is that a major ingredient of the late 1990s “disinflationary boom” is missing today. The US Versus The World We have presented Chart II-9 in previous reports to highlight that there is certainly no evidence of a global productivity surge, using output per worker as a proxy for the standard measure of labor productivity (output per hour worked). Some investors have countered that the US is a more dynamic economy, and that a sustained productivity boom would be more apparent in the US prior to its emergence in other countries. Or simply that the US alone is experiencing a productivity boom that will help reduce very elevated US inflation, with strong implications for Fed policy. Chart II-9During The Pandemic, Cross-Country Changes In Real Output Per Worker… Chart II-10…Are Mostly Explained By Different Fiscal Responses Chart II-11High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels Charts II-10 and II-11 present a different cross-country comparison that reinforces the view that the US is not likely experiencing a long-lasting productivity surge that will help reduce inflation. Chart II-10 highlights that in the face of a significant decline in employment, US output was supported by a substantial amount of “excess income” – the cumulative amount of household disposable income earned over the course of the pandemic in excess of what would have been predicted based on the pre-pandemic trend. Other major DM economies (such as the UK and euro area) either saw negative excess income or a modestly positive amount (Japan), underscoring that the fiscal response to the pandemic in most advanced economies was aimed at stabilizing income rather than raising it. In combination with Chart II-11 – which highlights that the US labor market recovery has significantly lagged behind the European and Canadian economies in terms of returning to the pre-pandemic employment trend – this would appear to explain why the US has experienced stronger real output per worker than other countries. Chart II-12Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Canada stands out as the outlier compared with the US, in the sense that it’s growth in real output per worker has been much lower but Canadian fiscal policy created a similar amount of excess income. However, it may be the case that the Canadian experience highlights that the US labor market recovery is the outlier, which could imply that the surge in US labor productivity may in fact have inflationary rather than disinflationary consequences at the margin. We discussed the factors that we believe are driving the slow recovery in the US working-age population in our 2022 annual outlook report, and how they are strongly linked to the pandemic. However, Canada has also clearly been affected by COVID-19, and yet it has experienced a more significant recovery in jobs. Chart II-12 highlights that there has been one major difference between the US and Canada during the pandemic: a substantial gap in the burden of disease from COVID-19. This raises the question of whether Canada has outperformed the US in terms of its labor market recovery, despite a similarly impactful fiscal response, because of a smaller labor shortage stemming from long-term COVID symptoms. Over the past two years, there have been many reports about people who have recovered from COVID but who continue to experience some symptoms of the disease. The medical community has labeled this condition as post-acute sequelae of SARS-CoV-2 infection (PASC), colloquially referred to as “long COVID.” Chart II-13Long-COVID Might Help Explain The US’ Lagged Return To Pre-Pandemic Employment The medical community’s understanding of long COVID is currently poor, and doctors do not know why some people get the condition or what treatment options are likely to be the most effective. Given this, it is possible that some reports of long COVID are, in fact, related to other conditions. But a recent research report from Brookings estimated that the US labor market may be missing 1.6 million workers because of long COVID’s effects (Chart II-13), which alone would account for 1 percentage point (or roughly 1/4th) of the growth in US real output per worker since the pandemic began. This circumstance would be inflationary rather than disinflationary on the margin, as it would imply that accelerating first and second quartile US wage growth may be sticky even as the pandemic recedes. Is Working From Home Positive For Productivity? We have noted above that the macro data argues against the idea of a sustained rise in US productivity stemming from the pandemic. A more micro-level perspective, one that examines the working-from-home (WFH) experience, also appears to support our case. It is true that surveys of employees highlight that their experience of WFH has been significantly better on average than workers expected and report their being more productive while working from home during the pandemic. Chart II-14 emphasizes that, based on the running surveys from Barrero, Bloom, and Davis (“BBD”), 60% of workers have conveyed better WFH outcomes relative to expectations, versus just 14% reporting worse outcomes. In addition, Chart II-15 clearly highlights that workers prefer at least some form of hybrid WFH arrangement, with just 22% of survey respondents reporting the desire to work from home either rarely or never. Chart II-14Remote Workers Have Reported Better Work-From-Home Outcomes Than What Was Expected Chart II-15Remote Workers Clearly Prefer A Hybrid Work Model However, worker preferences do not necessarily correlate with productivity gains, at least not to the same degree. Chart II-16 from the BBD surveys highlights that the share of workers reporting more efficiency while working from home is not as large as those reporting better outcomes relative to expectations, suggesting that employees are considering whether WFH arrangements are benefiting them personally when responding to their desired post-pandemic level of remote work. Chart II-17 also shows that employees working from home only spend a third of the time ordinarily allocated to commuting to working on their primary job; the rest is spent on childcare, leisure, home improvement, or working on a second job (which may or may not be a sustainable source of income). Chart II-16Less Than Half Of Workers Report Being More Efficient While Working Remotely Chart II-17Only 1/3rd Of Time Saved Commuting Is Spent On Primary Employment There is also some evidence from academic studies that indicates productivity fell during the pandemic for some remote workers. Michael Gibbs, Friederike Mengel, and Christoph Siemroth (2021) surveyed 10,000 professionals at a large Asian IT services company, and found that productivity declined because of a slight decline in average output and a rise in hours worked.2 Admittedly, elements of the study did point to some factors potentially impacting this decline in productivity that were more prominent in the earlier phase of the pandemic, specifically the issue of childcare (which would not likely be a drag on remote worker productivity in a post-pandemic environment). But it also noted that employees with a longer company tenure fared better, which in our view is an often overlooked element of remote work that points to less future productivity gains from WFH arrangements than may be recognized by investors. The outperformance of senior staff in a WFH environment is not particularly surprising: once employees have accrued significant experience, they spend less of their working time learning and more (or all) of their working time “doing.” It makes sense that employees who predominantly “platform” their existing experience may fare the same or better in a WFH arrangement, but it is highly questionable whether it is sustainable, because it makes it much more difficult for businesses to train the next generation of senior employees. The Gibbs, Mengel, and Siemroth study noted that higher communication and coordination costs featured prominently in their findings of reduced remote worker productivity. Importantly, they found that employees communicated with fewer individuals and business units, both inside and outside the firm, and received less coaching and one-to-one meetings with supervisors. While some firms may be able to mitigate these risks to the advancement and development of more junior staff while maintaining a hybrid on-site / WFH model, we suspect that many firms will fail to do so fully. Future Productivity: Pessimism Unwarranted, But No Inflation Salvation The fact that the US is not likely in the middle of a pandemic-driven productivity boom does not mean that the outlook for productivity is poor. In fact, we would point to two factors that lead us to believe that productivity growth will be better in the future than it has been over the past decade: The pronounced consumer deleveraging phase that existed for several years following the global financial crisis is over, and There are several identifiable technologies currently under development that are likely to have legitimate commercial applications and productivity-enhancing benefits in the future On the first point, we have contended in previous reports that the weak productivity growth observed during the first half of the last economic expansion was because of demand rather than supply-side factors. This notion is jarring for many investors, who are accustomed to think of productivity trends as being exclusively driven by supply-side phenomena. This is typically correct, in that the cyclical impact of fluctuating aggregate demand on measured productivity – particularly during and immediately after recessions – is usually temporary in nature. However, the 2008/2009 recession was highly atypical, in the sense that it was a household “balance sheet” recession rather than a normal “income” recession. This led to a prolonged period of US household deleveraging, below-average corporate sales growth, and poor growth in output per hour worked. In effect, the post-2008 deleveraging phase created a long-lasting, multi-year cyclical effect on measured productivity growth. In early-2009, pessimistic investors held to an understandable reason for why they doubted the sustainability of the economic recovery: there could be no meaningful labor market recovery if businesses expected several years of weak demand because of the likelihood of consumer deleveraging. In this respect, the post-2008 period served as an important natural experiment for macroeconomists and investors: we have learned that the response of firms to a durable but shallow economic recovery is, on the one hand, to hire additional workers, but, on the other hand, also to control wage and salary costs aggressively. Chart II-18Slow Productivity Growth Last Cycle Was A Demand Story, Not A Supply Story Chart II-18 encapsulates the point that weak productivity during the last economic cycle was closely tied to US household deleveraging. The chart highlights that the decline in total factor productivity due to goods-producing industries – heavily concentrated in manufacturing – was much larger than for private services from 2007 to 2019. Since there was no technological slowdown that disproportionally impacted the manufacturing industry during the period, this clearly points to demand-side rather than supply-side factors as the main driver of the post-GFC productivity slowdown. On the second point about future productivity growth, Table II-1 outlines five well-known technologies that are in various stages of development and are likely to lead to significant applications at some point in the future: artificial intelligence, automated driving (a specific application of AI), quantum computing, augmented/virtual reality and human-machine interface, and CRISPR/gene editing. The table outlines the nature of potential future applications, as well as projections from McKinsey Global Institute about the most likely commercialization timeline. Table II-1Technological Advancement Is Ongoing. It Won’t Likely Help Fight Inflation Over The Next Few Years A detailed analysis of each of these technologies is beyond the scope of this report, but Table II-1 underscores two key points for investors. The first is that further, technologically-driven productivity growth is not just possible, it is likely. It is clear what advancements will probably drive these productivity gains, and Table II-1 highlights only the most well-known technologies to which experts in the field would point to. The second point is that most major changes from these technologies are projected to occur beyond 2025, and, in many cases, beyond this decade. In the case of quantum computing, while it could potentially lead to an explosion of algorithmic power that would almost certainly have major commercial implications, it is even possible that this technology will initially subtract from total factor productivity growth before contributing positively. This is because of its potential to render much of the existing global internet security and privacy infrastructure useless, as highlighted by a NIST Cybersecurity White Paper last April: “Continued progress in the development of quantum computing foreshadows a particularly disruptive cryptographic transition. All widely used public-key cryptographic algorithms are theoretically vulnerable to attacks based on Shor’s algorithm, but the algorithm depends upon operations that can only be achieved by a large-scale quantum computer. Practical quantum computing, when available to cyber adversaries, will break the security of nearly all modern public-key cryptographic systems.”3 Some experts believe that the preparation required to avoid this outcome may dwarf that of the millennium bug (“Y2K”) problem of the late-1990s,4 which cost roughly 1% of GDP to fix – and thus was clearly not productivity-enhancing. The bottom line for investors is that while the long-term outlook for technologically-driven productivity growth is bright, it is unlikely to save the US and/or global economies from elevated inflation over the next several years if output gaps in advanced economies rise to strongly positive levels in the wake of the pandemic. Investment Conclusions Our analysis above has highlighted that the current surge in measured productivity looks very unlike what occurred in the mid-to-late 1990s, and that very atypical labor market compositional effects are likely responsible for the apparent rise in labor productivity. We have also highlighted that a cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the pandemic, and that there are micro-level arguments against the idea that work from home arrangements are productivity-enhancing. Finally, while the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. While we believe that the COVID-19 pandemic will recede in importance this year, it is not yet over. As such, investors do not yet know how strong the output gap in the US and other advanced economies will be on average over the coming two to three years, or what the pace of consumer price inflation will look like in the face of strong aggregate demand but substantially lower (or no) pressure from the supply-side of the economy (as we expect). Chart II-19There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates In a scenario in which aggregate demand remains strong next year and inflation remains above-target, even in the face of Fed tightening and a normalization in services/goods spending, we would expect to see significantly tighter fiscal or monetary policy. This is a scenario in which the secular stagnation narrative, which underpins the Fed’s low long-term interest rate projection, would likely be aggressively challenged by investors. Chart II-19 highlights that US equities would potentially suffer a 24% contraction in the forward P/E in a scenario in which the equity risk premium is in line with its historical average and 10-year US Treasury yields rise to the potential growth rate of the economy. We do not yet believe that a significant rise in long-term interest rate expectations will occur this year, meaning that investors should still be overweight stocks versus government bonds over the coming 6-12 months. But as we noted in last month’s report, we may recommend that investors reduce their equity exposure if 5-year, 5-year forward Treasury yields break above 2.5% (the FOMC’s long-run Fed funds rate projection), which we noted in Section 1 of our report is 50 basis points above current levels. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. 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 (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. 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 Content Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2     Michael Gibbs, Friederike Mengel, and Christoph Siemroth. “Work from Home & Productivity: Evidence from Personnel & Analytics Data.” Working Paper No. 2021-56. July 13, 2021. Pp. 1-30. 3    William Barker, William Polk, and Murugiah Souppaya. “Getting Ready for Post-Quantum Cryptography: Exploring Challenges Associated with Adopting and Using Post-Quantum Cryptographic Algorithms.” National Institute of Standards and Technology, US Department of Commerce. April 28, 2021. Pp. 1-7. 4    Jonathan Ruane, Andrew McAfee, and William Oliver. “Quantum Computing for Business Leaders.” Harvard Business Review, January-February 2022.

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com 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 about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Feature Is the worst over for US and EM equities? Clearly, the risk-reward of stocks has somewhat improved, given they are no longer overbought and some bad news has already been priced in. However, conditions for a durable bottom and a sustainable and lasting rally do not yet exist. In the case of the S&P 500, our capitulation indicator has not yet reached the lows that marked the major bottoms of the past 12 years (Chart 1). Chart 1US Stocks Have Not Reached Their Selling Climax Yet Chart 2Components Of US Equity Capitulation Indicator None of its four components – the advance/decline line, momentum, breadth and investor sentiment – are back to their lows of 2010, 2011, 2015-16 and 2018 (Chart 2). In the past three cases, the S&P 500 corrected by 17-20%. A correction of this magnitude is our base case for the S&P 500 at the moment. The S&P drawdown has so far been half of this. US inflation and the Fed’s policy remain the key headwinds to US share prices. Core consumer price inflation is substantially above the Fed’s preferred range (2-2.25%) and wage growth is accelerating. As a result, the Fed will lose credibility if it does not sound ready to hike interest rates materially. The US equity market is vulnerable to such a not-dovish stance from the Fed because it is still very expensive. Inflation has also become a political problem. One reason Biden’s popularity has been sliding in the polls is the rapid pace of consumer price increases. Heading into the mid-term elections in the fall, the White House and the Democrats will not oppose the Fed raising interest rates to fight inflation. Overall, BCA’s Emerging Markets Strategy team believes markets/investors are underestimating inflation risks in the US. Core inflation will not drop below 3% unless the economy slows down and employment/wages slump. High and rising trimmed-mean and median CPI measures suggest inflation is broad-based. Normalization in supply-side factors will not be enough to lower core inflation below 3%. Importantly, the median and trimmed-mean core inflation measures strip out goods and services that post abnormal fluctuations. Their elevated readings corroborate that inflation is genuine and broad-based. Hence, pressure on the Fed to tighten will remain substantial. This is bad news for a still overvalued US stock market. Chart 3EM EPS Is Set To Dissapoint Concerning EM equities and currencies, economic growth in EM will disappoint. Chart 3 suggests that EM corporate profits are set to deteriorate materially in the coming six months or so. Besides, investor sentiment on EM equities is not downbeat – it is neutral (Chart 28 below). From a contrarian perspective, there is not yet a case to buy EM stocks in absolute terms. China’s business cycle recovery is still several months away. In other EM countries, monetary policy has tightened substantially, real interest rates remain high, or the banking system is too unhealthy to support growth. Finally, fiscal policy will be slightly tight this year in the majority of EM. As domestic demand in China and in mainstream EMs disappoint and the Fed does not do a dovish pivot soon, EM currencies will resume their depreciation versus the US dollar. Chart 4 shows that China’s credit and fiscal impulse leads EM currency cycles and is presently pointing to more EM currency depreciation. Charts 32 and 33 (below) are pointing to further greenback strength. Finally, EM growth disappointments and a strong greenback will pressure EM fixed income markets. EM high-yield (HY) credit – both sovereign and corporate – has been selling off, but investment-grade (IG) credit has been holding up (Chart 5). This is a sign that investors have been reluctant to offload EM IG credit and points to lingering positive sentiment on EM and lack of capitulation. Sluggish EM growth and an appreciating US dollar are headwinds for EM credit markets. Chart 4EM Currencies Remain At Risk Chart 5EM Credit Markets: The Selloff Will Broaden Bottom Line: We continue to recommend a defensive strategy for absolute return investors. For global equity portfolios, we recommend underweighting EM and the US, and overweighting Europe and Japan. The path of least resistance for the US dollar is up for now. The charts on the following pages are the most important ones for investors today. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Stocks Have Not Reached Their Selling Climax Yet Even though only 17% of the NASDAQ’s stocks are above their 200-day moving average, the same measure for the NYSE index is 38%, well above its previous lows. Besides, the NYSE’s advance/decline line has broken down, signifying a broadening equity rout. Finally, the US median stock has broken below its 200-day moving average after going sideways for 9-12 months. When such a profile occurs, the sell-off lasts more than a couple of weeks. Chart 6 Chart 7 Chart 8 Chart 9 Non-US Stocks Are Not Oversold Yet Neither global ex-US nor EM stocks are very oversold. Global ex-US and European share prices in SDR terms have been moving sideways for about 9-12 months prior to breaking down recently. Such a breakdown means a weakness in share prices that will likely last for a while. Chart 10 Chart 11 Chart 12 Chart 13 Growth Stocks Have Broken Down Various indexes of growth/TMT stocks have broken below their moving averages that have served as a support since spring 2020. This along with the fact that US interest rates will likely rise suggests that the bull market in growth stocks is either over or in for a prolonged hibernation. Chart 14 Chart 15 Chart 16 Chart 17 Is FAANGM A Bubble? In the past 12 years, US FAANGM stocks rose as much as the previous bubbles. When those bubbles peaked, their prices did not move sideways but rather collapsed. We do not assert that US FAANGM stocks will drop by more than 35% (we simply do not know). The point we would like to emphasize is that the bull market is over for now. At best, US growth stocks will likely be in a trading range in the coming 12-24 months.  Chart 18 Chart 19 US Share Prices And Corporate Margins: Defying Gravity? From a very long-term perspective, the US equity market is rather overextended. Share prices in real terms are almost two standard deviations above their time trend. Similarly, corporate profits in real terms are also very elevated, not least in their reflection of record-high profit margins. The key questions for US equity investors are: (1) how persistent/sticky core inflation will be; and (2) how low corporate profit margins will drop. Wages are the key to both inflation and corporate margins. We believe wage growth will accelerate materially. That will be bad for the outlook of inflation and corporate profit margins, although it will be good news for corporate top lines. Chart 20 Chart 21 The Levels of EM Share Prices And Corporate Profits Have Been Flat For 12 years Contrary to the US, EM share prices are not overextended – they have been flat in absolute terms for the past 12 years. The reason for such dismal performance has been stagnant corporate profits. The latter have been flat-to-down in real terms for the past 12-14 years. A breakout in EM share prices in absolute terms will require their EPS entering a secular uptrend. While this is not impossible this decade, it is not imminent. Chart 22 Chart 23 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Based on a cyclically-adjusted P/E (CAPE) ratio, EM stocks are close to their fair value. In contrast, based on the same measure, US equities are very overvalued. As a result, the relative CAPE ratio of EM versus the US is at a record low. Hence, on a multi-year horizon, odds are that EM share prices will outperform their US peers. In a nutshell, EM ex-China, Korea, Taiwan currencies are also close to their fair value. We will be looking to upgrade EM in the coming months. Chart 24 Chart 25 Chart 26 Chart 27 Investors Are Not Bearish On EM And Europe One missing factor to upgrade EM (non-US markets in general) is investor sentiment. Sentiment is neutral on EM stocks and is fairly upbeat on Europe. In brief, a capitulation has also not yet occurred in non-US markets. On the whole, the current EM sell-off will likely linger until sentiment becomes downbeat. Chart 28 Chart 29 Directional Indicators For EM Stocks Points To More Downside The cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) moves in tandem with EM share prices. The same holds for the NZD versus the USD. The rationale is as follows: all of these currencies correlate with the global business cycle and global risk-on/off trends. Presently, the SEK/CHF cross and the NZD point to lower EM share prices. Chart 30 Chart 31 The US Dollar Is To Rally Further The Fed’s willingness (for now) to hike rates is positive for the greenback. The trend in relative TIPS yields between the US and Germany heralds further USD strength against the euro. Also, the cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) entails more upside in the broad trade-weighted US dollar. Chart 32 Chart 33 Worrisome Market Profiles Several markets such as EM non-TMT share prices, Korean tech stocks, the Chinese onshore CSI300 stock index and silver prices have all failed to break above their 200-day moving averages and are now relapsing. Such a profile is often consistent with new cyclical lows in these markets. Chart 34 Chart 35 Chart 36 Chart 37 China’s Liquidity And Credit Cycles Even though China has heightened the pace of monetary easing, it will take several months before its credit impulse rebounds. On average, it takes about six months for reductions in the required reserve ratio (liquidity injections) to produce a meaningful recovery in the credit impulse. So far, the excess reserve ratio has stabilized but not improved. This means the credit impulse will continue stabilizing in the coming months, but a major rise is unlikely in the near term. In turn, the credit cycle leads share prices by several months. All in all, a risk window for China-related plays remains open in the coming months. Chart 38 Chart 39   Footnotes

HighlightsUpgrade odds of Russia invading Ukraine from 50% to 75%. The US and allies are transferring arms to Ukraine while seeking alternate energy supply for Europe.Of the 75% war risk, we give 10% odds to Russia conquering all of Ukraine, as discussed in our “Five Black Swans For 2022.” Russia’s limited war aims worked in 2014 and President Putin tends to take calculated military risks. Full-scale invasion would force the West to unify.The remaining 25% goes to diplomatic resolution. It appears that the US is not offering Russia sufficient security guarantees. Ukrainian leaders do not have a domestic mandate to surrender and have not done so for eight years. Russia cannot accept the  status quo now that it has made armed demands for big change.Our third key view for 2022 – that oil producing states have geopolitical leverage – is vividly on display.Tactically stay defensive. But cyclically stay invested. Book 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.FeatureUkraine’s economy is small but investors rightly worry that an expansion of the still simmering 2014 war there will cause Europe’s energy supply to tighten, pushing up prices and dragging on European demand. Russia would cut off natural gas to Ukraine, which would cut off 6.6% of Europe’s natural gas imports, 18% of Germany’s, 77% of Hungary’s, and 38% of Italy’s (Chart 1). Chart 1Ukraine Hinges On Germany If Europe retaliates against Russia with crippling sanctions, Russia and Belarus could conceivably cut off another 20% of Europe’s imports and 60% of Germany’s imports. The Czech Republic, Finland, and Hungary get almost 100% of their natural gas from Ukraine and Russia, while Finland, Poland, and Hungary get more than half of their oil from Russia. In other words, Europe will try to avoid war and try to limit sanctions so that Russia does not further reduce supply.Yet Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession. The US has already committed to sweeping sanctions against Russia and is much more likely to follow through (though President Biden also wants to avoid an energy shock ahead of midterm elections).Energy consumption amounts to only 2% of European GDP, though it could rise to 5% in the event of a shock, as our European Investment Strategist Mathieu Savary has shown. This number would not be far from the 7% reached in 2008, which coincided with financial crisis and recession. All of Europe will suffer from high prices, not only those that import via Ukraine, and Europe’s supply squeeze would push up global prices as well. So the risk of a recession in Europe will rise if the energy squeeze worsens, even if a recession is ultimately avoided.Whatever Russia ends up doing with its military, it may start off with shock and awe. Europe might see its first major war since World War II. Global investors will react very negatively, at least until they can be assured that the conflict will remain contained in Ukraine. According to our market-based quantitative indicators of Russian geopolitical risk, there is still complacency – the ruble has not fallen as far as one would expect based on key macro variables (Chart 2). Chart 2Russia Geopolitical Risk: Two Quantitative Indicators  Chart 3Russian Market Reaction Amid Ukraine Crisis Investors will sell European – especially eastern European – equities and currencies even more rapidly if a war breaks out (Chart 3). It is too soon to buy the dip. What is needed is a Russian decision and then clarity on the scope of the western reaction. Even then, developed Europe and non-European emerging markets will be more attractive.Looking at global equities: How did the market respond to previous Russian invasions?Few conclusions can be drawn from Russia’s invasion of Georgia in 2008, given Georgia’s lack of systemic importance and the simultaneous global financial crisis (Chart 4). Stocks underperformed bonds and cyclicals underperformed defensives, but value caught a bid relative to growth.Russia’s initial invasion of Ukraine in 2014 occurred in a different macroeconomic context but saw stocks flat relative to bonds, cyclicals fall relative to defensives (except energy stocks), and small caps roll over relative to large caps (Chart 5). Value stocks, however, outperformed growth stocks. Chart 4Market Reaction To Russian Invasion Of Georgia​​​​​  Chart 5Market Reaction To Russian Invasion Of Crimea​​​​​  Chart 6Ukraine Crisis And Energy: 2022 Versus 2014 However, in today’s context, these cyclical trends are looking stretched, so a temporary pullback from these trends should be expected. Value stocks, especially energy stocks, have skyrocketed relative to growth and defensives and are likely to pull back in a global risk-off move (Chart 6). Tactically we recommend American over European assets, defensives over cyclicals, large caps over small caps, and safe-haven assets like gold and the Japanese yen.Washington Offers “No Change” To MoscowWhy is a diplomatic solution less likely than before?The US offered no concessions to Russia in its formal written response to Russia’s demands on January 26. “No change, and there will be no change” in longstanding policies, according to Secretary of State Antony Blinken.1 The relevant policies are not about NATO membership – Ukraine is never going to join NATO – but rather about the US and NATO making Ukraine a de facto member by providing arms and defense cooperation. Russia obviously sees a US-armed Ukraine as a threat to its national security.One of the few realistic demands of Russia’s – that the US and NATO stop providing arms – has been flung back in Russia’s face. Blinken pointed out in his press conference that the US has given more defense aid to Ukraine in the past year than in any previous year. He said the US will continue to provide arms while pursuing diplomacy, including five MI-17 helicopters on the way. He also noted that the US has authorized allies to transfer American-origin arms to Ukraine.2The importance of the defense cooperation is not the quality of the arms being transferred (so far) but the long-term potential for the US to turn Ukraine into Russia’s Taiwan, i.e. a foreign-backed military enemy on its doorstep. The costs of inaction today could be checkmate from Russia’s long-term strategic point of view. Russia has warned for 14 years that it saw Ukraine as a red line and yet the US and NATO have increased defense cooperation. It is a moot point whether the US provides arms because it does not empathize with Russia’s security interests or because it believes Russia will attack Ukraine regardless.A diplomatic solution could still come from the US, if more information comes to light, or from Ukraine itself, under French and German pressure. Ukraine could make promises to respect Russia’s national security interests and implement the Minsk Protocols it was forced into after Russia seized Crimea in 2014.3If Ukraine surrenders, Russia can claim victory and reduce the threat of war, at least temporarily. But it would not eliminate the long-term risk of war since Ukraine’s government may not be willing or able to implement any such agreement. Ukraine views the Minsk agreement as a Russian imposition and it has rejected key parts of it (such as federalization and granting rights and privileges to Russian separatists in Donbass) for eight years already.4The joint statement from Russia, Ukraine, France, and Germany on January 26 reaffirms the ceasefire in the Donbass.5 It is unlikely that Russia can walk away with this ceasefire alone, having made fundamental demands regarding Russia’s long-term security and the European order. It is more likely that any Ukrainian violation of the ceasefire will now offer a pretext for Russia to respond with military force.Russia’s military advantage is immediate whereas diplomatic attempts by Ukraine to buy time could help it stage a more formidable defense against Russia in future, given ongoing US and NATO defense cooperation. This is why the continuation of arms transfers is the signal. Russia is incentivized to take action sooner rather than later now that the western willingness and urgency to provide arms has increased.Putin has succeeded with his “small war” and “hybrid war” strategy thus far. Russian forex and gold reserves at $630 billion (38% of GDP), gradual diversification away from the dollar (16% of forex reserves), low short-term external debt (5% of GDP), an alternative bank communication system, a special economic relationship with China, a Eurasian Economic Union that can help circumvent sanctions, all provide Russia with some buffer against US sanctions.GeoRisk Indicators: Europe Chart 7European GeoRisk Indicator Amid Ukraine Crisis In our Q3 2021 outlook, we argued that European political risk had bottomed due to Russia. Our geopolitical risk indicators show that financial markets tend to price European political risks in line with the USD-EUR exchange rate. The dollar rallied in 2021 and has since fallen back but a war and energy squeeze in Europe should help the dollar stay resilient, as should Federal Reserve rate hikes (Chart 7).If Russia attacks, the Ukrainians will fall back and then mount an insurgency. This will make the war more difficult than its planners initially believe. It will also raise the risk that war will spill over. Neighbors that provide economic aid – not to mention military aid – will eventually make themselves vulnerable to Russian attack, either to destroy commerce or cut insurgency supply lines.NATO will fortify its borders with troops but then tensions will grow on those borders, reducing security and raising uncertainty in the Baltics, Poland, Slovakia, and the Czech Republic. Ukraine could become a war zone like Libya or Syria except that this time the US and Russia would truly be fighting a proxy war against each other.Other European Risks Pale In ComparisonWe will monitor the French election in case the Ukraine conflict causes dynamics to shift against President Emmanuel Macron. Most likely Macron’s diplomatic flourishes, combined with France’s insulation from Russia and Ukraine, will benefit him at the ballot box.In the UK, Prime Minister Boris Johnson faces a leadership challenge. He will probably survive but the Conservative Party faces a serious challenge over the coming years. Labour’s comeback will build ahead of the next election, given that the pandemic has dealt a powerful blow against the Tories, who have been in power since 2010 and are therefore becoming stale. Labour has gotten over the Jeremy Corbyn problem.What matters is whether the UK rejoins the EU, whether Scotland leaves the UK, and whether the next government has a strong majority with which to lead. So far there have not been major changes on these issues:The Tories still have a 75-seat majority through 2024.Support for Scottish independence is stuck at 45% where it has been since 2014.Polling is still evenly divided on Brexit. Labour taking power is a prerequisite to any reunion with the EU, Labour does not want to campaign on re-opening the Brexit issue. While Labour will want to run against inflation, and win back the middle class, rather than for the EU.Thus political risk will be flat, not returning to Brexit highs anytime soon, which is marginally good news for pound sterling over a cyclical horizon (Chart 8). Chart 8UK GeoRisk Indicator And Boris Johnson's Troubles India Enters Populist Phase Of Election Cycle2022 will mark the beginning of India’s election season in full earnest, even though general elections are not due until 2024. This is because within the five-year election cycle spanning from 2019-2024, this year will see elections in some of India’s largest states (Chart 9).More importantly 2022 will see elections take place in most of India’s northern region (Chart 10), which is a key constituency for the ruling Bhartiya Janata Party (BJP). Chart 9India: Major State Elections This Year​​​​​  Chart 10North India In Focus With State Elections​​​​​ Of all the state elections due this year, the most critical will be those in Uttar Pradesh, where voting will begin on February 10, 2022. Final results will be declared a month later on March 10, 2022.Uttar Pradesh Will Disappoint BJPAt the last state elections held in Uttar Pradesh in 2017, BJP stormed into power with one of the strongest mandates ever seen in this sprawling and heterogenous state. The BJP boosted its seat share to an extraordinary 77%, leaving competitors far behind (Chart 11). Chart 11Bhartiya Janata Party (BJP) Stormed Into Power In Uttar Pradesh (UP) In 2017 Cut to 2022, the BJP appears likely to cross the 50% majority threshold but will cede seat share to a regional party called the Samajwadi Party (SP).What will drive this reduction in seats? The reduction will be driven by a degree of anti-incumbency sentiment and some adverse socio-political arithmetic. In a state where voting is still driven to a large extent by identity politics, it is worth recalling that the BJP was able to win the 2017 elections by pulling votes from three distinct communities:BJP’s core constituency of upper caste Hindus.A subset of Other Backward Classes (OBCs).A subset of a community belonging historically to one of the lowest social levels in India called Dalits.This winning formula of 2017 may not work in 2022 as the BJP faces resentment from parts of each of these three communities as well as from farmers (who were against farm law reforms that the BJP tried to pass).There is a chance that these groups may flock to the regional Samajwadi Party in 2022. The latter is in a position of strength as it is expected to retain support from its core constituency of Muslims and upper-caste OBCs too.Yet the risk is to the downside for the ruling party. Modi and the BJP have suffered a hit to their popular support from the global pandemic and recession, like other world leaders.Reading The Tea Leaves For 2024The pro-Modi wave that began in 2014, and gained steam in Uttar Pradesh in 2017, became a tsunami by 2019, causing the BJP to win a decisive 56% of seats in the national assembly. So, if the BJP loses seats in Uttar Pradesh this year, what will be the implications for the general elections of 2024?In a base case scenario, the Modi-led BJP appears set to emerge as the single largest party in the 2024 elections (albeit with a lower seat share than the 62 of 80 seats that the BJP managed in 2019). As the BJP administration ages, it is expected to lose a degree of seat share in its core constituency of north India. But these losses should be partially offset by gains in regions like east India where the BJP continues to make inroads. Also, national parties tend to attract higher vote share at general elections as compared to state elections, and this is true for the BJP. Most likely the pandemic will have fallen away by 2024 and the economy will be expanding.However, a lot can change in two years, and a major disappointment at Uttar Pradesh would sound alarm bells. By 2024, the BJP will have been in power for ten years. So it is not a foregone conclusion that the BJP will win a single-party majority for a third time, even if it does remain the biggest party.Regional parties like the Samajwadi Party (from Uttar Pradesh), Trinamool Congress (from West Bengal), Shiv Sena (from Maharashtra) and Aam Aadmi Party (from New Delhi) are small but rising and may incrementally eat into the BJP’s national seat share.Policy Implications For 2022 Chart 12India’s Fiscal Report Card May Worsen With Populism India’s central government will unveil its budget for FY23 on Feb 1, 2022 in the Indian parliament. We expect the government to announce a fiscal deficit of 6.6% of GDP which will be marginally lower than the FY22 target of 6.8% of GDP. However, with key elections around the corner, we allocate a high probability to the government announcing a big-bang pro-farmer or pro-poor scheme from this pulpit. This high focus on populism and inadequate focus on capital expenditure could lead markets to question India’s fiscal well-being at a time when its debt levels are high (Chart 12).Distinct from policy risks in the short run, geopolitical risks confronting India are elevated too. India’s relationship with China continues to fester. Sino-Indian frictions could easily take a turn for the worst in 2022 as India enters the business end of its five-year election cycle on one hand and China’s all-important 20th National Congress of the Chinese Communist Party (NCCCP) is due in the fall of 2022. China could take advantage of US distraction in Ukraine to flex its muscles in Asia. A geopolitical showdown with China would likely only cause a temporary drop in Indian equities, but taken with other factors, now is not the time to buy.Bottom Line: We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India.GeoRisk Indicators: Rest Of WorldNeutral China: China’s performance relative to emerging markets may be starting to bottom but we do not recommend buying it. Domestic political risk is still rising according to our indicator and we expect it to keep rising (Chart 13). Negative political surprises will occur in the lead up to the twentieth national party congress and the March 2023 implementation of the “Common Prosperity” plan. Any Russian conflict will distract the US and enable General Secretary Xi Jinping to cement his second ten-year term in office – and China’s reversion to autocracy – with minimal foreign opposition. The US’s conflict with China is one reason Russia believes it has a window of opportunity. Chart 13CHINA GEORISK INDICATOR Short Taiwan: Taiwan’s geopolitical risk has paused far short of previous peaks as the country’s currency and stock market benefit from the ongoing semiconductor shortage. But a peak may be starting to form in relative equity performance (Chart 14). We doubt that China will see any Russian attack on Ukraine in 2022 as an opportunity to invade Taiwan, although economic sanctions and cyber-attacks are an option that we fully anticipate. Invading Taiwan is far more difficult militarily than invading Ukraine and China is less ready than Russia for such an operation. However, China might be able to exploit a Russian attack as soon as 2024. Chart 14TAIWAN TERRITORY GEORISK INDICATOR Long South Korea: South Korea’s presidential election is approaching on March 9 and this event combined with North Korea’s new cycle of missile provocations will keep political risk elevated (Chart 15). The conservative People Power party has pulled ahead in opinion polling and the incumbent Democratic Party has been weakened by the pandemic. But the race is still fairly tight and a viable third party candidate could make a comeback. China’s policy easing should eventually benefit South Korea. Chart 15SOUTH KOREA GEORISK INDICATOR Long Australia: Australia’s federal election must be held by May 21 and anti-incumbency feeling has taken hold, with the Liberal-National coalition collapsing in opinion polls relative to the Australian Labor Party. Australia still faces shockwaves from the pandemic and China’s secular slowdown, reversion to autocracy, and conflict with the US, especially if the US gets distracted in Europe. Political risk is high and rising (Chart 16). However, Australia benefits from rising commodity prices and we favor developed markets outside the United States. Chart 16AUSTRALIA GEORISK INDICATOR Long Canada: Canada’s recapitalized its political system with last year’s general election and political risk is subsiding (Chart 17). Canada benefits from rising oil and commodity prices and close proximity to the hyper-stimulated US economy. Chart 17CANADA GEORISK INDICATOR Neutral Turkey: Turkey is one of our perennial candidates for a “black swan” event as the country’s political stability continues to suffer under strongman rule, unorthodox monetary and fiscal policy, military adventures in North Africa and Syria, and now a Russian bid to dominate the Black Sea. Elections looming in 2023 will provoke turmoil as the Erdogan administration is extremely vulnerable and yet has many ways to try to cling to power (Chart 18). Chart 18TURKEY GEORISK INDICATOR Neutral Brazil: Brazilian political risk is subsiding as the market expects former President Lula da Silva to return to power in this October’s presidential election and replace current populist President Jair Bolsonaro. Relative equity performance always appears as if it has bottomed only to inch lower in the next selloff. China’s policy easing is a boon for Brazil but China is not providing massive stimulus, the election will be tumultuous, and even a Lula victory will need to see a market riot to ensure that structural reforms are pursued (Chart 19). Chart 19BRAZIL GEORISK INDICATOR Long South Africa: South Africa still faces elevated political risk despite the conclusion of the 2021 municipal elections. However, the ruling African National Congress, which is pursuing an anti-corruption drive, is likely to stay in power, lending policy continuity. Equities have bottomed and are rebounding relative to emerging markets (Chart 20). The danger is that structural reforms will slip ahead of the spring 2024 election. Chart 20SOUTH AFRICA GEORISK INDICATOR Investment TakeawaysTactically stay long gold, defensives over cyclicals, large caps over small caps, Japanese industrials versus German, GBP-CZK, and JPY-KRW.Book a 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.   Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Ritika Mankar, CFAEditor/Strategistritika.mankar@bcaresearch.comFootnotes1      For Blinken’s press conference on the US formal response to Russia, see US Department of State, "Secretary Antony J. Blinken at a Press Availability," January 26, 2022, state.gov.2     For Ukraine’s criticism that Germany should offer pillows in addition to helmets, see Humeyra Pamuk and Dmitry Antonov, "U.S. responds to Russia security demands as Ukraine tensions mount," Reuters, January 26, 2022, reuters.com. For the US’s $2.5 billion in defense aid to Ukraine since 2014, see Elias Yousif, "U.S. Military Assistance to Ukraine," January 26, 2022, stimson.org. For purpose and significance, see Samuel Charap and Scott Boston, "U.S. Military Aid to Ukraine: A Silver Bullet?" Rand Blog, rand.org.3     Michael Kofman, "Putin’s Wager in Russia’s Standoff with the West," War on the Rocks, January 24, 2022, warontherocks.com.4     In 2021 the US apparently moved to embrace the Minsk Protocols for the first time, but since then it has not joined the talks. See National Security Adviser Jack Sullivan, "White House Daily Briefing," December 7, 2021, c-span.org. 5             Élysée, "Declaration of the advisors to the N4 Heads of States and Governments," January 26, 2022, elysee.fr. See also "Russia, Ukraine agree to uphold cease-fire in Normandy talks," DW, January 26, 2022, dw.com.Geopolitical CalendarStrategic ThemesOpen Tactical Positions (0-6 Months)Open Cyclical Recommendations (6-18 Months)

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 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 - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##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  

Highlights The Biden administration faces significant risks from outside the US economy – our third “key view” for 2022. The Ukraine conflict brings one external risk to the forefront. These external risks would exacerbate the global supply squeeze, potentially pushing up commodity prices until they start to kill demand. Investors should prepare for oil price overshoots.  Exogenous risks – such as foreign policy crises – rarely help the president’s party in the midterm election. Any crisis that adds to short-term inflation will hurt the ruling party. Tactically we continue to prefer defensive equities. Close our tactical long industrials / short consumer discretionary trade for a gain of 11.6%. Close long energy stocks for a 15.6% gain and convert to long energy small caps versus large caps. Buy the dip in cyber security stocks. Feature Stock market volatility is back, thanks in no small part to external risks such as Europe’s energy shortage and Russia’s conflict with the West over Ukraine. In our forecast for 2022, we highlighted the Biden administration’s external risks as our third key view. The rapidly deteriorating geopolitical situation was one of several reasons behind this view and it has now clearly moved to the forefront. In this report we highlight the consequences for domestic-oriented US investors. Biden’s immediate external risks, if they materialize, will increase the likelihood that Democrats will lose control of Congress, causing US fiscal policy to freeze and driving policy uncertainty and the dollar upward. For detailed coverage of the Ukraine conflict and its global geopolitical, macro, and market implications please refer to our Geopolitical Strategy reports. Why Is Biden Vulnerable To External Risks The Biden administration and the Democratic Party face serious external risks in 2022. The Omicron variant and global supply constraints are a major factor. Also the US’s domestic political divisions invite challenges from abroad. President Biden is politically weak ahead of midterm elections on November 8. His net approval rating is under water at -10 percentage points. Republicans are now leading the generic congressional ballot with 45.5% support against Democrats’ 41.8%. On a deeper level, Democrats are beset by a socialist fringe on their left wing, making it difficult to pass legislation, and an enthusiastic nationalist opposition movement with a viable challenger for the presidency in 2024 (former President Trump). At best they will pass one more major bill this year before Congress gets gridlocked. Foreign rivals have an advantage in this context. America’s chief rivals face limited political constraints at home (no midterm elections) but they can make low-cost, high-impact threats against the Biden administration through their leverage over the global supply chain and hence voters’ pocketbooks. External Risks Are Inflationary (At Least At First) External risks begin with inflation. The US’s large imbalance of investment over savings is evident in a current account deficit of 3.3% and deteriorating terms of trade. American demand is exceedingly strong due to accumulated household savings, a new capex cycle, and lingering effects of monetary and fiscal stimulus. Yet global supply is impeded. Import prices are rising at a 5.7% rate, the fastest since the BLS started the series in 2010, while imports from China are rising at a 4.7% clip. China’s “zero Covid” policy implies that supply disruptions will keep up the inflationary pressure this year (Chart 1, first panel). The US is also importing inflation from rising commodity prices. West Texas Intermediate crude oil prices have risen to $83 per barrel and average gasoline prices stand at $3.3. With global supply-demand balances tight, WTI prices should average $77 per barrel this year and $78 next year, according to our Commodity & Energy Strategy. In this context, unplanned supply disruptions are likely and will put more pressure on the supply side. Any conflicts with oil producers such as Russia and Iran will backfire in the form of higher prices at the pump (Chart 1, second panel). Yet geopolitical competitors (Russia, Iran, China) have unfinished business with the US stemming from the Trump administration. It is also possible that Biden could negotiate diplomatic solutions, reducing the risk of an oil price spike, but that is not the current trajectory. Chart 1Biden's External Risks Are Inflationary For Now Interest rate hikes from the Federal Reserve will not easily control inflation derived from external sources and supply constraints. They will take time to dampen domestic demand. Yet voters usually solidify their opinions by mid-summer. Inflation may not have come down much by that time. Biden and the Democratic Party are at the mercy of the global supply chain. In this context Russia deliberately forced its way to the top of the US and global agenda by demanding that the West renounce any attempt to threaten its national security via Ukraine or the former Soviet Union. Energy Shock From Russia? The Ukraine crisis threatens an increase in global energy prices. Russia provides 8% of Europe’s commodity imports, 18% of its energy imports, and 16% of its natural gas imports (Chart 2). Russia is already withholding energy supplies from Europe, helping push natural gas prices up by 122% since last August. If war ignites, Russia could reduce energy flows to Ukraine and hence to the rest of Europe. Europe would not be willing to impose as harsh of sanctions as the US because its energy supply depends on it. The US can increase exports to Europe but it cannot replace Russia without depriving its other allies and partners, including India, Japan, and South Korea (Chart 3). The squeeze will cause prices to rise at first but if it is not addressed by higher output from the US and OPEC 2.0, then demand will be destroyed. Note that in 1979, 2008, and 2014, Russian military invasions coincided with a peak in global oil prices. Chart 2Geopolitical Risks Cause Resource Squeeze Chart 3Can US Replace Russia For Europe? Not Really. If other supply problems emerged simultaneously, the slowdown could be especially disruptive. If US-Iran negotiations fail, then another energy supply risk will emerge immediately this spring. The implication is not only a rise in oil prices but also a resilient dollar, which is also the implication of the Fed’s looming rate hikes. Defensive plays would tend to beat cyclical plays, at least in the short run until the crisis abates. But it is important to look at previous examples of Russian aggression to test this hypothesis. US Market Response To Russian Belligerence When Russia invaded Georgia in August 2008, the attack had limited impact on global financial markets, which were focused on the subprime mortgage crisis unfolding on Wall Street. Naturally stocks underperformed bonds, cyclicals underperformed defensives, and value went sideways against growth. Small caps rallied at first versus large caps but then hit a turning point from outperformance to underperformance (Chart 4). Note that the invasion began while President Putin watched the summer Olympics live in Beijing. So one cannot rule out a limited military action against Ukraine in the near term just because Putin is also headed to Beijing for this winter’s Olympics. When Russia invaded Ukraine in February 2014, seizing the Crimean peninsula in the Black Sea, the attack had a greater impact on global financial markets than with Georgia, although Ukraine’s relevance to the global economy was (and is) still limited. Chart 4Market Reaction To Russia Invasion Of Georgia, 2008 Chart 5Market Reaction To Russia Invasion Of Ukraine, 2014 Bonds outperformed stocks, cyclicals were flat-to-up against defensives (energy clearly outperformed defensives), and small caps stumbled but then beat out large caps (Chart 5). Energy stocks theoretically stood to benefit but crashed later that year due to supply glut and China policy tightening. In 2022 the situation is different from these previous Russian invasions in that the world is already in the thrall of an energy supply squeeze brought on by various factors. China’s economy is growing slowly but authorities are easing policy. A comparison of the winter of 2021-22 with that of 2013-14, when Russia invaded Crimea, suggests that energy stocks have already far outpaced growth and defensives (Chart 6). Energy small caps, however, could rally substantially against large cap peers. Tactically US investors should maintain a risk-averse positioning until the Russians make a military decision and the West announces its retaliatory measures. This analysis suggests that cyclicals and small caps face volatility but can ultimately grind higher after the onset of any new war in Ukraine. The magnitude of the war will obviously matter, which is why we maintain a defensive tactical positioning. The next question centers on the medium-term policy impact of Biden’s external risks. Chart 6Market Context: 2022 Versus 2014 Implications For US Midterms And Policy It is possible that Biden’s external risks will play a role in the 2022 midterms. It depends on which risks materialize. Most likely a Russian re-invasion of Ukraine would have a negative effect on the Democrats, especially if it adds to voters’ inflation woes. Major foreign policy successes or failures have a substantial impact on a president’s re-election chances but midterms are less obvious. Midterms almost always go against the president’s party because the previous election’s losers turn out in droves while winners sit home in complacency or disillusionment. The midterm electorate tends to be older, whiter, and more educated than the presidential electorate. Chart 7 shows only midterm elections in which external risks – such as foreign policy – played a major role. In the House, the only time the president’s party gained seats was in 2002, though it only lost four seats in 1962. In the Senate, the president’s party gained seats in 1962, 2002, and 2018 and only lost 2 seats in 1954. From these points we can draw the following conclusions: Chart 7US Midterm Elections: Ruling Party Performance Amid Foreign Policy Crises Foreign policy crises do not generally help the president’s party. While major crises like 9/11 helped the Republicans, and the 1962 Cuban Missile Crisis minimized Democrats’ losses, nevertheless the 1942 midterm occurred after Pearl Harbor and the Democrats lost seats. Minor crises like the 1958 “Lebanon Crisis” also do not help. Russia’s invasion of Ukraine in 2014 falls under this category and did not help President Obama’s Democrats. A major threat to the homeland can help the president’s party on the margin. This is the significance of 1962 and 2002. The ruling party either minimized losses or made absolute gains in the House, while gaining seats in the Senate. (The 2018 midterm is the other case in which the president’s party gained Senate seats, amid President Trump’s trade war with China, but Republicans suffered heavily in the House.) Wartime escalation and entanglement hurt the president’s party. President Johnson’s Democrats suffered deep losses in 1966, as did President George W. Bush’s Republicans in 2006. Obama’s troop surge in Afghanistan was not the main issue but did not help his party in 2010. Ceasefires and peace treaties do not help the president’s party, even when the end of the war is seen as a victory. World War I was drawing to a close in 1918 but Democrats suffered for having gotten the US involved. Democrats also lost in 1946, despite US triumph in WWII. The Korean war ended on a far more ambivalent note and Republicans suffered at the ballot box. Vietnam was drawing to an ignominious close in 1974, which also occurred in the aftermath of the Arab oil embargo, recession, and Watergate scandal, so no surprise Republicans lost seats. If there is a foreign policy crisis this year, the “best case” for Biden’s Democrats – in crass political terms – would be one that engenders a patriotic rally, like happened with the Cuban Missile Crisis or 9/11. If Democrats only lose four seats in 2022, like Kennedy in 1962, they will have a one-seat majority in the House. However, this best-case scenario is unlikely. As noted, 1962 and 2002 consisted of direct threats to the US homeland. All other crises either hurt or did not help the president’s party. In 2014, while voters had other things on their minds that year, Russia’s invasion of Crimea reinforced criticisms of Obama’s foreign policy already centered on Libya, Syria, and Iran. Obama responded with sanctions and aid to Ukraine, as Biden threatens to do today. Democrats lost 13 seats in the House and 9 seats in the Senate. A similar negative impact should be expected if Russia re-invades in 2022. Biden is already vulnerable: his approval rating collapsed after his messy withdrawal from Afghanistan (reinforcing the fourth bullet about ending wars above). A new foreign policy crisis could cement the narrative of foreign policy incompetence. It matters a great deal whether an exogenous crisis automatically hurts the voter’s pocketbook. If it does, then any initial rally around the flag will fade over time, leaving the negative material impact behind and angering voters. In 1974, President Ford’s approval rating shot up above 50% as he took over from Nixon, yet his party still suffered from the inflationary economic backdrop and dour foreign policy backdrop. In 1978, President Carter’s approval rating also recovered to nearly 50% in time for the vote but it was not enough to overcome inflationary malaise – and Iranian oil strikes began in September (Chart 8). If we subtract the Misery Index (unemployment plus inflation) from the president’s approval rating, we see that Kennedy had a 70% approval during the Cuban Missile Crisis, and Bush had a 62% approval in 2002. But Johnson and Carter were sinking toward 35% during their first midterms, which is where Biden stands today (Chart 9). Chart 8Different Reactions For Different Crises Chart 9Best And Worst Case Scenarios Of Foreign Policy Crisis For Democrats Thus Biden’s external risks, depending on which ones materialize, suggest that the Democratic Party will face another headwind in November. Democrats are very likely to lose the House and somewhat likely to lose the Senate. Gridlock is already setting in – as will be apparent with the potential government shutdown over the February 18 deadline to pass spending bills. But the midterm will formalize it. Policy uncertainty will continue to creep up and weigh on investor risk appetite this year. In other words, even if cyclicals rally through a Ukraine conflict, they may not outperform defensives later this year. Investment Takeaways Cyclically we are booking an 15.6% gain on our long energy trade and will convert it to a long US energy small caps relative to large caps trade. The external risks highlighted in this report would push up oil prices at least initially (Chart 10). However, volatility will pick up from here. OPEC 2.0 will want to keep Brent crude prices from settling above the $90 per barrel that starts to crimp demand, as our Commodity & Energy Strategy argues. Higher prices will also encourage new production, including from the US shale patch (Chart 11). Note that energy stocks, like other cyclicals, tend to underperform during midterm election years as policy uncertainty affects markets. Chart 10Book Gains On Tactical Long Energy Equities Trade Chart 11US Oil Producers Will Step Up  Tactically we recommend closing our long industrials / short consumer discretionary for a gain of 11.6%. Normally, consumer discretionary stocks are the best performing sector during midterm election years while industrials are the worst. But because of China’s policy easing, we took a tactical bet that the opposite would occur at the start of the year. However, external risks should now cause this situation to reverse by pushing up the dollar, penalizing industrials, without hurting the American consumer too much (Chart 12). Industrial equities are pricing in strong capex intentions but geopolitical conflicts would weigh on those intentions, while new orders and core durable goods orders could suffer a bit (Chart 13). The midterms will come into focus later this year and weigh on industrials as well. Chart 12Close Long Industrials Trade For Now Chart 13Industrials Still Attractive On Cyclical Basis Cyclically stick with cyber security stocks. They have sold off along with the tech sector as interest rates rise. But long cyber security is a secular investment thesis based on digitization of the economy, rising cyber crime, and geopolitical risk. Tensions with Russia, proxied by the fall in the ruble and rise in aerospace/defense stocks, point to the fact that investors recognize international tensions will remain high (Chart 14). Cyber space will remain an area of conflict even if physical conflict does not materialize. Growth stocks should also revive later as midterm policy uncertainty picks up. Chart 14Cyber Security Is A Secular Trade ... Buy The Dip Chart 15Overweight Health Care Amid Political Risk Tactically stick with overweight health care on rising uncertainty and expectations that the dollar will pick up (Chart 15). Defensives, especially health, should also outperform as the year goes on and midterms approach. Pricing power is returning to the sector but the Biden administration only has a little legislative ammunition left and its regulatory focus lies elsewhere for now.     Matt Gertken Vice President 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 Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Feature Chart 1Weak Economic Fundamentals Undermine Stock Performance Monetary policy easing has intensified in the past two months. The PBoC reduced one-year loan prime rate (LPR) by 10 bps and five-year by 5 bps following last week’s 10bps cut in policy rates1 and December’s 50 bps drop in the reserve requirement rate (RRR). Nonetheless, the onshore financial market’s response to the monetary policy actions has been muted. China’s A-share market price index fell by 3% in the past month. Credit growth has bottomed, but there is no sign of a strong rebound despite recent rate decreases (Chart 1, top panel). The impaired monetary policy transmission mechanism will likely delay China’s economic recovery, which normally lags the credit cycle by six to nine months. Moreover, the marginal propensity to spend among both corporates and households continues to decline, highlighting a lack of confidence among real economy participants, and will in turn dampen the positive effects of policy stimulus (Chart 2).  The poor performance of Chinese onshore stocks (in absolute terms) is due to a muted improvement in credit growth and deteriorating economic fundamentals (Chart 1, bottom panel). Our model shows that China’s corporate profits are set to contract in next six months, implying that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive (Chart 3). Therefore, investors should maintain an underweight allocation to Chinese equities for the time being. Chart 2Lack Of Confidence Dampens Corporate Earnings Outlook Chart 3China's Corporate Profits Set To Contract In Next Six Months   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Improving Liquidity, Weakening Credit Demand The modest uptick in December’s total social financing (TSF) growth largely reflects a significant increase in government bond issuance, while bank loan growth continued on a downward trend (Chart 4). Corporate loan demand remained sluggish, which dragged down aggregate bank credit growth (Chart 5). Downbeat business confidence suggests that corporate demand for credit will take longer to turn around, and therefore will reduce the effectiveness of current easing measures. Chart 4Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Chart 5Corporate Demand For Loans Weaker Than Suggested By Headline Data Meanwhile, corporate bill financing has risen rapidly in recent months and now accounts for almost 40% of new bank loans, the highest level since 2010 (Chart 5, bottom panel). The high share of short-term lending to the corporate sector highlights the underlying weakness in both loan supply and demand.  Banks are risk averse and reluctant to approve longer-term credit to the corporate sector, while corporates are unwilling to take on more debt.  As a result, banks have had to issue short-term bills in order to meet their lending quota. Proactive Fiscal Policy Will Have A Limited Impact On Infrastructure Investments Chart 6Local Government SPBs Will Be Frontloaded In 2022 Fiscal policy will likely be frontloaded in Q1 this year, but the impact of a proactive fiscal policy on boosting infrastructural investment may be limited. According to a statement by the Ministry of Finance last December, around RMB1.46 trillion in the quota for local government special purpose bonds (SPBs) has been frontloaded for 2022. If we assume that all of the SPBs will be issued in Q1, the amount will be higher than SPBs issued during the same period in 2019, 2020 and 2021 (Chart 6). We expect a total SPBs quota of RMB 3.5 trillion for 2022, roughly the same as 2021.  This implies a zero fiscal impulse on SPBs in 2022 compared with 2021. However, there were an estimated 1.2 trillion in SPB proceeds in 2021 that local governments failed to invest and this amount could be deployed in 2022. If we add last year’s SPB carryover to this year’s quota, there may be a 30% increase in the available funds to invest in infrastructure projects in 2022. Chart 7Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending However, a 30% jump in SPB proceeds does not suggest an equal boost in infrastructure spending this year (Chart 7). As noted in previous reports, SPBs issued by local governments only account for around 15% of total funding for infrastructure spending. Bank loans, which remain in the doldrums, are a much more significant driver in supporting the sector’s investment.  Secondly, infrastructure spending has structurally downshifted since 2017 due to a sweeping financial deleveraging campaign to rein in shadow banking activity by local government financing vehicles (LGFVs). Shadow banking activity, which is highly correlated with infrastructure investment growth, is stuck in a deep contraction with no signs of an imminent turnaround (Chart 7, bottom panel). Thirdly, land sales play a prominent role in local government financing, accounting for more than 40% of local government aggregate revenues2 compared with about 15% from SPBs (Chart 8). Local government fiscal spending power will be constrained due to a significant and ongoing slowdown in land sales and regulatory pressures on LGFVs (Chart 8, bottom panel).    Therefore, we expect that infrastructure spending will only moderately rebound in 2022. At best, it will return to its pre-pandemic rate of around 4% (year-over-year) in 2022 (Chart 9, top panel). Notably, onshore infrastructure stocks have priced in the recent favorable news about proactive fiscal policy support in 2022 (Chart 9, bottom panel). Given that infrastructure investment will likely only improve modestly this year, on a cyclical basis the sector’s stock performance upside will be capped and renewed weakness is likely. Chart 8Government Funds Face Headwinds From Falling Land Sales Chart 9Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate More Policy Fine-Tuning Is Underway, But Housing Policy Reversal Remains Doubtful Last week’s 5bp reduction in the 5-year LPR, which serves as a benchmark for mortgage loans, was positive for the housing market. However, the cut is insufficient to revive the demand for housing. Moreover, the asymmetrical rate reductions - a 10bps drop in the 1-year LPR versus a 5bps reduction in the 5-year - signals that the authorities are reluctant to decisively reverse housing policies. Sentiment in the housing sector remains downbeat. A survey conducted by the PBoC shows that the willingness to buy a home has plunged to the lowest level since 2017 (Chart 10). Medium- to long-term household loan growth, which is highly correlated with home sales, decelerated further in December (Chart 10, bottom panel). Given that home prices continue to decline, buyers may be expecting more price discounts and refrain from making purchases despite slightly cheaper mortgage rates. Although there was a modest pickup in medium- to long-term consumer loan growth in November, it was mainly driven by pent-up mortgage applications delayed by the banks in Q3. Moreover, advance payments for real estate developers remained in contraction through end-2021. The prolonged weakness in the demand for mortgages and homes highlights our view that it will take more than a minor mortgage rate cut to revive sentiment (Chart 11). Chart 10Sentiment In Housing Market Has Plummeted To A Multi-Year Low Chart 11Funding Among Real Estate Developers Has Not Improved Without a decisive improvement in home sales, real estate developers will continue to face funding constraints, which will weigh on new investment and housing projects (Chart 12). We expect the contraction in real estate investment and housing starts to be sustained through at least 1H22 (Chart 13). Chart 12Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Chart 13Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Chinese Export Growth Will Converge To Long-Term Growth Chart 14Vigorous Exports Provided Crucial Support To China's Economy In 2021 China’s exports grew vigorously in 2021, providing critical support to the economy.  Net exports contributed 1.7 percentage points to the 8.1% rate of real GDP growth in 2021, the highest growth contribution since 2006. China’s share of global exports expanded to more than 15%, about 2 percentage points higher than the pre-pandemic average from 2015 to 2019 (Chart 14). The export sector probably will not repeat last year’s strong performance. The widening divergence of exports in value and in volume suggests that the solid aggregate value of exports has been mainly buttressed by soaring export prices since July 2021 (Chart 15). The price effect will likely gradually abate in 2022 due to easing global supply chain constraints, softer global economic growth and a high base factor from 2021. Indeed, export prices from China and other industrialized countries may have already peaked (Chart 16). Chart 15Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Chart 16Export Prices May Have Peaked Services spending worldwide will likely normalize and lead global demand growth in 2022. Meanwhile, goods spending will moderate, implying weaker demand for China’s manufactured goods (Chart 17). Furthermore, China’s strong exports to emerging markets (EM) since Q2 2021 reflected supply shortages due to production interruptions in the EMs (Chart 18). We expect supply chain disruptions in these economies to ease in 2H22 when Omicron-induced infections subside and antiviral treatments become available worldwide. As such, China’s exports to those regions may gradually return to pre-pandemic levels. Chart 17US Household Consumption Will Likely Rotate From Goods To Services In 2022 Chart 18Rising Exports To EMs In 2021 May Not Continue Into 2022 China’s manufacturing utilization capacity reached a historical high in 2021, supported by hardy external demand for goods. However, profit margins in the manufacturing sector have been squeezed due to surging input costs (Chart 19). Manufacturing investment growth has been falling, reflecting the reluctance by manufacturers to expand their business operations amid narrowing profit margins (Chart 20). The profit outlook for the manufacturing sector will be at risk of deterioration when the growth in both export volumes and prices moderate in 2022.  Chart 19Manufacturing Sector's Profit Margins Have Been Squeezed Chart 20Manufacturing Investment Growth And Output Volume Both Rolled Over Rising Import Prices Mask The Weakness In Chinese Domestic Demand Chinese import growth in value remained resilient through December, but has increasingly been driven by rising import prices. Import growth in volume, which is a truer picture of China’s domestic demand, decelerated at a faster rate in 2H21 (Chart 21). Credit impulse, which normally leads import growth by around six months, only ticked up slightly. The minor improvement in the rate of Chinese credit expansion will provide limited support to the country’s imports in 1H 2022 (Chart 22).  Chart 21Rising Import Prices Masked The Weakness In China's Domestic Demand   Chart 22Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Chart 23Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints The volume of Chinese-imported key commodities, such as iron ore and steel, rebounded in the past three months, but its growth remains in contraction on a year-on-year basis (Chart 23). The improvement in Chinese commodity imports, in our view, reflects an easing in production constraints rather than escalating demand. Recently released economic data, ranging from manufacturing PMI, industrial production, fixed-asset investment and construction activity, all point to an imbalanced supply-demand picture in China’s economy (discussed in the next section).    Sluggish Quarterly Economic Growth At End Of 2021 China’s economy expanded by 8.1% in 2021 or at a 5.1% average annual rate in the past two years.  However, quarterly GDP growth on a year-over-year basis slowed further to 4% in Q4 from 4.9% in the previous quarter. On a sequential basis, seasonally adjusted GDP growth in Q4 was 1.6 percentage points above that of Q3, but slightly below its historical mean (Chart 24). Chart 24Subdued GDP Growth In Q4 Chart 25Investment And Consumption Have Been Poor Economic Links Chart 26Softness In Investment And Consumption More Than Offset Robust Exports Although industrial production accelerated somewhat in December, it reflects a catch-up phase following a period of constrained output amid last fall’s energy crisis (Chart 25). On the other hand, lackluster domestic demand and a further slowdown in the housing market significantly dragged down China’s economic expansion in Q4. Both fixed-asset investment and consumption decelerated significantly in 2021 Q4, more than offsetting an improvement in net exports (Chart 26, top panel). Notably, year-over-year growth rates in construction and real estate components of real GDP fell below zero in Q4 (Chart 26, bottom panel). In light of the subdued credit growth through end-2021, China’s economic activity will not regain its footing until mid-2022.  Slow Recovery In Household Consumption Likely Through 1H22 The household consumption recovery was sluggish in 2021 and it will face strong headwinds at least through 1H22. China’s consumption recovery has been hindered by a worsening labor market situation, depressed household sentiment and renewed threats from flareups in domestic COVID-19 cases. China’s labor market situation shows a mixed picture. The urban unemployment rate has dropped to pre-pandemic levels and stabilized at 5.1% in December. It remains well within the government’s 2021 unemployment target of “around 5.5%”. However, urban new job creations plunged sharply and the number of migrant workers returning to the cities remains far below the pre-pandemic trend (Chart 27). China’s imbalanced economic recovery in the past two years led to a substantially slower pace of job creation in labor-intensive service sectors (Chart 28). Moreover, wages have been cut and the unemployment rate among younger workers have climbed rapidly in sectors suffering from last year’s regulatory crackdowns in real estate, education and internet platforms. Even though policies have recently eased at margin, it will take time for labor market dynamics (a lagging indicator) to improve. Chart 27Labor Market Situation Is Worsening Chart 28Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Chinese household expenditures have lagged disposable incomes since the outbreak of the pandemic (Chart 29). The propensity to consume has declined since 2018 and the downward trend has been exacerbated by the pandemic since early 2020 along with a soaring preference to save (Chart 30). Chart 29Chinese Household Expenditures Have Lagged Disposable Income Growth Chart 30Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Household consumption also faces renewed threats from increases in domestic COVID-19 cases. Since Q3 last year, more frequent city-wide lockdowns and inter-regional travel bans have had profound negative effects on the country’s service sector and retail sales (Chart 31 & 32). Omicron has also spread to China, triggering new waves of stringent countermeasures. China will not abandon its zero-tolerance policy towards COVID anytime soon, thus we expect the stop-and-go economic reopening to continue to weigh on the country’s service sector activity and consumption at least through 1H22. Chart 32Service Sector Activities Struggle To Return To Pre-Pandemic Trends Chart 31China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes 1     The 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rates. 2     Including local government budgetary and managed funds revenues.   Strategic View Cyclical Recommendations Tactical Recommendations