Financial Markets

Executive Summary Return Of The 'Pocketbook Voter' President Biden’s pledge to fight inflation ahead of the midterm elections got a boost with the Gulf Arab states pledging to increase oil production in July and August. Yet OPEC’s action should not be overrated. The Saudis are not clearly bailing out Biden … at least not yet. Biden’s other inflation-fighting tools are also limited. The Fed will hike rates, which will weigh on inflation, at least in the short run. A short-term moderation in inflation will cause big shifts in financial markets. It will not save the midterms for Democrats, but gridlock is disinflationary so the effect is the same. Inflation risks will persist over the long run.   Recommendation (Cyclical) Inception Level Inception Date Return Small Vs. Large Cap Energy 0.6485 26-JAN-22 14.2% Oil And Gas Transportation And Storage Vs. S&P 500 0.0527 30-MAR-22 16.5% Bottom Line: Expect inflation to moderate in the short run. Oil prices will be volatile. Book a 14% profit on small cap versus large cap energy stocks and a 16.5% profit on the oil and gas transportation sub-sector relative to the broad market. Feature President Biden kicked off the summer – and the midterm election campaign – by defending his record thus far and pledging a three-pronged strategy to fight inflation. His options are limited but he received a boost from OPEC right off the bat. The bottom line is that disinflationary pressures are emerging. These include congressional gridlock, which is likely to return in January 2023. Biden’s policies will not save his party from a defeat in the midterms but moderating inflation will have huge investment consequences. Biden’s Three-Pronged Plan Consumer confidence is hurting while inflation eats away at real wage growth for Americans (Chart 1). Confidence is 14% higher than when Biden took office but 17.5% lower than when it peaked in June 2021. The latest survey from the Conference Board showed another decrease in May. This is foul weather for a ruling party that already stands to suffer a major check on its power when voters go to the polls in the fall. Biden’s approval rating is likely to stabilize but only at the current low level of 41.4%. Voters are focusing on the economy more than other issues like health care, the environment, or foreign affairs (Chart 2). Chart 1Consumer Confidence And Real Wages Tumble Chart 2Return Of The 'Pocketbook Voter' In the Wall Street Journal Biden laid out his party’s election pitch.1 First, he argued that the US economy is transitioning from rapid recovery to stable growth – i.e. that it is not going into recession. That would be good, but a recession is possible and the slowdown is politically deadly: Household Savings: Aggregate household savings have risen from $1Tn in 2019 to $3.9Tn today, which Biden cited as evidence of improving financial security. The problem is that inequality skews the picture and the average American is unlikely to feel secure. Low and middle income earners have depleted their savings or seen only a small increase (Chart 3). The Biden administration failed to improve inequality as promised while the uneven economic recovery means that lower-paid Americans do not have as much ability to buffer spending as the aggregate savings imply. They will be unhappy in November. Chart 3Normal Households No Longer Flush With Savings Jobs And Wages: Biden highlighted the role of his economic stimulus in lowering unemployment and argued that Americans have better paying jobs. But inflation has eroded real wages and incomes, as highlighted in Chart 1 above. Business Investment: Biden argued that business investment is brisk. But sentiment is turning. New orders of core capital goods have rolled over and capex intentions are falling (Chart 4). Manufacturing Comeback: Biden also touted the US manufacturing comeback, claiming that factory jobs are growing at fastest rate in 30 years. But again the tide is shifting against him, with the employment component of manufacturing purchasing manager indexes now signaling contraction (Chart 5). Biden, like Presidents Trump and Obama, has invested heavily in the “Buy America” re-industrialization narrative, so this trend is threatening. Chart 4Business Investment Setback Chart 5Manufacturing Employment Weakening A recession may indeed be avoided but the risk will not go away in time for the election. A recent study showed that at today’s extremely high level of inflation and extremely low level of unemployment, the odds of recession range from 60%-70% over the next 12-24 months.2 Second, Biden promised voters that he will fight inflation with all the powers of the White House. He laid out a three-pronged approach. However, his options are fairly limited and voters will not change their minds easily over the next five months: The Fed will hike rates: Biden argued that it is the Fed’s job to fight inflation and he will not interfere with rate hikes. While Biden offered admirable verbal support for an independent and non-partisan central bank, the truth is that real interest rates have not been this low since the highly politicized Fed chairmanship of Arthur Burns (Chart 6). While Biden has no reason to discourage rate hikes at the moment, he may change his tune as rates rise, growth slows, and the presidential election approaches. So may Powell, but by then it may be too late. In short, the Fed will hike, which will weigh on inflation, but it will not help Biden win voters this fall or avoid a recession by 2024. Congress will expand capacity: Biden argued that the bipartisan infrastructure bill that he signed into law and his other legislative proposals will boost the supply side of the economy. We are moderately optimistic about Congress’s ability to pass a party-line reconciliation bill that provides subsidies for the energy sector. This could pass under the consensus-building rubric of fighting Russia and climate change at the same time. But this measure, along with Biden’s Housing Supply Action Plan, child care and elderly care subsidies, and other proposals often look more like demand-side stimulus than supply-side reforms. They would fan inflation by increasing government spending and budget deficits. Moreover the administration cannot fix broken supply chains while China remains subject to strict Covid-19 lockdowns (Chart 7). In short, Congress may pass a reconciliation bill but it would be mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms. Chart 6Biden Doesn't Need To Interfere With The Fed Chart 7Supply Snarls Will Continue While China Struggles With Covid The budget deficit will fall: Biden argued that budget consolidation will reduce inflation, pointing to this year’s estimated $1.7 trillion drop in the budget deficit and arguing that the deficit is falling lower than pre-pandemic levels. He also argued that robust tax revenues from the economic recovery justified his previous fiscal stimulus (the American Rescue Plan Act). However, the budget is merely normalizing from extreme pandemic heights – there have obviously not been any long-term fiscal reforms (Chart 8). If Congress passes a reconciliation bill then Biden may succeed at passing a minimum corporate tax, which would mark an important success. But while the fiscal drag is negative for inflation, it is also negative for the economy this year and for Biden’s party in the midterms, and long-term budget trends are inflationary. Chart 8No Sign Of Budget Control Over Long Run – Budget Deficits Are Inflationary The takeaway is that the Fed’s actions are disinflationary. Congress may or may not pass a climate bill before the election, but if it does, the budget deficit will be the same or larger and the economy will be the same or slightly stimulated. In brief Biden’s anti-inflation plan is to avoid interfering at the Fed. Extremely low unemployment will not save Biden and the Democrats this election season, any more than it saved Trump and the Republicans in 2018 (Chart 9). The Fed will rein in inflation at least in the short run. The election will lead to gridlock, which will freeze fiscal policy. Bottom Line: Inflation expectations will moderate but not because of any supply-side reform or fiscal consolidation coming from the Biden administration this year. Chart 9Low Unemployment Will Not Save Democrats Will Biden Ease Russian Energy Tensions? No. Biden’s other avenues for reducing inflation – not addressed in his editorial – lie in the foreign policy realm. The Biden administration is turning toward foreign policy as gridlock settles over Capitol Hill. Biden’s foreign policy will be insular, reactive, and focused on the midterm elections. Could Biden facilitate ceasefire talks in Ukraine so as to ease energy pressures stemming from Russia? The short answer is no. Biden imposed an oil embargo on Russia and ultimately agreed to the EU’s embargo. Biden can afford to run large risks with Russia this year because a larger confrontation or crisis with Russia would not hurt the Democrats in the midterm elections. Indeed the best hope for the Democrats is to recreate the 1962 congressional election, when John F. Kennedy stared down Soviet leader Nikita Krushchev in the Cuban Missile Crisis in October just before the election. Kennedy’s Democrats lost four seats in the House, gained four in the Senate, and kept control of both. Biden’s approval rating is nowhere near Kennedy’s but his party’s outlook is bad enough that he may be willing to run the risk of a crisis that could lead to a favorable rally-around-the-flag effect in the fall (Chart 10). Biden’s clearance this week of the highly mobile artillery rocket system for Ukraine – despite the risk that Ukrainians would launch attacks into Russian territory – underscores this point. Bottom Line: Biden will not ease tensions with Russia ahead of the midterm to try to reduce energy prices. Chart 10Biden Can Risk A Bigger Russia Crisis Will Biden Lower China Tariffs? No. What about China – will Biden ease the Trump administration’s tariffs on China to reduce inflation before the midterm election? Treasury Secretary Janet Yellen has repeatedly signaled support for this idea. The Trump administration marked a historic increase in US tariffs and the Biden administration has so far offered relief only for US allies (Chart 11). Again the short answer is no. Protectionist sentiment will prevail during midterm election season and US voters have turned decisively unfavorable toward China in recent years (Chart 12). The China tariffs have not been the driver for US inflation so tariff relief would bring minimal price relief while exacting a high political cost of making Biden look weak, wishy-washy on his pro-democracy values, and (according to Republicans) corrupt. Biden would be offering unilateral benefits to China without gaining Chinese trade concessions. Chart 11Biden Keeps Trump's Tariffs On China Chart 12Protectionist Sentiment To Prevail Amid Midterms Recently the Biden administration gave some indications of where it stands on China policy. Biden visited US allies in Asia Pacific and provoked China over the Taiwan Strait. Secretary of State Antony Blinken unveiled the administration’s comprehensive China policy and declared that the US would remain focused on China as the “most serious long-term challenge” despite Russia’s open belligerence in Europe.3 On paper, US-China trade relations do not look that bad. While China is falling short of its Phase One trade deal import promises, the truth is that a global recession intervened – and those promises were made under duress when the US slapped sweeping sanctions on Chinese exports. The commodity trade is booming, as is to be expected amid global energy shortages (Chart 13). The problem is that neither the US nor China has the domestic political capital to offer structural concessions in the short run, while both sides are girding for a century-long power struggle over the long run. Supply insecurity will result in the commodity trade suffering as a vast global substitution effect takes place. This is due to Russia’s energy breakup with Europe, growing Russia-China trade linkages, and ongoing US-China tensions. Global trade and US-China trade are set to slow, while China’s surge in energy imports from the US will abate for reasons of state security. Chart 13US-China Trade Faces Strategic Limits Bottom Line: No reduction in US tariffs on China is likely. Any reduction will have minimal macroeconomic effects and will be replaced by other punitive measures, given the underlying strategic competition and protectionist election politics. Meanwhile China’s “Zero Covid” policy will weigh on trade ties and sustain price pressures in the short run, as mentioned. Will Biden Lift Iran Sanctions? Probably Not. What about the Middle East? Can Biden convince the core OPEC states to pump more oil in lieu of Russian production? Or can Biden lift sanctions on Iran to undercut soaring gasoline prices? On this front Biden received welcome news on June 2 when Gulf Arab states promised to increase production by 638,000 barrels per day in July and August, up from an expected 430,000. At the same time news broke that Biden will visit Saudi Arabia, including potentially Crown Prince Mohammed bin Salman (MBS), and other Gulf partners sometime in June. There is not yet a clear understanding between Biden and MBS but it is possible that one will develop. The trigger for OPEC’s declaration is the EU oil embargo on Russia. EU is finalizing an embargo on 90% of oil imports – everything except the oil flowing through the Southern Druzhba pipeline to land-locked eastern European states. The embargo will impair Russian energy production: it could fall by as much as 2-3 million barrels per day, distribution interruptions will occur as Russia transitions to Asian buyers, and Russia’s long-term production capacity could be damaged. The result could be a destabilizing price spike. While the core OPEC states have just enough spare capacity to cover that gap in theory (Chart 14), they will not want to commit all spare capacity at once. Chart 14OPEC Spare Capacity There is still a lot of uncertainty about how rapidly the embargo will be enforced, how much Russian production will suffer, whether the OPEC states will meet these new production increases (all except Saudi have been falling short), and what will be the OPEC policy beyond August. But for now it is clear that the Gulf Arab states are helping the US and EU by signaling some extra supplies at a critical time. The Gulf Arabs benefit from high oil prices and have previously ignored the G7’s pleas to increase production. But they also need to prolong the business cycle – a cycle-killing price shock from Russia is not in their interest. They are interested in keeping up revenues, maintaining domestic stability, and maintaining their position as the gatekeepers of the global oil supply and price. Secondarily, they are interested in maintaining close relations with the US, which guarantees their national security. OPEC supply easing at this juncture is obviously beneficial to Biden ahead of the US midterm election in November. But there is not yet an understanding on this front because the US is also negotiating to rejoin the 2015 nuclear agreement with Iran, which Saudi Arabia and the Gulf states oppose. Biden’s trip to the Gulf suggests that nothing is settled yet. The OPEC production increase is not proof alone that the US is breaking off talks with Iran. If the Gulf states thought the US were going to strike a deal with Iran, they might produce more oil to preempt the deal and grab more market share, which is what they did in 2014 in advance of the original 2015 US-Iran nuclear deal. The Saudis do not want US shale producers and Iranian exporters to form an unholy alliance that steals market share and compromises Saudi security. Still, we expect the US-Iran deal to fall apart. The Biden administration does not have a unified international coalition to enforce sanctions on Iran. Nor does it have the political capital or longevity to give Iran credible security guarantees that would convince it to freeze its nuclear program. Recent events support our view. The UN atomic watchdog says that Iran’s stockpile of highly enriched uranium has risen by 30% in three months. Meanwhile the US seized an Iranian tanker off Greece, Iran seized two Greek tankers, and Greece warned about dangers to shipping in the Persian Gulf. To develop a better understanding between Biden and MBS, the US needs to assure the Saudis that it will not renew the deal with Iran. The Saudis will not provide oil at Biden’s whim but they may provide if they have satisfaction that the US will scrap the deal, or otherwise compensate them, such as through increased defense assistance (which Biden threatened to cut off when he entered office). Investors should expect OPEC to fall short of its current promises – and yet to try to provide the minimum production increases necessary to prevent a destabilizing oil spike. OPEC’s interest is to make a windfall for as long as possible, which means not killing the cycle out of greed. This policy could be positive for oil prices after the immediate downward price adjustment. But for now investors should merely expect oil volatility as the EU’s embargo enforcement, Russian retaliation, Russian oil production, OPEC implementation, and US sanctions on Iran are all up in the air. A successful US-Iran deal would deepen the drop in oil prices. But odds are 60/40 that that deal will fail, leading to an escalation of tensions in the Middle East. Biden will have to underscore the US’s red line against Iranian nuclear weaponization. Oil supply disruptions will increase in frequency across the region. Bottom Line: OPEC has given Biden’s anti-inflation campaign a boost but it is too soon to declare that oil prices will substantially abate. The US-Iran deal will likely fail, increasing Middle Eastern instability and supply risks. Investment Takeaways Given that we expect continued volatility in the oil space, we are booking a 14% gain on our long small cap energy versus large cap energy trade. We are also booking a 16.5% gain on our overweight position in the oil and gas transportation and storage sub-sector. We will revisit these trades in future reports. Overall we maintain a defensive portfolio strategy. Biden’s anti-inflation campaign is meeting with some success in the Middle East but the US confrontation with Russia and the likely failure of US-Iran talks suggests that price spikes can still kill more demand and lead to further growth upsets.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Footnotes 1     See Joseph R. Biden, Jr, “Joe Biden: My Plan for Fighting Inflation,” Wall Street Journal, May 30, 2022, wsj.com.  2     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu.  3    See Antony J. Blinken, “The Administration’s Approach to the People’s Republic of China,” US Department of State, May 26, 2022, state.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary What Will Be The Implications Of China’s Common Prosperity Policies? On the one hand, Chinese stocks are oversold, equity valuations are attractive and investor sentiment is downbeat. This means that a lot of bad news has already been priced into Chinese share prices, which is positive from a contrarian perspective. On the other hand, the government remains committed to its dynamic zero-COVID policy and will resort to lockdowns whenever there is an outbreak. The Omicron variants have extremely high transmission rates, which means that the probability of new lockdowns is non trivial. Hence, the biggest risk to Chinese share prices is renewed outbreaks and lockdowns – developments which are impossible to forecast. That is why, in our opinion, Chinese stocks are facing fat tails risks. Infrastructure spending will recover modestly in H2 2022. The property sector rebound will be very muted. Chinese exports will contract. The structural outlook is unfriendly for shareholders of platform companies. The known unknowns are: Will the dynamic zero-COVID policy be successful in containing the virus? Will “animal spirits” among consumers and businesses be revived? Will western investors come back to Chinese stocks? The RMB is facing near-term risks as its interest rate differential versus the US dollar dips deeper into negative territory. Bottom Line: For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core / benchmark allocation in Chinese stocks. We maintain our long A-shares / short investable Chinese stocks strategy. Feature As strict lockdowns in key cities are lifted, the Chinese economy is bound for a snap back. Consumer spending will improve, and the government’s infrastructure push will revive capital spending modestly. What does this mean for Chinese stocks? Numerous crosscurrents make the current outlook for Chinese stocks hard to navigate. This report elaborates on variables that we can forecast and those we cannot. Odds of a material rally are not insignificant, but the probability of another relapse is not trivial either. That is why Chinese stocks presently have fat tails. For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core/ benchmark allocation in Chinese stocks. The rationale for maintaining a neutral position is that Chinese share prices could also be range-bound in the coming months. In other words, positives could offset negatives, and the fat tails outcomes might not transpire. In regard to relative performance and regional allocation, we continue to recommend that emerging market portfolios overweight Chinese A-shares and maintain a neutral stance on investable stocks. Meanwhile, global equity portfolios should remain neutral on A-shares while underweighting investable ones. This positioning is consistent with our overall EM allocation – we continue to recommend underweighting EM within a global equity portfolio. What We Know Equity Valuations And Investor Sentiment Are Depressed To begin with, there are a number of indicators that point to low equity valuations and depressed investor sentiment towards Chinese stocks: Analysts’ net EPS revisions for both Chinese A-shares and investable stocks have plunged deep into negative territory (Chart 1). Chinese net EPS revisions are also low relative to EM and global stocks (Chart 2). Chart 1Sentiment On Chinese Stocks Is Downbeat Chart 2Net EPS Revisions: China vs. EM And China vs. Global Stocks   The average of the NBS manufacturing PMI new orders and backlog of orders suggests that A-shares EPS will shrink considerably (Chart 3). A-share valuations have become attractive. Our composite valuation indicator points to below average valuations (Chart 4, top panel). This indicator is based on three variables: (1) median multiples; (2) 20% trimmed-mean multiples; and (3) equal-weighted multiples. The latter uses equal weights rather than market cap weights for sub-sectors in the calculation. Chart 3China: Corporate Profits Are Contracting Chart 4Chinese A-Shares Are Attractive   In turn, each component is constructed using the averages of the trailing P/E, forward P/E, price-to-cash earnings, price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and the bottom 10% of sub-sectors, i.e., it removes outliers. Our cyclically adjusted P/E ratio for A-shares currently stands at close to one standard deviation below its mean (Chart 4, bottom panel). The trailing and forward P/E ratios for the equal-weighted A-share index are 18 and 12, respectively. As to the investable universe, any valuation measure for the index is not useful because banks and SOEs continue to be “cheap” for a reason. In turn, internet stocks are fallen angels and their past valuations are not a good roadmap for the future. We discuss the structural outlook for their profitability below. Chart 5Chinese Investable Stocks Have Reached Technical Support Lines Finally, Chinese equities have become oversold. Investable non-TMT share prices are back to their lows of the past 12 years while TMT/growth stocks are at their long-term moving average (Chart 5). In sum, a lot of bad news has already been priced into Chinese share prices, which is positive from a contrarian perspective. Dynamic Zero-COVID Policy We have a very high conviction level that the government will remain committed to its dynamic zero-COVID policy for now. COVID cases in Shanghai and Beijing have declined following the lockdowns. This will only embolden authorities to pursue their dynamic zero-COVID policy and resort to lockdowns whenever outbreaks occur. Consistent with the dynamic zero-COVID policy, the government will inject more stimulus into the economy to offset the negative impact of past and potential future lockdowns. With inflation very subdued, the central government will not shy away from stimulating demand. In fact, the PBoC is allegedly resorting to “window guidance”, i.e., instructing banks to increase their loan origination. However, we do not have a high conviction view on: (1) whether lockdowns could prevent the virus from spreading and (2) whether stimulus will lift household and business confidence and their willingness to consume and invest. See more on this below. Infrastructure Investment Will Recover Modestly So far, the data does not suggest that a recovery in infrastructure investment is underway. Chart 6 illustrates that the number of investment projects approved by National Development and Reform Commission and the length of newly installed electricity transmission lines are not yet rising (Chart 6). Also, steel bar and cement prices are falling despite low output of these materials (Chart 7). This signifies very weak demand. Chart 6Few Signs of Recovery In Infrastructure Investment Chart 7Falling Prices of Raw Materials = Weak Demand   Furthermore, land sales make up 40% of local government revenue and the value of land sales is down substantially from a year ago. Lower land sales weighing on local government finances and their ability to spend. Nevertheless, odds are that the central government will force local governments to boost infrastructure investment modestly by providing more funding and increasing their special bond issuance quota. For example, Beijing ordered state-owned policy banks to set up an 800 billion yuan ($120 billion) line of credit for infrastructure projects. Chart 8A Snapback in Home Sales Is Possible That said, a revival in traditional infrastructure investment will be more muted than it has been in past cycles. Beijing has been very clear in recent years that local governments should not pursue inefficient debt-fueled infrastructure spending, to the point that local officials have been warned that they will be held responsible for debt-financed spending during their lifetime, i.e., even after they retire from their positions. This risk – and the lack of funding due to the shortfall in land sales – will structurally limit local governments’ capacity and drive to invest in traditional infrastructure.  The Property Sector Rebound Will Be Muted Residential property sales will likely tick up after having crashed by 30% in the past 12 months (Chart 8). Yet, this will be a mean-reversion rebound rather a full-fledged cyclical recovery. Even though authorities have been easing restrictions for property buyers, any rebound in home sales and construction activity will be modest for the following reasons: The economic slump of the past 12 months and recent lockdowns have weighed on household incomes, which will hinder demand. Housing remains unaffordable for many households who live in poor conditions. Meanwhile, many affluent households already own multiple properties. A lack of confidence in the outlook for house prices will reduce high-income household’s willingness to invest in new properties. Even though restrictions have eased, property developers – which have experienced a major crackdown, are still overleveraged, and face uncertain housing demand – will be reluctant to increase their debt and start new projects. Rather, the lack of funding for property developers points to a major drop in completions in the near term (Chart 9). As we argued in the report titled China: Is The Property Carry Trade Over?, the real estate market is experiencing a structural breakdown, rather than a cyclical one. The performance of property developers stocks supports this hypothesis (Chart 10, top panel). As such, any recovery will be tame and fragile. Chart 9Shrinking Property Developer Funding = Less Housing Completion Chart 10Structural Breakdowns in Stocks And Bonds Of Property Developers   In addition, the prices of property developers offshore bonds remain in a clear downtrend (Chart 10, bottom panel). Exports Are Set To Contract Chinese exports will contract in H2 2022 due to reduced spending on goods in the US and Europe as well as in the developing world. Specifically, in the US and euro area, consumption of goods ex-autos boomed during the pandemic and will revert to their means as households spend more on services and less on goods (Chart 11). Declining real household disposable income will also reinforce this trend (Chart 12). Chart 11US and Euro Area ex-Auto Goods Consumption Will Shrink Chart 12US And Euro Area Household Real Disposable Income Is Contracting     In fact, US retail inventory of goods ex-autos has already surged (Chart 13). As retailers cut back on their new orders, Chinese exports will contract materially. Chart 13US Retail Goods ex-Auto Inventories Have Swelled In addition, domestic demand in developing economies will also disappoint. EM household spending on consumer goods will underwhelm as more of their income is spent on food and energy. Also, high and rising local interest rates will curb credit origination in mainstream emerging economies. Consequently, their capital spending, employment and income growth will remain subdued. In China, exports as a share of GDP has increased to 19% from 17.5% in 2019. Hence, a contraction in exports will be painful for the overall economy. The Structural Outlook Is Unfriendly For Shareholders Of Platform Companies The government has toned down its rhetoric and its actions related to platform/internet companies. However, we view this development as a tactical rather than a structural change. The key economic policymaker Liu He made market friendly statements towards platform companies on March 16 and May 17 when their share prices were plunging. We believe that the aim of his comments was solely to calm the market and restore investor confidence. We maintain that the structural outlook for shareholders of platform companies remains negative for the following reasons: Higher uncertainty about their business model = higher equity risk premium = lower equity multiples. The government will be regulating their profitability like those of monopolies and oligopolies, which justifies lower multiples. These companies will be performing social duties – i.e. redistributing profits from shareholders to the Chinese people. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges are significant. Common prosperity policies pose a risk to the broader corporate sector. These policies will redistribute national income from corporates to households. Chart 14 illustrates that the share of employee compensation has been rising and the share of corporate profits in national income has been falling since 2011-12. These trends will be reinforced by common prosperity policies in the coming years. This is an negative development for shareholders of Chinese companies. Chart 14What Will Be The Implications Of China's Common Prosperity Policies? The Known Unknowns Will The Dynamic Zero-COVID Policy Be Successful? The biggest risk to Chinese share prices is renewed virus outbreaks and lockdowns. It is impossible to forecast these risks. That is why, in our opinion, Chinese stocks are facing fat tail risks. On the one hand, Omicron variants have extremely high transmission rates, making the virus very hard to contain. On the other hand, the government has shown that its dynamic zero-COVID policy has for now succeeded in containing the virus in both Shanghai and Beijing. It is certain, however, that the Chinese economy will incur considerable costs to prevent Omicron from spreading. In addition to the financial costs of ongoing widespread testing, there are also logistical impediments and inefficiencies that these testing and verification policies introduce, even in the absence of lockdowns.  Will “Animal Spirits” Among Consumers And Businesses Revive? Another major unknown is whether confidence among consumers and businesses will recover so that they resume spending. If private sector sentiment remains weak, then stimulus measures will have a low multiplier. In other words, the ongoing stimulus will likely fail to boost economic activity. Our proxies for marginal propensity to spend by households and enterprises have been very depressed (Chart 15). Other sentiment/confidence surveys convey the same message. Further, credit demand is non-existent. Banks have lately been buying corporate acceptance bills to fulfill their loan quota (Chart 16). Chart 15Chinese Households And Enterprises Are Reluctant To Spend More Chart 16China: Banks Bought Refinancing Bills in April To Make Their Loan Quota   Critically, the property market has always been a key determinant of overall consumer and business sentiment. Since 2008, there has been no recovery in the Chinese economy without a recovery of property sales, prices and construction (Chart 17). We are doubtful that property sales and construction will stage a strong recovery in the next six to nine months. Thus, our bias is that the multiplier effect of Chinese stimulus will underwhelm in the coming months. Will Western Investors Come Back To Chinese Stocks? Geopolitical tensions between the US and China and the events around the US-Russia clash reduce the likelihood that western investors will come back to Chinese markets, even as growth prospects improve. Chart 18 demonstrates that foreign investors have only marginally reduced their holdings of Chinese onshore stocks (A-shares) and bonds. These data encompass not only western investors, but also investors from other emerging Asian countries. Chart 17China: Housing Cycle = Business Cycle Chart 18Foreigners Sold A Small Portion Of Their Onshore Equity and Bond Holdings   The risk is that western investors will use any rebound in Chinese shares to reduce their exposure. This will weigh on investable stocks and preclude any significant and durable rally. A Word On The Exchange Rate The RMB will remain volatile in the coming months and will likely depreciate further against the US dollar: Shrinking exports will weigh on foreign exchange availability from exporters. With Asian currencies depreciating against the US, Beijing will be willing to tolerate moderate and gradual yuan depreciation against the greenback to maintain its export competitiveness. The one-year interest rate differential between China and the US has recently turned negative which has probably triggered a shift of deposits from RMB into the USD (Chart 19). In Hong Kong, deposits have recently begun shifting from yuan to HKD, i.e., USD (Chart 20). This development has coincided with the China-US, and hence, China-HK, interest rate differential turning negative. Chart 19China-US: The Interest Rate Differential Has Turned Negative Chart 20A Shift From RMB To HKD or USD Deposits   Finally, there will be more foreign capital outflows if either (1) COVID outbreaks and, hence, lockdowns persist, or (2) US-China tensions escalate. As Chart 18 above illustrates, foreign portfolio capital outflows have so far been modest. Bottom Line: The near-term outlook for the US dollar remains positive as the Fed maintains its hawkish stance. Consistently, the RMB will struggle in the near term but its multi-year outlook is positive. Investment Recommendations The outlook for Chinese stocks is characterized by fat tails. Odds of a material rally are not insignificant but also the probability of another relapse is not trivial either. For absolute return investors, one way to play such a bifurcated market outlook is to buy out-of-money call options and out-of-money put options simultaneously while maintaining a core / benchmark allocation in Chinese stocks. In regard to relative performance /regional allocation, we continue to recommend that emerging market portfolios overweight Chinese A-shares and maintain a neutral stance towards investable stocks. Meanwhile, global equity portfolios should remain neutral on A-shares while underweighting investable ones. This positioning is in-line with our overall EM allocation – we continue to recommend underweighting EM within a global equity portfolio. Consistently, we maintain our long A-shares / short investable Chinese stocks strategy. Onshore government bond yields will continue sliding as the main problem in China is deflation and weak growth, not inflation. The RMB is facing near term risks as its interest rate differential versus the US dollar dips deeper into negative territory. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Chart I-3...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal   Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Listen to a short summary of this report.       Executive Summary Recession Checklist US stocks were down almost 20% at their lowest point in May. Any lower and they would be pricing in recession. Central banks will raise rates to or above neutral to ensure that inflation comes back down to their targets. This will cause growth to slow. Markets will now start to worry more about faltering growth than about high inflation. In our recession checklist (see Table), no indicator is yet pointing to recession, but some may do so soon. The jury is likely to be out for some time on whether there will be a recession in the next 12-18 months. In the meantime, equities are likely to move sideways, amid high volatility. Bottom Line: Investors should stay cautiously positioned for now, with only a neutral weighting in equities, and tilts towards more defensive markets and sectors. We recommend a large holding in cash to allow for funds to be redeployed quickly when there is a better entry-point.   The narrative driving global markets has shifted from worries about inflation, to fretting about the risk of recession. Although headline inflation remains high (8.3% year-on-year in the US and 8.1% in the eurozone), inflation pressures have clearly peaked (for now, at least): Broad measures, such as the US trimmed-mean PCE, have started to ease significantly (Chart 1).  Recommended Allocation Chart 1Inflationary Pressures Are Starting To EaseBut now signs are emerging of a slowdown in economic growth. The Citigroup Economic Surprise Indexes in all the major regions have turned down (Chart 2), and global industrial production is falling year-on-year (albeit partly because of lingering supply-side bottlenecks) (Chart 3).   Chart 2Global Growth Is Turning Down Chart 3IP Growth Has Turned Negative Equity markets – with US stocks down 19% from their peak to the May low, and global stocks 17% – are pricing in a slowdown, but not yet a recession. As we have often argued, it is almost unheard of to have a bear market (defined as a greater than 20% decline in US stocks) without a recession – the last time that happened was in 1987 (and all on one day, Black Monday) (Chart 4). Note from the chart how often stocks correct by 19-20%, on concerns about recession, without tipping into a bear market. That is where we stand today. Chart 4US Stocks Don't Fall More Than 20% Without A Recession Table 1Recession Checklist So the key question is: Will we have a recession over the next 12-18 months? We have dug out the recession checklist we last used in 2019 (Table 1). While none of the indicators are yet clearly pointing to recession, several may do so by year-end (Chart 5). And there are a number of warning signs starting to flash. The US housing market – the most interest-rate sensitive part of the economy – could soon see home prices falling, after the 200 BPs rise in the 30-year mortgage rate since the start of the year (Chart 6). Wages have failed to rise in line with inflation, which has led to retail sales falling year-on-year in real terms (Chart 7). And there are even some signs that companies are slowing their hiring, presumably on worries about the durability of the recovery: In the latest ISM surveys, the employment component fell to close to 50 (Chart 8). Chart 5Some Recession Indicators Look Worrying Chart 6Housing Is The Most Vulnerable Sector Chart 7Real Retail Sales Are Falling Chart 8Signs That Companies Are Growing Wary Of Hiring? The strongest argument against there being a recession is the $2.2 trillion of excess savings held by US households (and $5 trillion among households in all major developed economies). The argument is that, even if interest rates rise and real wage growth is negative, consumers can continue to spend by dipping into these accumulated savings. But there are some problems here. The savings are highly concentrated among the rich, who have a lower propensity to spend (Chart 9). Because of “mental accounting” biases, people may think only of current income, not savings, when considering how much to spend. And, as spending shifts back from goods to services, now that pandemic rules are largely over (Chart 10), spending on manufactured products is likely to fall below trend (since many purchases were brought forward). But it is hard to catch up on previously missed services spending (you can’t take three vacations this year to make up for those you missed in 2020 and 2021), and so services spending will, at best, only return to trend. Chart 9The Rich Have All The Money Chart 10Can Services Take Over From Goods Spending?     Meanwhile, central banks will be focused on fighting inflation. All of them are expected to take rates to or above neutral over the next 12 months (Chart 11) – implying a squeeze on aggregate demand. Although inflation may be peaking, it is still well above most central banks’ comfort zones. In the US, for example, the FOMC expects core PCE to ease to 4.1% by year-end and 2.6% by end-2023, but that is still higher than its 2% target. The Fed is likely to remain focused on the upside risks to inflation: From rising services prices (Chart 12), and the risk of a price-wage spiral (Chart 13). BCA Research’s bond strategists expect the Fed to hike by 50 BPs at each of the next two meetings (in June and July), and then to revert to 25 BPs a meeting, as long as it is clear by then that inflation is trending down.1 Chart 11Rates Are Going To Or Above Neutral Everywhere Chart 12Inflation Risks: Rising Services Prices...Our conclusion is that the jury is out on the probability of recession – and is likely to stay out for a while. So far this year, equities and bonds have both performed poorly – with a 60:40 equity/bond portfolio producing the worst start to a year in three decades (Chart 14). Equities have wobbled because of tight monetary policy and worries about slowing growth; bonds because of inflation concerns. This is likely to remain the case until there is more clarity about the risk of recession. In this environment, we expect global equities to move sideways, with significant volatility – falling on signs of weakening growth, but rallying on hopes that the Fed may change its course.2  Chart 13...And A Price-Wage Spiral Chart 14Nowhere To Hide This Year We continue, therefore, to recommend fairly cautious portfolio positioning, with a neutral weight in global equities (and a preference for defensive country and sector allocations). Investors should keep a healthy holding in cash, giving them dry powder to use when a better entry-point into risk assets presents itself. Fixed Income: Bond yields have fallen over the past month, with the US 10-year Treasury yield slipping to 2.8% from 3.1% in early May. As per BCA Research’s Golden Rule of Bond Investing, the level of yields will be determined by whether the Fed (and other central banks) surprise dovishly or hawkishly relative to market expectations (Chart 15).3 The Fed is likely to hike slightly less this year than the market is pricing in, but may continue to raise rates beyond mid-2023, compared to a market expectation of rate cuts then (see Chart 11, panel 1 above). This points to the 10-year yield remaining broadly flat for the rest of this year, but possibly rising after that. Historically, rates tend to peak in line with trend nominal GDP growth (Chart 16). This means that, if the expansion continues for another couple of years, the 10-year yield could reach 4%. We, therefore, recommend an underweight on bonds. However, government bonds do now represent a good hedge again, with strong capital gain in the event of recession (Table 2). We recommend a neutral weight on government bonds within the fixed-income category. Chart 15The Golden Rule Of Bond Investing Chart 16Rates Tend To Peak In Line With Trend Nominal GDP Growth Table 2Government Bonds Now Offer Good Returns In A Recession Chart 17Credit Now Offers Attractive Valuations The recent rise in credit spreads has opened some opportunities. Valuations for both investment-grade (IG) and high-yield (HY) bonds are now attractive again, with all but the highest-quality bonds trading at a breakeven spread higher than the long-run median (Chart 17). The likelihood of defaults is rising, however, so we lower our weighting in HY (whilst remaining slightly overweight) and raise the weight in IG, also to a small overweight. We fund this by cutting our recommendation in Emerging Market debt to underweight. Credit, especially in the US, now offers tempting returns as long as the economy avoids recession, and is a relatively low-risk way to gain exposure to upside surprises.   Chart 18US Performance Has Lagged This Year Equities: US relative equity performance has been a little disappointing year-to-date, dragged down by the performance of the IT sector (Chart 18).  Nonetheless, we stick to our overweight, given the market’s lower beta and the likely greater resilience of the US economy. Among sectors, we raise our weighting in Energy to overweight from neutral. Our energy strategists recently lifted their forecast for end-2022 Brent crude to $120 from $90, and raise the possibility of even $140 (see below for more on why). Despite the sharp outperformance of Energy stocks over the past six months, the sector has barely registered net inflows – presumably because of ESG (Chart 19). As we argued in a recent report, oil producers could be the new “sin stocks”, making the sector attractive over the next few years to investors who do not have ethical restraints on investing in it. We fund the overweight in Energy by lowering our weighting in Industrials to neutral. Capex is a late-cycle play and capital-goods makers benefited as manufacturers rushed to increase production during the recent consumer boom. But signs are now emerging that companies are becoming more cautious on capex (Chart 20). Chart 19Weak Flows Into The Energy Sector Despite Strong Performance Chart 20Companies Are Becoming More Cautious On Capex Commodities: China’s growth remains very weak and, although commodity prices have started to fall (with copper down 9% and iron ore 11% in Q2), they have not yet caught up with the slowdown in Chinese imports (Chart 21). The key question is whether China will now roll out a big stimulus. Given the government’s determination to persevere with the zero-Covid policy, and its need to achieve the 5.5% GDP growth target this year, it will eventually have no choice. But it is reluctant to trigger another housing boom, and there are doubts about how effective stimulus would be given the property market’s dysfunction. For now, we remain cautious on the Materials sector, and on commodities as an alternative asset – though the long-term structural story (because of the build-out of alternative energy) remains strong. Oil and natural-gas prices are likely to remain high due to disruptions in supply from Russia. Russia will probably have to shut 1.6 m b/d of production following the EU embargo on Russian oil imports. The EU is rushing to build up natural-gas inventories before the winter, in case Russia bans gas exports to Europe in retaliation (Chart 22). Higher oil prices are positive for the Energy sector, and for countries such as Canada (whose equity market we raise to neutral, funding this by trimming the overweight in the US). Chart 21Commodity Prices Dragged Down By Weak Chinese Growth Chart 22The EU Will Need To Buy Lots Of Natural Gas Currencies: Momentum, cyclical factors, and interest-rate differentials still favor the US dollar. Although the Fed will not raise rates quite as much as futures are pricing in, other central banks – especially the ECB and the Reserve Bank of Australia – will miss by more (Table 3). Nevertheless, the USD looks very overvalued (Chart 23) and speculators are long the currency. This means that, once global growth bottoms, there could be a sharp depreciation in the dollar. We remain neutral on the USD. Our preferred defensive currency is the CHF, since the other usual safe haven, the JPY, will remain depressed if, as we expect, the Bank of Japan persists with its yield curve control, limiting the 10-year JGB yield to 0.25%. Table 3Most Central Banks Will Not Hike As Much As Futures Predict Chart 23US Dollar Is Very Overvalued Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Report, “Echoes Of 2018” dated May 24, 2022. 2     BCA Research’s US equity strategists call this a “Fat and Flat” market. Please see “What Is Next For US Equities? They Will Be Fat And Flat”. 3     Please see “Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks” for an explanation of how the Golden Rule works in different countries.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary European Spreads Have Cheapened Up More Than US Spreads Corporate bond spreads in the US and Europe have widened since early April, with European credit taking a bigger hit because of worsening growth and inflation momentum. European corporate bond valuations look fairly cheap, both for investment grade and high-yield.  This is true in absolute terms but also relative to the US, where spread valuations are more mixed.  An easing of stagflation fears in Europe is a necessary condition for a valuation convergence with the US. The US investment grade credit curve is steep relative to the overall level of credit spreads, making longer-maturity corporates more attractive. Energy bonds offer the most compelling combination of valuation and fundamental support (from high oil prices) within US investment grade. Within US high-yield, Energy valuations look much less compelling after the recent outperformance. The best medium-term industry values in European credit are in investment grade Financials and high-yield Consumer Cyclicals & Non-Cyclicals. Bottom Line: Continue to favor both US high-yield and European investment grade corporates versus US investment grade.  Stay neutral high-yield exposure on both sides of the Atlantic.  Within Europe, stay up in quality within both investment grade and high-yield until near-term macro risks on growth & inflation subside. Feature Corporate bonds in the US and Europe have gone through a rough patch in recent weeks, underperforming government bonds in response to the “triple threat” of high inflation, tightening monetary policy and slowing growth momentum.  European credit has taken the more severe hit compared to the US, with markets pricing in greater risk premia because of additional regional threats to growth (and inflation) from the Ukraine war. In this Special Report, jointly presented by BCA Research US Bond Strategy and Global Fixed Income Strategy, we assess credit spread valuations in US and European corporates after the latest selloff, across credit tiers, maturities and industry groups.  Stay Cautious On US Corporate Bonds Chart 1US Credit Spreads In a recent Special Report, we argued in favor of a relatively defensive allocation to US corporate bonds. Specifically, we advised investors to adopt an underweight (2 out of 5) allocation to US investment grade corporates and a neutral (3 out of 5) allocation to US high-yield. Our rationale was that a flat US Treasury curve signaled that we were in the middle-to-late stages of the economic recovery. Additionally, at the time, corporate bond spreads weren’t all that attractive compared to the average levels seen during the last Fed tightening cycle (Chart 1). Spreads have widened somewhat since we downgraded our allocation and, as such, we see some scope for spread tightening during the next few months as inflation rolls over and the Fed lifts rates by no more than what is already priced in the curve. That said, with the Fed in the midst of a tightening cycle, we think it’s unlikely that spreads can stay below average 2017-19 levels for any meaningful length of time. As a result, we maintain our current cautious allocation to US corporate bonds. US High-Yield Versus US Investment Grade The recent period of US corporate bond underperformance can be split into two stages based on the relative performance of investment grade and high-yield. US investment grade underperformed junk in the early stages of the selloff (between September and mid-March), as spread widening was driven by the Fed’s shift toward a more restrictive policy stance and not a meaningful uptick in the perceived risk of a recession and/or default wave (Chart 2A). Chart 2ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 But recession and default fears started to ramp up in mid-March, and this caused high-yield to join the selloff (Chart 2B). In fact, US investment grade corporates managed to recoup some of their earlier losses while lower-rated junk bonds struggled to keep pace. Chart 2BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present We contend that the risk of a meaningful uptick in corporate defaults during the next 12 months is low. In fact, we estimate that the US high-yield default rate will fall to between 2.7% and 3.7% during the next year, well below the 5.2% currently priced into junk spreads. Going forward, we expect the US corporate bond landscape to be defined by increasingly restrictive monetary policy and a benign default outlook. As we noted in the aforementioned Special Report, this environment is reminiscent of the 2004-06 Fed tightening cycle when high-yield bonds performed much better than investment grade. Investors should maintain a preference for high-yield over investment grade within an otherwise defensive allocation to US corporate bonds. US Industry Groups Chart 3A shows the performance of US corporate bonds in the early stages of the recent selloff, but this time split by industry group. High-yield Energy sticks out as a strong outperformer, though we also notice that every high-yield sector performed better than its investment grade counterpart. Chart 3ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Chart 3B once again shows how the relative performance between investment grade and high-yield has flipped since mid-March, though we see that high-yield Energy, Transportation and Utilities have performed better than the rest of the index.  Chart 3BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Interestingly, despite the strong outperformance of high-yield Energy bonds, investment grade Energy credits performed mostly in line with other investment grade sectors. We believe this presents an excellent opportunity.  The vertical axis of Chart 4A shows our measure of the risk-adjusted spread available in each investment grade industry group. Our risk-adjusted spread is the residual after adjusting for each sector’s credit rating and duration. The horizontal axis shows each sector’s Duration-Times-Spread as a simple measure of risk. Our model shows that Financials, Technology, Energy, Utilities, Communications and Basic Industry all stand out as attractive within the investment grade corporate bond universe. We identify the investment grade Energy sector as a particularly compelling buy. Chart 4AUS Investment Grade Corporate Sector Valuation In a prior report, we demonstrated, unsurprisingly, that the oil price is an important determinant of whether Energy bonds perform better or worse than the rest of the corporate index. With our commodity strategists calling for the Brent crude oil price to average $122/bbl next year, this will provide strong support to Energy bond returns. Cheap starting valuations for investment grade Energy bonds make them look even more compelling. Chart 4B repeats our valuation exercise but for high-yield industry groups. Within high-yield, we find that Financials, Transportation, Communications and Consumer sectors stand out as attractive. Interestingly, high-yield Energy bonds now look slightly expensive compared to the rest of the junk bond universe, a result of the sector’s recent incredibly strong performance. Chart 4BUS High-Yield Corporate Sector Valuation US Credit Curve We define the credit curve as the difference in option-adjusted spread between the “Long Maturity” and “Intermediate Maturity” sub-indexes for each investment grade credit tier, as defined by Bloomberg. We exclude high-yield from this analysis because very few high-yield bonds are classified as “Long Maturity”. To analyze the credit curve, we observe that credit curves tend to be steeper when credit spreads are tight, and vice-versa. This is because tight spreads indicate that the perceived near-term risk of default is low. As a result, short-maturity spreads tend to be lower than spreads at the long-end of the curve. Conversely, a wide spread environment indicates that the perceived near-term risk of default is high, and this risk will be more reflected in shorter maturity credits. Charts 5A, 5B and 5C show the slopes of the credit curves for Aa, A and Baa-rated securities. Immediately we notice that credit curves are positively sloped in each case, and also that each credit curve is somewhat steeper than would be predicted based on the average spread for the overall credit tier. Chart 5AAa-Rated Credit Curve Chart 5BA-Rated Credit Curve Chart 5CBaa-Rated Credit Curve This strongly suggests that investors should favor long-maturity over short-maturity US investment grade corporate bonds. European Corporates Look Cheap Vs. US Equivalents – For Patient Investors Chart 6European Credit Spreads At Past 'Non-Crisis' Peaks Turning to the euro area, the Bloomberg investment grade OAS and high-yield OAS currently sit at 167bps and 490bps, respectively (Chart 6). These levels are well below the peaks seen during the 2020 COVID recession and the 2011/12 European debt crisis, but are in line with the spread widening episodes in 2014/15 and 2018. Our preferred measure of credit spread valuation, 12-month breakeven spreads, show that European investment grade and high-yield spreads are in the 75th and 67th percentile of outcomes, respectively, dating back to the inception of the euro in 1998 (Chart 7).1 These are both higher compared to the breakeven percentile rankings for US investment grade (48%) and US high-yield (52%). The gap between the breakeven percentile rankings for investment grade bonds in the euro area versus the US is the widest seen over the past two decades.  That gap reflects the fact that European economic growth has softened versus the US according to the S&P Global manufacturing PMIs, while European inflation has accelerated towards very elevated US levels (Chart 8).  Chart 7European Spreads Have Cheapened Up More Than US Spreads Chart 8European Corporate Underperformance Reflects Relative Growth & Inflation Both of those trends are a product of the Ukraine war, which has led to a massive spike in European energy costs given the region's huge reliance on Russian energy supplies, particularly for natural gas. While the US has also suffered a massive increase in its own energy bills, the inflation spike has been higher in Europe, leading to a bigger drag on economic confidence and growth. Thus, the widening spread differential between corporate bonds in Europe relative to the US likely reflects a growth-related risk premium. Chart 9A Turning Point For European Corporate Bond Performance? As euro area inflation has ratcheted higher, so have expectations of ECB monetary tightening. The euro area overnight index swap (OIS) curve now discounts 172bps over the next 12 months, a huge swing from the start of 2022 when markets were expecting the European Central Bank (ECB) to stand pat on the interest rate front. In comparison, markets are pricing in another 224bps of Fed tightening over the next 12 months, even after the Fed has already delivered 75bps of tightening since March. Importantly, the gap between our 12-month discounters, which measure one-year-ahead interest rate changes discounted into OIS curves, for the US and Europe has proven to be a reliable leading indicator – by around nine months - of the relative year-over-year excess returns (on a USD-hedged basis) of European and US corporate bonds, especially for investment grade (Chart 9). The fact that this is a leading relationship suggests that the upward repricing of ECB rate expectations seen so far in 2022 is not yet a reason to turn more cyclically negative on European corporate bonds versus the US. The earlier upward repricing of expected Fed tightening is the more relevant factor, and is signaling that both US investment grade and high-yield corporates should underperform European equivalents over at least the rest of 2022.  BCA Research Global Fixed Income Strategy already has a recommended allocation along those lines, with an overweight to euro area investment grade and an underweight to US investment grade. While the trade has underperformed of late, the combined messages from the relative 12-month breakeven spread rankings (cheaper European valuations) and 12-month discounters (the Fed is further ahead in the tightening cycle) leads us to stick with that relative cross-Atlantic tilt. The main risk to that stance is any deterioration of the flow of energy supplies from Russia to Europe that results in a stagflationary outcome of a bigger growth slowdown with even faster inflation. That is a scenario that would make it difficult for the ECB to back down from its recent hawkish forward guidance, resulting in European corporate spreads incorporating an even wider risk premium.  Given that near-term uncertainty, we are advocating that investors maintain no relative tilt on more growth-sensitive, and riskier, European high-yield relative to the US – stay neutral on both. Stay Up In Quality On European Corporates Looking at euro area corporate debt across credit ratings and maturity buckets, there are few compelling immediate valuation stories in absolute terms, although there are potential opportunities unfolding on a relative basis.  Within investment grade, credit quality curves have steepened during the recent selloff, with lower-rated credit seeing larger spread widening (Chart 10). The gap between Baa-rated and A-rated European corporate spreads now sits at 52bps, right in the middle of the 25-75bps range since 2014. In high-yield, the gap between Ba-rated and B-rated credit spreads is 222bps, and the gap between B-rated and Caa-rated spreads is 370bps (Chart 11) – both are still below the previous peaks in those relationships seen in 2012, 2015 and 2020. Chart 10European IG Credit Quality Curve Can Steepen ##br##More Chart 11European HY Credit Quality Curve Still Below Previous Peaks For both investment grade and high-yield, there is still room for credit curves to steepen if European growth expectations continue to deteriorate. However, when looking at spread valuations across the credit quality spectrum, and across maturity buckets, euro area corporate spreads look much cheaper than US equivalents. In Chart 12, we show a snapshot of the current 12-month breakeven percentile rankings for individual credit quality tiers and maturity groups, for investment grade and high-yield in the euro area and US.  The relative attractiveness of European credit relative to the US is evident, with European spreads now at higher percentile rankings across all quality tiers and maturity buckets. The largest gaps between 12-month breakeven percentile rankings are in the +10 year maturity bucket, the AAA-rated and AA-rated investment grade credit tiers, and the Ba-rated high-yield credit tier. This suggests any trades favoring European corporates versus the US should stay up in credit quality. Chart 12Corporate Spread Valuations By Maturity & Credit Rating Favor Europe Comparing European & US Industry Spread Valuations When looking at the industry composition of the euro area and US corporate bond indices, there are a few major notable differences. Within investment grade, there is a greater concentration of Energy and Technology names in the US, while Financials are more represented in the European index (Chart 13).  Those same three industries also have the largest relative weightings in the high-yield indices (Chart 14), although there is also a slightly larger weighting of high-yield Transportation companies in Europe compared to the US.  This means that a bet on European credit versus the US is essentially a bet on European Financials versus US Energy and Technology. Chart 13Investment Grade Corporate Bond Market Cap Weights Chart 14High-Yield Corporate Bond Market Cap Weights When looking at the same sector metrics that were shown earlier in this report for the US – comparing risk-adjusted spreads to Duration-Times-Spread – we find some interesting cross-Atlantic valuation differentials. For investment grade in Europe (Chart 15), only Energy and Financials have positive risk-adjusted spread valuations (after controlling for duration and credit quality), while having the highest level of risk expressed via Duration-Times-Spread. This contrasts to the US where more sectors have positive risk-adjusted spreads - Energy, Financials, Utilities, Basic Industry and Communications. Investors should favor the latter three industries in the US relative to Europe. Chart 15Euro Area Investment Grade Corporate Sector Valuation Within high-yield in Europe, Energy and Financials also offer positive risk-adjusted valuations, but so do Consumer Cyclicals and Consumer Non-Cyclicals (Chart 16). This lines up similarly to US high-yield valuations. The notable valuation gaps exist in Transportation and Communications, which look cheap in the US and expensive in Europe, creating potential cross-Atlantic relative value trade opportunities between those sectors (and within an overall neutral allocation to junk in both regions). Chart 16Euro Area High-Yield Corporate Sector Valuation Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 12-month breakeven spreads measure the amount of spread widening that would be necessary to make the return on corporate bonds equal to that of duration-matched government bonds over a one-year horizon.  The spread is calculated as a ratio of the index OAS and index duration for the relevant credit market. We look at the historical percentile ranking of that ratio to make a more “apples for apples” comparison of spreads that factors in index duration changes over time. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Selloffs across financial markets and evidence of decelerating growth have reminded us to play it close to the vest, but they haven't made us bearish. The stability of intermediate- and long-run inflation expectations suggests that the inflation genie has not yet gotten out of the bottle and that the Fed will be able to hold off on squashing the expansion until late 2023 or early 2024. Households' willingness to dip into their excess savings to maintain their spending in the face of inflationary pressures bodes well for the economy for the remaining year and a half that the excess savings cushion can be expected to last. The definitive causes of reduced labor force participation continue to elude researchers but we expect participation will improve over the rest of the year as the low-paid workers responsible for the exodus return to the grind. The Fed Fever Has Broken Bottom Line: Investors have no end of things to worry about, but we remain disposed to see the glass as half-full. We expect the expansion to continue at least into the second half of 2023 and that risk assets will generate positive excess returns over Treasuries and cash for the next twelve months. Feature We have begun meeting clients face-to-face again, in addition to continuing with conference calls. Our discussions with investors and colleagues highlight how uncertain the market and economic landscapes remain. Conditions remain especially uncertain and our views depend on the flow of data; as more pieces of the puzzle emerge, the way we assemble it is subject to change. Conviction Levels In Uncertain Times You are among the optimists at BCA and have been for a while. Are the equity selloff and the current slowdown making you nervous? Do you still see the glass as half-full? It’s our job to be nervous. The way we see the money management ecosystem, managers are responsible for worrying for their clients and we’re responsible for worrying for the managers. We continually ask how we could be getting it wrong and actively seek out information that challenges our view. We are neither foolish nor inexperienced enough to be overconfident; we’re always looking over our shoulder and our head has been on a swivel ever since the pandemic arrived. Related Report  US Investment StrategyIt All Depends On Whom You Ask The recent equity decline and growth deceleration have not materially changed our already low conviction level. All investment researchers look backward to look forward. That is to say that we review past interactions between macro variables and financial assets for guidance about future interactions. We even build regression models to formalize our empirical studies, though we keep them in their proper place. We know that models have blind spots and do not rely solely on them any more than we would change lanes on the highway based only on a glance at our rear-view mirrors. A central challenge of the last two-plus years has been that real-time conditions are so unusual that there is little historical framework for evaluating them. Much of what has occurred over that stretch has lacked a close precedent: vast swaths of the economy had not previously been idled in the interest of public safety; Congress did not appropriate 25% of a year’s GDP for distribution to households, businesses and state and local governments in any prior 13-month stretch; job losses had not been so starkly concentrated among unskilled workers while leaving knowledge workers largely unscathed; aggregate household savings and net worth have never risen so much, so fast; and central banks have launched campaigns that would make William McChesney Martin’s head spin, much less Walter Bagehot’s. The scope of the economic challenges and the novelty of the policy responses limit the usefulness of analytical methods that depend on the notion that the future will largely resemble the past. It is therefore too soon to tell if we should be more nervous. As we write, the S&P 500 has blasted 8% off its intraday lows five sessions ago and incoming economic data continue to resist a blanket bullish or bearish interpretation. We empathize with investors’ impatience; one would think that the key macro questions should be settled by now, given how long we’ve been discussing them. They are not settled, though, and we will revisit open debates as new data arrive. The Term Structure Of Inflation Expectations Real-time inflation prints are terrible and much more concerning than tame inflation expectations. Why are you focusing almost exclusively on inflation expectations? We have been keeping a close eye on the course of inflation expectations over time, or their term structure, ever since inflation began to emerge from its extended hibernation. As unsettling as it has been to witness 40-year highs in inflation, we have taken solace from the fact that market prices have uniformly indicated that businesses and investors expect that inflation will recede to familiar levels over the longer run. As indicated by the arrows in the right-hand column, long-term inflation expectations are considerably lower than near-term expectations as implied by the TIPS and nominal Treasury markets (Table 1, top panel) and directly indicated by CPI swaps (Table 1, bottom panel). Expressed as a continuous time series, neither the Treasury (Chart 1, top panel) nor the CPI swaps (Chart 1, bottom panel) market has wavered in its view that high inflation will not persist beyond the near term. Table 1The Inflations Expectations Curve Is Sharply Inverted   That is important because it suggests that neither businesses nor investors will need to adjust their strategies to accommodate a lasting upward inflection in price pressures. For businesses, that means that they don’t foresee a need to fight tooth and nail to pass along increased costs. Investors continue to be content with nominal long-term Treasury yields vastly below current year-over year inflation, investment-grade corporate yields that are about half of it and high-yield corporate yields that are a percentage point below it. Chart 1Investors And Businesses Don't Foresee A Lasting Change ...​​​​​​ Chart 2... And Neither Do Households Although high inflation seems to have spooked the households responding to University of Michigan consumer sentiment survey takers, they remain unperturbed about its long-run direction. The difference between University of Michigan respondents’ long-run and near-term inflation expectations remains around multi-year lows (Chart 2), as 5-year expectations have held steady at 3% for three straight months. The inference that University of Michigan survey respondents expect high inflation to be fleeting is supported by their views on the advisability of big-ticket purchases. The share of respondents who deem it a bad time to buy a car because prices are (temporarily) high remains near all-time high levels (Chart 3, middle panel), while those who think buying now is auspicious because prices won’t come down is near all-time lows (Chart 3, top panel). The difference between the two continues to set record lows (Chart 3, bottom panel). The consensus view on consumer durables purchases is the same – now is a bad time to buy because high prices won’t last (Chart 4). The economic takeaway is that consumers are willing to bide their time until prices come back to earth and will not exacerbate upward price pressures by clamoring to buy before prices go even higher. Chart 3Consumers Are Willing To Wait Out Supply-And-Demand Imbalances, ... Chart 4... Instead Of Exacerbating Them By Rushing To Buy Now Bottom Line: Economic participants adjust their behavior based on their long-run inflation expectations. If they think the current fever will break, businesses, investors and consumers will not act in ways that fuel a self-reinforcing cycle in which high prices beget still higher prices. The longer that economic actors expect inflation pressures will abate, the greater the chance that they will. Interest Rates And The Fed You’ve been calling for interest rates to stop backing up, but it still feels like they only want to rise. It has been quite a ride from 1.72% on 10-year Treasuries from the beginning of March to 3.12% at the beginning of May, but we have gotten 40 basis points of retracement over the last three weeks (Chart 5). The nearly unanimous view that rates would keep rising was a contrarian sign that the move may have been played out. Reduced expectations for Fed rate hikes have also played a part in bringing yields down. After peaking at 3.45% on May 3rd, the day before the FOMC wrapped up its May meeting, the expected fed funds rate in twelve months is down to 3.09% (Chart 6). Chart 5The Benchmark Treasury Yield ...​​​​​ Chart 6... Has Moved With Rate-Hike Expectations​​​​​​ Chart 7Everything, All At Once While the prevailing view among commentators is that the Fed waited too long to begin removing monetary accommodation, financial markets have moved swiftly to price in a policy shift. Chair Powell and his colleagues have been taking every opportunity to communicate their seriousness about combating inflation and financial conditions have responded to their public relations campaign without delay (Chart 7, top panel) – yields have backed up (Chart 7, second panel), spreads have widened (Chart 7, third panel), stocks have fallen (Chart 7, fourth panel) and the dollar has surged (Chart 7, bottom panel). Our Global Investment Strategy colleagues argue that the Fed may soon perceive that tighter financial conditions threaten its soft landing goals and dial back the hawkish rhetoric if inflation eases in line with our house view. The Fed’s hawkish surprises might be behind us for the time being. Lightning Round You have argued that households will be more inclined to spend their excess pandemic savings than hoard them and that those savings will provide a buffer against inflation’s bite. The latest Personal Income Report showed that April’s savings rate was nearly half of its pre-pandemic level; are you now worried that the savings are going too fast to cushion the economy? We stand by our view that households will spend their excess savings and continue to think our guesstimate that they will spend half of them will prove to be conservative. We consider the declining savings rate – 6% in January, 5.9% in February, 5% in March and 4.4% in April, versus February 2020’s 8.3% – to be good news, indicating that socked-away stimulus payments are having the beneficial time-release effect of keeping the consumer afloat despite high inflation. We calculate that April’s accelerated consumption as a share of disposable income amounted to $60 billion of dis-savings relative to our no-pandemic baseline estimate, knocking excess savings down to $2,150 billion. At that rate, one-half of the excess balance will last for another 17 months. Will labor force participation ever get back to its pre-pandemic levels? If it doesn’t, upward wage pressures could be greater than you expect, and a wage-price spiral could be brewing. No one has satisfactorily determined why participation remains muted. It seems most likely to us that COVID fears, as indicated by the Census Bureau’s Household Pulse Survey, are the principal driver. Lavish stimulus measures may have played a role as well, though their tailwind has surely faded for households at the bottom rungs of the wealth and income distribution. We expect that participation will recover across the rest of the year as COVID morphs from acute threat to manageable nuisance and as the low-income workers who account for the shrinkage in the labor force (Chart 8) are pressed by financial exigency to return to the grind (Chart 9). Chart 8Those Who Have Left The Work Force ...​​​​​ Chart 9... May Have To Come Back Soon​​​​​​ What is your view on inflation? If you think recession fears are overblown, you must not think inflation will be bad enough over the rest of the year to induce the Fed to kill the expansion. The difference between our view and the recession-is-imminent crowd’s is merely one of timing. We expect inflation will abate enough over the rest of the year that the Fed won’t have to break up the party until late 2023/early 2024. We do think, however, that Congress and the Fed overstimulated demand in the wake of the pandemic and sowed the seeds for the eventual end of the expansion and the bull markets in equities and credit. We don’t think the overstimulation will manifest itself until late 2023 or early 2024, however, so we expect that the expansion and the bull markets in risk assets will trundle along for another year. Housekeeping We planned to dial up the risk exposures in our ETF portfolio this week, in line with BCA’s recent tactical equity upgrade to overweight from neutral. It isn’t always easy to make tactical recommendations on a weekly publication schedule and while waiting out a five-and-a-half-hour flight delay at O'Hare last Friday, we wished that we could have pushed a button to increase our equity allocation. Now that the S&P 500 has rallied over 6.5% week-to-date as we go to press, we are going to hold off on making any adjustments until next week at the earliest. With apparent short-term resistance just 1% away at 4,200 (the previous triple-bottom support level), we expect that we may find a better entry point and are willing to wait patiently for it.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Executive Summary Equities Are Closer To Capitulation The market appears to be moving away from concerns about inflation toward worries about slowing growth. The initial stage of the sell-off in risky assets, pricing in tighter monetary policy, may now be complete. The next and final stage of the bear market will be pricing in a global growth slump. Slowing growth is not yet built into consensus expectations, neither for earnings nor GDP – downgrades and negative surprises are in store. The US consumers are under duress and are unlikely to lend a “spending hand” to support economic growth. Inflation is easing. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “put” is no longer at play – falling equities will help the Fed tame inflation via the “wealth effect”. The next chapter for the market is down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by short-lived rallies on hopes that the Fed may change its course. Our updated Equities Capitulation Scorecard is marginally more positive on equities but is still signaling that not all conditions for a sustainable rebound are yet met.​​​​​​ Bottom Line: Repricing of tighter monetary policy is likely complete. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-lived rallies. Monetary Tightening Is Probably Priced In Until now, the sell-off in equity markets was a repricing of tighter monetary conditions. One may argue that most of the damage has been done: Since the beginning of the year, the NASDAQ is down 30% while the S&P is down 20%. Nearly 34% of stocks in the S&P 500, and 14% of stocks in the NASDAQ are trading below their 200-day moving average. Does this mean that the sell-off is over and that hawkish Fed fears are overdone? After all, over the past few days, Fed rate expectations appear to have topped out (Chart 1), and Treasury yields have come down 37 bps from their recent peak to 2.75% (Chart 2). Monetary conditions have tightened substantially year to date, although more tightening is still on the way (Chart 3). The Citi Inflation Surprise Index has turned decisively down (Chart 4) and some of the series most affected by supply chain bottlenecks, such as shipping costs, have been deflating. Chart 1Fed Rate Expectations Have Stabilized Chart 2Treasury Yield Has Come Down Chart 3Financial Conditions Are Getting Tighter Chart 4Inflation Is Starting To Surprise To The Downside Is it clear sailing for longer-duration assets like growth equities? Not so fast: While much adversity has been priced in, a sustainable rebound in equities is probably still elusive. Worries About Economic Growth Are Starting To Dominate The Market Narrative We posit that long-term rates have come down because the markets have moved on from worries about raging inflation and the hawkish Fed to concerns about a downshift in growth both in the US and globally. As such, both earnings and economic growth disappointments are on the cards, potentially leading the markets down further. Overall, the next phase of the sell-off in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. Thunder Clouds On The Horizon During the J.P. Morgan Investor Day, Jamie Dimon, in his otherwise upbeat speech, said that there are “thunder clouds on the horizon.” Indeed, the list of investor concerns is long: A global growth slowdown, build-up of inventories, inflation damaging consumer purchasing power, the soaring costs of raw materials, declining corporate profitability, tightening monetary conditions and, to top it all, a stronger dollar. However, from Dimon’s standpoint, these are just that: Clouds that could dissipate at any time. Of course, there is always a chance that things will turn out better than expected, and a “softish landing” is on the cards. We hope Dimon is right… Economic Growth Surprises To The Downside For now, our working assumption is that the economy is still strong, but growth is decelerating. To us, this is a story about the second derivative. The troubling part is that slowing growth is not yet built into consensus expectations: It is confounding that GDP growth forecasts have still barely budged from the beginning of the year and do not yet reflect all the headwinds listed above (Chart 5). Moreover, the Q1-2022 GDP revision has shown that growth was weaker than initially reported, with the latest reading of -1.5%, growth reduced by investments weaker than initially anticipated.  The Atlanta Fed Nowcast GDP tracker points to only 1.8% annualized growth in Q2-2022. Elevated expectations are setting investors up for disappointment, which will lead to the next leg of the sell-off. The Citigroup Economic Surprise Index has recently shifted into negative territory (Chart 6). Chart 5GDP Forecasts Need To Be Revised Down Further Chart 6Economic Data Disappoints What is the evidence of slowing growth? Walking down the main street of any major city and seeing restaurants overflowing with customers and people buzzing in and out of shops, one may think that the economy is booming. Yet, there is plenty of evidence to the contrary. The ISM PMI is on a downward trajectory, hitting 55 in May, which was also 2.4 points below consensus. The S&P Global (former Markit) May flash PMI readings have also declined from 59.2 in April to 57.5 in May. This is hardly surprising: As night follows day, monetary tightening leads to slowing growth (Chart 7). Inventory overhang: It is noteworthy that the ISM PMI new orders-to-inventories ratio (NOI) is in a free-fall: It is foreshadowing further weakness in manufacturing activity as demand for durable goods is fading (Chart 8). May durable goods orders were also soft. Chart 7Monetary Tightening Leads To Slower Growth Chart 8Inventories Are Building Up   Freight volumes are also contracting, pointing to weakening growth, and are consistent with the NOI ratio (Chart 9). Global growth is also slowing as evidenced by the contraction in global trade volumes (Chart 10): US and European demand for goods ex-autos is shrinking following the pandemic binge, while China’s recovery has been delayed. Chart 9Freight Volumes Also Point To Weaker Growth Chart 10Global Export Volumes Are Set To Shrink Economic growth is slowing, and more negative surprises are in store. Earnings Growth Expectation Have Gotta Come Down While the stock market is not the economy, they are closely intertwined. One of the key differences between the two, however, is that the US economy is dominated by services, while the S&P 500 has higher exposure to goods. With the current demand for services outstripping demand for goods, the economy should fare better than the market (Chart 11). Therefore, it does not bode well for S&P 500 earnings expectations that the Q1-2022 GDP revision flagged earnings contracting 2.3% on a quarter-on-quarter basis, under the weight of slowing sales and rising costs. And while the S&P 500 Q1-22 results were just fine, the ratio of negative/positive guidance for Q2-22 was roughly two to one. Slowing growth at home and abroad, rising costs of raw materials and wages, as well as fading demand for goods will weigh on earnings over the balance of the year (Chart 12). Chart 11Slowing Growth Will Weigh On Earnings Chart 12US EPS Expectations Have Not Yet Been Downgraded Also, there is the not-so-small issue of a strong dollar, which has gained nearly 13% since January 2021. This makes US goods more expensive and also reduces companies’ bottom lines via the currency translation effect. According to our rough estimates, every percentage change in the USD reduces earnings growth by roughly 33 bps, i.e., 4.3% off earnings caused by the entire dollar move. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Importantly, US economic growth does not need to contract for a profit recession to take hold. However, S&P 500 EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10%; despite the recent market rout, US stocks have not yet priced in negative profit growth. However, either downgrades or earnings disappointments are coming, neither of which bodes well for US equity performance. Earnings growth expectations need to come down to reflect reality on the ground.   Valuations Are Only Optically Cheap And one more salient point: If earnings expectations are set to unrealistically high levels, then the recent forward multiple of the S&P 500 is not 17x, but 2 to 3 points higher, and, voilà, US equities no longer look cheap. Will US Consumers Save The Day? Perhaps things are not as dire as we describe. After all, US consumers are healthy, their balance sheets are pristine, and retail sales look good. There is also the not-so-small issue of $2.2 trillion in excess savings. This argument rings true. Chart 13Negative Real Wage Growth Is Sapping Consumer Confidence However, inflation continues to put pressure on US consumers. Negative real wage growth is sapping their confidence (Chart 13) and is cutting into their purchasing power. Soaring inflation also makes people concerned about the future as they watch their life savings melt away. Underwhelming reports from Walmart and Target are cases in point: Lower-income consumers are shifting spending away from discretionary items and towards necessities. Strong reports from Dollar General and Family Dollar indicate that many Americans are price sensitive and are shopping around. Home Depot commented that fewer customers walked through its doors (but the ones that did, tended to spend more in nominal terms). And retail sales are reported in nominal terms: Rising prices inflate growth rates. Indeed, excess savings may help achieve the “soft landing.” However, there are early signs that either many lower-income Americans have spent the money, or their savings accounts are earmarked for a rainy day, and many people aim to spend only what they earn. However, higher-income Americans are still willing to spend, but this group is shifting spending away from goods and towards services, which is consistent with strong results from the US airline carriers, which report a significant gain in pricing power. A similar message came from both Nordstrom and Macy’s. Clearly, American consumers are highly heterogeneous, and there is a significant bifurcation between “haves” and “have nots.” It is, however, concerning that many of the wealthier Americans have lost a significant percentage of their nest eggs in the stock market. The theory goes that the wealth effect is one of the main mechanisms through which monetary tightening affects consumer demand (Chart 14). It stands to reason that it is only a matter of time (unless the stock market rebounds) before even the wealthier cohorts start tightening their belts, dampening demand for consumer services. Chart 14Nest Eggs Are Dwindling Another obvious implication is the effect of dwindling investments on the housing market: Americans are watching their down payments disappear, with cash buyers subject to the same negative forces. The US consumer is under duress, and the more embedded the inflation and the deeper the market rout, the greater proportion of the US population is affected, making them less and less likely to lend a “spending hand” to support economic growth.  Inflation Will Turn: Too Little, Too Late One may also argue that inflation will turn, which would help both the economy and the markets, and will reset the Fed trajectory. Inflation will come down assisted by the arithmetic of the base effect. Supply chain bottlenecks are clearing, shipping costs are coming down, and demand is weakening – all of these developments point to inflation coming down over the next few months. However, this process may be rather slow: Inflation permeates the entire economy (Chart 15), and there are also signs that a vicious wage-price spiral is taking hold (Chart 16). Therefore, inflation is unlikely to revert to levels that the Fed and the US consumer will consider acceptable any time soon. Chart 15Inflation Is Broad-based And It Will Take Time For It To Revert To Acceptable Levels Chart 16Wage-Price Spiral Is Taking Hold Just recently, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation… We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 6.2%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. While we believe that the Fed will be steadfast in its objective to combat inflation, any positive news on inflation will be perceived by a hopeful market as a sign that the Fed may alter its course, which would lead to a rally, only to be punctured by the negative news from either growth or the Fed. Positive inflation surprises will ignite powerful rallies but are unlikely to alter the trajectory of monetary policy. The Fed “Put” Is No More The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with the wealthier Americans paying the toll.   When Bad News Is Good News We make a case that disappointing growth will be the next chapter of this market saga. One might wonder if poor growth readings would actually be perceived by the market as a positive: Not only does disappointing growth put downward pressure on Treasury yields but also creates an expectation that the Fed will pause and monetary policy will end up looser than initially projected. Our take is that stable or lower rates will offer support for equities, and that is the reason why we conclude that the first stage of the repricing is complete. Will slower growth invite a more gentle and considerate Fed? We don’t think so as the Fed has already telegraphed that it now aims for a “softish landing” and that fighting inflation will incur some “pain”. Investment Implications Chart 17In 1980-82, The Market Was "Fat And Flat" We expect the market to be “fat and flat” over the next few months, i.e., alternating between pullbacks and short-term rallies. Rallies are frequent during bear markets and other severe corrections and are generally significant in magnitude. Markets showed a similar pattern in 1980-1982 as Chairman Volker was battling inflation (Chart 17). The bull market took hold only in 1982. Rallies will follow pullbacks because the market is not yet ready for a sustainable rebound. This first leg of the correction was pricing in tighter monetary policy. The next leg down will be the market pricing in slowing growth both at home and abroad, corporate earnings disappointments, and weakening consumer demand. Over the next few months, the market is likely to trend down but in a “fat and flat” manner, with “growth disappointment” equity sell-off being punctuated by fast and furious rallies on hopes that inflation is abating, and that a gentler, data-driven Fed would be more supportive of the economy and the markets. Thus, with markets looking oversold, a short-lived rally is now likely. It will be accompanied by a change in leadership: Energy and Materials will give back gains, while Big Tech and other cyclicals will bounce. And US equities may still plumb new lows on the back of economic growth or earnings growth disappointments. The market will also not take it kindly if inflation turns out to be stickier than expected and is accompanied by slowing growth: Stagflation is one of the most challenging regimes for US equities (Chart 18). Sticky inflation would call for an even more aggressive rate hiking cycle. Chart 18Stagflation Would Be The Worst Possible Outcome For The Markets Table 1Equities Are Closer To Capitulation We believe that a sustainable rebound will take place once most of the negative “news” is priced in. Compared to two months ago, we conclude that the first part of the adjustment process, i.e., pricing in tighter monetary policy, has run its course. Now it is a matter of adjusting growth expectations. Our “Equities Capitulation” scorecard (“Have We Hit Rock Bottom” report), adds up to -1, a slightly less negative reading than the -2 just a few weeks ago — but a reading which still signals negative equity returns (Table 1). We conclude that staying close to the benchmark, with a small tilt towards defensive growth, remains the most sensible strategy.   Bottom Line The first stage of the market correction is probably complete and tighter monetary policy is getting priced in. The next leg down for equities will be pricing in slower economic growth and a potential earnings recession. We expect the market to be “fat and flat” over the next several months as rallies ignited by soothing inflation readings are punctured by growth disappointments and a resolute Fed.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation Recommended Allocation: Addendum

Listen to a short summary of this report.         Executive Summary US Financial Conditions Have Tightened Significantly This Year US financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations. If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the US and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. Stay overweight stocks, favoring non-US equities over their US peers. We are closing our short 10-year Gilts trade, initiated at a yield of 0.85%, for a gain of 7.5%. We are also opening a new trade going long Canadian short-term interest rate futures versus their US counterparts. Investors expect Canadian rates to exceed US rates in 2024, which seems unlikely to us given that the Canadian housing market is much more sensitive to higher rates than the US market. Bottom Line: After having tightened significantly over the past seven months, financial conditions should loosen modestly during the remainder of the year. This should benefit risk assets. Fed Focused on Financial Conditions Chart 1Tighter Financial Conditions Will Hurt Growth Like many central banks, the Fed sees financial conditions as a key driver of the real economy. While there are many financial conditions indices (FCIs), most include bond yields, credit spreads, equity prices, and the exchange rate as inputs. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa. Goldman’s US FCI is especially popular among market participants. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the historic relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below-trend pace by the second quarter of 2023. In fact, the tightening in the Goldman FCI over the past 12 months already suggests that the manufacturing ISM will fall below 50 (Chart 1).  Along the same lines, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved slightly into restrictive territory. Aside from a brief period at the outset of the pandemic, the index has been consistently in expansionary territory since early 2013 (Chart 2). Chart 2The Chicago Fed Financial Conditions Index Has Moved Into Slightly Restrictive Territory Other data are consistent with the message from the FCIs. Most notably, growth estimates for the US and for other major economies have come down over the past few months (Chart 3). Economic surprise indices have also fallen, especially in the US.   Chart 3AGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Chart 3BGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Mission Accomplished? Chart 4The Fed Expects To Lift Rates Above Its Estimate Of Neutral Given the recent tightening in financial conditions and weaker growth expectations, the Fed is likely to soften its tone. Already this week, Atlanta Fed President Raphael Bostic suggested that the Fed could pause raising rates in September in order to assess the impact of the Fed’s tightening campaign. The Fed minutes also conveyed a sense of flexibility and data-dependence about the timing and magnitude of future hikes once rates reach 2%. It’s worth stressing that the Fed expects rates to rise in 2023 to about 40 bps above its estimate of the terminal rate (Chart 4). Jawboning rate expectations higher would potentially undermine the Fed’s goal of achieving a soft landing for the economy. Inflation Will Dictate How Much Easing Lies Ahead There is a big difference between not wanting financial conditions to tighten further and wanting them to loosen. The Fed would only want to see an easing in financial conditions if inflation were to fall faster than expected. Chart 5 shows how the year-over-year change in the core PCE deflator would evolve over the remainder of the year depending on different assumptions about the month-over-month change in the deflator. The Fed would be able to reach its expectation of year-over-year core PCE inflation of 4.1% for end-2022 if the month-over-month change averages 0.33%. Monthly core PCE inflation averaged 0.3% in February and March and is expected to clock in at around the same level for April once the data is released tomorrow. Chart 5AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) Chart 5BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) Regardless of tomorrow’s data print, as we discussed last week, we expect the monthly inflation rate to average less than 0.3 in the back half of the year. If that happens, inflation will surprise to the downside relative to the Fed’s expectations. Consistent with the observation above, market-based inflation expectations have already declined. The 5-year TIPS inflation breakeven has fallen from 3.64% in March to 2.98% at present. The widely watched 5-year/5-year forward breakeven rate is back down to 2.29%, at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 6).1 The Citi US Inflation Surprise Index has also rolled over (Chart 7). Chart 6Market-Based Inflation Expectations Have Come Down Of Late Chart 7The US Inflation Surprise Index Has Rolled Over Financial Conditions  Abroad Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar (Chart 8). Nevertheless, with growth momentum having already deteriorated sharply, central banks are signaling a more balanced approach towards policy normalization. Chart 8Financial Conditions Have Tightened More In The US Than Elsewhere This Year ECB: Wait and See? In a blog post published on Monday, Christine Lagarde observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than they were two years ago. In her mind, this warrants ending net purchases under the Asset Purchase Programme early in the third quarter. It also warrants raising the deposit rate by 25 bps at both the July and September meetings, bringing it back to zero from -0.5% at present. Beyond then, Lagarde was circumspect about what should be done, stressing the need for “gradualism, optionality and flexibility.” She noted that “The euro area is clearly not facing a typical situation of excess aggregate demand or economic overheating … Both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends.” She then added: “The outlook is now being clouded by the negative supply shocks hitting the economy … households’ expectations of their future financial situation dropped to their second-lowest level on record in March and remained close to that level in April.” The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023 (Chart 9). BCA’s Global Fixed Income team, led by Rob Robis, foresees only 50 bps of tightening over the next 12 months. Chart 9Markets Expect Rates To Rise The Most In The Anglo-Saxon World The UK, Canada, and Australia: Frothy Housing Markets Will Limit Rate Hikes The Bank of England (BoE) hiked rates by 90 bps over the past 12 months. The UK OIS curve is priced for another 140 bps of rate hikes over the next year. According to the BoE’s forecasting models, this would raise the unemployment rate by two percentage points while lowering inflation to below 2% within the next two-to-three years. In our opinion, that is more tightening than the BoE would like to see. BCA’s strategists expect the BoE to deliver only another 75 bps of hikes over the next year. Chart 10Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries The Canadian economy has been quite strong, with the unemployment rate falling to 5.2% in April, the lowest since 1974. The Canadian OIS curve is discounting 195 bps of interest rate hikes over the next 12 months, substantially more than the 150 bps of tightening our fixed income team foresees. By mid-2024, investors expect Canadian policy rates to be about 25 bps above US rates. This seems unreasonable to us, and as of this week, we are expressing this view by going long the June 2024 3-month Canadian Bankers’ Acceptance (BAX) futures contract (BAM4) versus the corresponding 3-month US SOFR futures contract (SFRM4). A more liquid option is to simply go long the 10-year Canadian government bond versus the 10-year US Treasury note. At present, Canadian 10-year government bonds are yielding  5 bps more than their US counterparts. Unlike in the US, where household debt has fallen over the past 14 years, debt in Canada has risen, fueled by a massive housing boom (Chart 10). High indebtedness and the prevalence of variable rate/short-term fixed-rate mortgages will limit the ability of the BoC to raise rates. The Australian OIS curve is currently discounting 262 bps of rate hikes over the next year which, if realized, would take the cash rate to 3.3% – a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. BCA’s fixed income strategists expect only 150 bps of tightening over the next 12 months. Japan: Yield Curve Control Will Continue Chart 11Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World The Bank of Japan expects inflation excluding fresh food prices to remain at about 2% in the second half of 2022, but then to slow to 1.1% in the fiscal year starting April 2023. The Japan OIS curve is discounting almost no tightening over the next 12 months. Long-term inflation expectations are far lower in Japan than in any other major economy, which makes ultra-low rates a necessity for the foreseeable future (Chart 11). China: Outright Easing Chart 12Covid Restrictions Have Eased Only Modestly In China China faces a trifecta of problems: A weakening housing market; slowing external demand for manufactured goods; and the ongoing threat of Covid-related lockdowns. Despite a steep drop in the number of new Covid cases over the past month, China’s lockdown index has only eased modestly, as the authorities continue to fret about the next outbreak (Chart 12). The leadership in Beijing has responded with policy easing. The PBoC lowered the 5-year loan prime rate by 15 bps last week, the largest such cut since 2019. This followed a cut in the floor rate for first-home mortgages that was announced on May 15. BCA’s China strategists believe these measures will arrest the deep contraction in the property market but will not spark a full-blown recovery due to the ongoing commitment of the government to the “three red lines” policy.2  In normal times, a Chinese real estate slump would be a cause of grave concern for global investors. These are not normal times, however. Public enemy number one these days is inflation. A weaker Chinese property market would curb commodity demand, thus helping to cool inflation. That would be a welcome development for global investors. Investment Conclusions Global financial conditions have tightened to the point that betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric.  We took partial profits on our short 10-year Treasury trade earlier this month (initiated at a yield of 1.45%). As of this week, consistent with the earlier decision of BCA’s fixed income strategists to upgrade UK Gilts, we are closing our short 10-year Gilt position (initiated at a yield of 0.85%) for a gain of 7.5%. The coming Goldilocks environment of falling inflation and supply-side led growth will buttress equities. We expect global stocks to rise 15%-to-20% over the next 12 months, with non-US markets outperforming the US. Looking further out, the fate of Goldilocks will rest on where the neutral rate of interest resides. If the neutral rate in the US turns out to be substantially lower than 2.5%, then any growth recovery will falter as the lagged effects of restrictive monetary policy work their way through the economy. Conversely, if the neutral rate turns out to be substantially higher than 2.5%, then inflation will reaccelerate as the economy overheats. Given the choice, we would wager on the latter outcome. Thus, while we expect global bond yields to decline over a 12-month horizon, we foresee them rising over a 2-to-5-year time frame. Similarly, while stocks will strengthen over the next 12 months, they are likely to encounter another bout of turbulence starting late next year or in 2024 as central banks initiate a second round of rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter     Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Global financial markets appear to be moving away from inflation worries to pricing in a major growth slump. Global growth is downshifting, and financial markets have not yet priced this in. Given that the US dollar is a countercyclical currency, it will remain firm despite lower US growth and interest rate expectations. Emerging Asian currencies will drop further. A new currency trade: Go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile.   Recommendation INITIATION DATE RETURN Short KRW / Long JPY 2022-05-26   Bottom Line: Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields will likely roll over and bonds will outperform stocks in the near-term.     Global financial markets appear to be moving away from worries about inflation to pricing in a major growth slump. The recent simultaneous drop in US Treasury yields and US share prices indicate that the market theme is shifting from inflation to a growth scare. Chart 1A Sign of Peak In Bond Yields Interestingly, high-yielding currencies such as AUD, NZD, and CAD have recently started underperforming low-yielding JPY and CFH (Chart 1, top panel). The former are a play on global growth while the latter are vulnerable to rising US interest rates. Thus, the financial markets’ theme seems to be moving from inflation to weaker growth. The facts that this currency ratio correlates with 10-year US Treasury yields and has rolled over at its previous peaks signal that investors’ global growth concerns will likely intensify (Chart 1, top and bottom panels). As such, this currency ratio and US bond yields will continue drifting lower. Overall, the next phase of the selloff in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. A pertinent question for investors is whether global risk assets have already priced in a global growth slump. Is A Global Slowdown Priced In? Our hunch is that the unfolding global economic slowdown is not yet fully priced in global financial markets. Chart 2Global Export Volumes Are Set To Shrink In the near term, global share prices will continue to falter and odds are rising that US bond yields are putting in a major top. In short, global stocks will underperform US bonds, and the USD dollar will remain firm: First, global trade volumes are heading into contraction (Chart 2). Global export volumes are set to contract as US and European demand for goods ex-autos shrinks following the pandemic binge. Meanwhile, China’s recovery has been delayed to Q3. We discussed the reasons why we expect global exports will contract in H2 2022 in our April 21 report. Declining global trade volumes will support the greenback in the near term because the broad trade-weighted US dollar does well when global growth is weakening. Besides, US dollar liquidity is rapidly decelerating, which is also positive for the broad-trade weighted US dollar (the latter is shown inverted in Chart 3). Second, US rail carload is contracting, pointing to weakening growth in America (Chart 4). Chart 3No Sign Of Reversal In Trade-Weighted USD Chart 4US Growth Is Downshifting Related Report  Emerging Markets StrategyA Whiff Of Stagflation? This does not mean that a US recession is imminent. Yet, as we discussed in past reports US corporate profits can contract modestly even if GDP slows but does not contract. Third, US EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10% (Chart 5). Similarly, although our forward-looking indicator for EM EPS points to a contraction 12-month forward EPS growth expectations are still at 10% (Chart 6). Chart 5US EPS Expectations Have Not Yet Been Downgraded Chart 6EM EPS Are Set To Contract We expect slower top line growth and shrinking profit margins to cause US and EM corporate profits to contract by about 5% and 10-15%, respectively, in the next 12 months. In brief, neither US nor EM stocks have priced in negative profit growth. Fourth, Chart 7 illustrates that slowing global broad money growth is typically associated with a compression in the P/E ratio of global equities. As of now, there are no sign of reversal in global broad money growth and equity multiples. Chart 7Will Global Equity Multiple Compression Continue? Chart 8US Stocks Are Set To Underperform US Treasurys In Near Term Finally, sentiment towards US stocks is very elevated relative to sentiment towards US Treasurys (Chart 8, top panel). Yet, the composite momentum indicator for the US stock-to-bond ratio is breaking below the zero line (Chart 8, bottom panel). This breakdown warns of a period of equity underperformance versus US Treasurys, which would be consistent with pricing in a material economic slowdown. As US growth slows, will the Fed back off from its hawkish rhetoric? Yes, it will tone down its hawkishness at a certain point – but it will not do so immediately. The basis is that even though core US inflation will roll over, it will remain well above 4% versus the Fed’s 2% target. Importantly, wages are a lagging variable, and they will surprise to the upside in the near-term amid tight labor market conditions. This will lead the Fed to err on the hawkish side to manage upside risks to inflation and inflation expectations. All in all, the Fed is not about to do a policy U-turn in the near term. Therefore, we maintain our view that the Fed and stock markets remain on a collision course. Bottom Line: Global growth is downshifting, and financial markets have not yet priced this in. As a result, US bond yields will likely roll over and bonds will outperform stocks in the near term. The US dollar as a countercyclical currency will remain firm despite lower US growth and interest rate expectations. Emerging Asian Currencies Will Depreciate Further Asian export volumes will contract in H2 2022. This is negative for emerging Asian currencies. Chart 9Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian exchange rates correlate with global trade and global manufacturing cycles, and these currencies will depreciate as global consumer goods demand shrinks (Chart 9). We use an equally-weighted average of KRW, TWD, SGD, THB, PHP and MYR versus the USD to measure the performance of emerging Asian currencies. We exclude the CNY and JPY as they exhibit different dynamics. Chinese imports of various goods and commodities were already contracting in March, prior to the broadening of mainland lockdowns (Chart 10). Weak demand from China will weight on other Asian economies. The CNY is likely to weaken a bit more versus the US dollar due to the challenges facing the Chinese economy. This will reinforce further depreciation in emerging Asian currencies. Relative share prices of global cyclicals versus defensives also point to more downside in emerging Asian currencies (Chart 11). Chart 10Chinese Imports Were Contracting Prior Lockdowns Chart 11Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio   Bottom Line: An impending contraction in Asian export shipments is negative for emerging Asian currencies. A New Trade: Long Japanese Yen / Short Korean Won One way to play the global trade contraction and peak in US interest rate expectations themes is to go long the JPY / short the KRW: The Korean won typically depreciates versus the Japanese yen when (1) the global manufacturing cycle enters a downtrend and (2) US bond yields decline (Chart 12). These two macro forces are about to transpire and will help the JPY to outperform the KRW. Chart 12KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Chart 13Trade-Weighted Yen Is At Its Historic Lows The Japanese yen has already depreciated significantly versus both the USD and the Korean won. In fact, the trade-weighted yen is close to its historic lows (Chart 13). In addition, investors are very short the yen (Chart 14). The overhang of short positions could cause a violent reversal in the JPY/USD exchange rate.   The Japanese yen is extremely cheap according to the real effective exchange rate based on unit labor costs (Chart 15, top panel). By that same measure, the Korean won is not cheap (Chart 15, bottom panel). Chart 14Investors Are Very Short Yen Chart 15The Yen Is Much Cheaper Than The Korean Won   Bottom Line: We recommend that investors go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile. On February 2, 2022, we booked profits on our short KRW/long USD position, which we initiated on March 25, 2021. Investment Recommendations Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields are likely peaking. Favor bonds over stocks within both global and EM balanced portfolios. Although the US dollar’s bull market is advanced, a final upleg is likely. Stay short the following EM currencies versus the US dollar: ZAR, PLN, HUF, COP, PEN, PHP and IDR. Consistently, emerging Asian currencies have more downside. A major buying opportunity in EM local currency bonds will emerge once the US dollar begins its descent.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Highlights The Fed’s hawkish shift over the past six months has caused a sharp increase in US interest rates. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. In addition to a severe contraction in real home improvement spending, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. The growth in total home sales and the MBA mortgage application purchase index are already in negative territory, housing affordability has deteriorated meaningfully, and the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, the breadth of house prices and building permits, consumer surveys, housing equity sector relative performance, and the fact that mortgage rates have likely peaked for the year point to a more optimistic outlook for housing. At a minimum, they do not yet suggest that the current slowdown in housing-related activity is recessionary. Structural factors are also supportive of the pace of housing construction in the US. While a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. The opposite is true: the US and several other developed market economies have underbuilt homes over the past decade. This should limit the drag on economic growth from housing-related activity, and reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Feature Chart II-1The Fed's Hawkish Shift Has Caused An Extremely Sharp Rise In Interest Rates The Fed’s hawkish shift over the past six months has caused US interest rates to rise at an extremely rapid pace. Panel 1 of Chart II-1 highlights that the spread between the US 2-year Treasury yield and the 3-month T-bill yield reached a 20-year high in early April of this year. Panel 2 shows that the two-year change in the 30-year mortgage rate will reach the highest level since the early 1980s by the end of this year if mortgage rates remain at their current level. Over the longer run, it is the level of interest rates that matters more than their change. However, changes in interest rates and other key financial market variables are also important drivers of economic activity, especially when they happen very rapidly. Given the speed of the recent adjustment in US interest rates, and the fact that the Fed funds rate will have likely reached the Fed’s neutral rate forecast by the end of this year, investors have understandably become concerned about the potential for a recession in the US. In this report we examine the US housing market for signs of an imminent recession, given the housing sector’s strong interest rate sensitivity. We conclude that while a slowdown in the housing market is clearly underway, several signs suggest that this slowdown is not recessionary. Investors should remain laser-focused on the pace of housing-related activity over the coming 6-12 months, but for now our assessment of the housing market is consistent with a modest overweight stance towards stocks within a multi-asset portfolio. A Brief Review Of The Housing Sector’s Contribution To Growth Table II-1 highlights the importance of the housing sector as a driver/predictor of US recessions. This table highlights that real residential investment is not a particularly important contributor to real GDP growth during nonrecessionary quarters, but it is the only main expenditure component exhibiting negative growth on average in the year prior to a recession.1 Table II-1Real Residential Investment Tends To Contract In The Year Prior To A Recession When examining the contribution to economic growth from the housing sector, investors and housing market analysts often fully equate real residential investment with housing construction. In fact, while direct construction of housing units accounts for a sizeable portion of the contribution to growth from housing, it is just one of four components. This is an important point, as one of the often-overlooked elements of real residential investment has strongly leading properties and is currently providing a very negative signal about the housing sector. Chart II-2 breaks down what we consider as aggregate real “housing-related activity”, and Chart II-3 presents the contributions to annualized quarterly growth in housing activity from the four components. For the sake of completeness, we include personal consumption expenditures on furnishings and household equipment as part of housing-related activity, alongside the two main components of real residential investment: permanent site construction (including single and multi-family properties), and “other structures.” In reality, “other structures” is not predominantly accounted for by the construction of different types of residential properties; it is almost entirely composed of spending on home improvements and brokerage commissions on the sale of existing residential properties. Chart II-2Housing Construction Is An Important Part Of Residential Investment, But There Are Other Contributing Factors Chart II-3Home Improvement Spending And Brokerage Commissions Also Drive Residential Investment     Aside from the link between existing home sales and the general demand for newly-built homes, the prominence of brokerage commissions in other residential structures investment helps explain why existing home sales are strongly correlated with real residential investment (Chart II-4, panel 1). Given that a distributed lag of monthly housing starts maps closely to permanent site construction (panel 2), starts and existing home sales explain a good portion of the contribution to growth from housing-related activity. Of the two remaining components of housing-related activity, Chart II-5 highlights that personal consumption expenditures on furniture and household equipment generally coincide with the pace of housing construction and new home sales. We take this to mean that the consumption component of housing-related activity is typically a derivative of the decision to build a new home or sell an existing one. Chart II-4Existing Home Sales Explain Commissions, And Housing Starts Explain Permanent Site Construction Chart II-5The Pace Of Contraction In Home Improvement Spending Is Worrying   What is not coincident with construction and existing home sales is residential home improvement: Panel 2 of Chart II-5 highlights that it has strongly leading properties, and is currently contracting at its worst rate since the 2008 recession. Data on real home improvement spending is only available quarterly from 2002, so the ability to compare the current situation to previous housing market cycles is limited. But the pace of contraction is worrying and underscores that investors should be on the lookout for corroborating signs of a major contraction in the housing market. Is The Housing Data Sending A Recessionary Signal? In addition to the severe contraction in real home improvement spending shown in Chart II-5, there are several other housing-related indicators that are ostensibly pointing in a bearish direction. In particular, Chart II-6 highlights that both the growth in total home sales and the MBA mortgage application purchase index are already in negative territory, that housing affordability has deteriorated meaningfully, and that the National Association of Home Builders’ (NAHB) housing market index is falling sharply. However, there are also several signs pointing to a more optimistic outlook for housing, or at least indicating that the current slowdown in housing-related activity is not recessionary. We review these more optimistic indicators below. The Breadth Of House Prices And Building Permits In sharp contrast to previous periods of serious housing market weakness and/or recessionary periods, there is no sign yet of a major slowdown in US house price appreciation including cities with the weakest gains. In fact, Chart II-7 highlights that house prices have recently been reaccelerating on a very broad basis after having slowed in the second half of last year, which hardly bodes poorly for new home construction. Chart II-6A US Housing Sector Slowdown Is Certainly Underway Chart II-7No Sign Yet Of A Major Deceleration In House Prices   It is true that US house price data is somewhat lagging, so it is quite likely that price weakness is forthcoming. However, there has been no sign of a major slowdown in prices through to March 2022, by which point 30-year mortgage rates had already risen 200 basis points from their 2021 low. More importantly, Chart II-8 highlights that a state-by-state diffusion index of authorized housing permits has done a very good job at leading the growth in permits nationwide, and is currently not pointing to a contraction in activity. Chart II-9 presents explanatory models for the growth in US housing starts and total home sales based on our state permits diffusion index, pending home sales, the change in mortgage rates, and housing affordability. The chart underscores that a contraction in housing activity is not what these variables would predict, even though starts and sales should be growing at a much more modest pace than what has prevailed on average over the past two years. Chart II-8Our Building Permits Diffusion Index Leads Housing Construction Activity, And Is Not Pointing To A Major Slowdown Chart II-9Reliably Leading Indicators Of Construction And Home Sales Do Not Point To A Recessionary Outcome     Consumer Surveys The University of Michigan consumer survey shows that consumers feel it is the worst time to buy a home since the early-1980s (Chart II-10), which seems like a clearly negative sign for the housing market and an indication of the likely impact of tighter policy on housing-related activity. And yet, panel 2 highlights that this is the result of the fact that house prices in the US have surged during the pandemic, not that mortgage rates have risen too high. It is true that the number of survey respondents citing “interest rates are too high” is rising sharply, but this factor as a share of all “bad time to buy” reasons given is not meaningfully higher than it was in 2018, 2011, or 2006. It is clear that high prices are also the culprit for why consumers report that it is a bad time to buy large household durables and not that large household durables are unaffordable or that interest rates are too high (Chart II-11). Chart II-10Nearly The Worst Time To Buy A Home, Mostly Due To Prices (Not Interest Rates) Chart II-11Same Story For Large Household Durables   It may seem counterintuitive for investors to see Charts II-10 and II-11 as in any way positive for the housing market. But, to us, the notion that elevated house prices are the main source of poor affordability supports the idea that a normalization of the housing market will occur through a combination of marginally lower demand, a slower pace of house price appreciation, and a sustained pace of housing market construction. This implies that existing home sales may be weaker than housing construction over the coming year, but the latter will help to support the contribution to overall economic growth from housing-related activity. Housing Sector Relative Performance Despite the significant slowdown in real home improvement spending and the recent decline in the NAHB’s housing market index, Chart II-12 highlights that home improvement retail and homebuilding stocks have not exhibited significantly negative abnormal returns over the past year – as they did in 1994/1995 and in the lead up to the global financial crisis. The chart, which presents a rolling 1-year “Jensen’s alpha” measure for both industries, attempts to capture the risk-adjusted performance of the industry versus the S&P 500. While the chart shows that both industries have generated negative alpha over the past year, the magnitude does not appear to be consistent with a recession. In the case of homebuilder stocks in particular, negative abnormal returns over the past year should have been meaningfully worse given the year-over-year change in mortgage rates. Chart II-13 highlights that homebuilder performance has not been cushioned by a deep valuation discount in advance of the rise in mortgage rates. Chart II-12Housing-Related Equity Sectors Are Not Warning Of A Housing-Driven Recession Chart II-13Homebuilders Were Not Excessively Cheap Before Mortgage Rates Spiked   In short, the important takeaway for investors is that the relative performance of housing-related stocks is not yet consistent with a housing-led US recession. Mortgage Rates Are Not Restrictive, And Have Likely Peaked As we highlighted in Chart II-1, the two-year change in the US 30-year conventional mortgage rate will be the largest in history by the end of this year, save the Volcker era, if the mortgage rate remains at its current level. However, it is not just the change in interest rates that matters for economic activity, but rather also the level. Encouragingly, Chart II-14 highlights that the level of mortgage rates has not yet risen into restrictive territory relative to the economy’s underlying potential rate of growth. In addition, it appears that mortgage rates have overreacted to the expected pace of monetary tightening – and thus have likely peaked for this year. Two points support this view: First, panel 2 of Chart II-14 highlights that the 30-year mortgage rate is one standard deviation too high relative to the 10-year Treasury yield, underscoring that the former has overshot. And second, Chart II-15 highlights that the mortgage rate is still too high even after controlling for business cycle expectations, current coupon MBS yields, and bond & equity market volatility. Chart II-14Mortgage Rates Are Not Yet Restrictive, But Have Likely Peaked For The Year Chart II-15No Matter How You Slice It, US Mortgage Rates Are Stretched   Structural Factors Supporting Housing Construction Chart II-16The US And Several Other DM Countries Have Underbuilt Homes Since The Global Financial Crisis Our analysis above points to a scenario in which the housing market slows in a nonrecessionary fashion, supported by relatively buoyant construction activity. Structural factors, which are mostly a legacy of the global financial crisis, are also supportive of the pace of housing construction in the US and other developed market economies. We presented Chart II-16 in our June 2021 Special Report, which shows the most standardized measure of cross-country housing supply available for several advanced economies: the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1) and those that have experienced either an uptrend in housing construction relative to output or a flat trend (panel 2). The US, along with the euro area, the UK, and Japan, all belong to the first group, with commodity-producing and Scandinavian countries belonging to the second group. The point of the chart is that the US and most other major DM economies have seemingly experienced a chronic undersupply of homes in the wake of the global financial crisis, which should continue to support housing construction activity even if demand for housing is slowing because of a sharp increase in mortgage rates. Given that the trend in real residential investment to GDP is a somewhat crude metric of housing supply, Chart II-17 presents a more precise measure for the US. It shows the standardized trend in permanent site residential structures investment (both single- and multi-family) relative to both the US population and the number of households. The chart makes it clear that the US vastly overbuilt homes from the late-1990s to 2007, but also vastly underbuilt since 2008. Relative to the number of households, real permanent site residential structures investment is still half of a standard deviation below its long-term average – even after the surge in construction that occurred in 2020. Chart II-18 highlights a similar message: it shows that the US homeowner vacancy rate (the proportion of the housing stock that is vacant and for sale) was at a 66-year low at the end of the first quarter. Chart II-19 shows that the monthly supply of existing one-family homes on the market is also at a multi-decade low, but that the supply of new homes for sale spiked in April. Chart II-17More Precise Home Supply Measures Underscore That The US Needs To Build More Houses Chart II-18The Homeowner Vacancy Rate Is Extremely Low     At first blush, this spike in the monthly supply of new homes relative to sales is quite concerning, as it has risen back to levels that prevailed in 2007. One point to note is that the increase in new home inventory relates to homes still under construction; the inventory of completed homes for sale remains quite low. In addition, from the perspective of a homebuilder, a rise in the monthly supply of new homes relative to home sales is only concerning if it translates into a significant increase in the amount of time to sell a completed home, as has historically been the case (Chart II-20). Chart II-19Existing Home Inventories Remain Low Relative To Sales... Chart II-20...And Higher New Home Inventories Are Not Affecting Time-To-Sale Of Completed Homes   Chart II-20 highlights that a fairly significant divergence between these two series has emerged over the past decade. Despite roughly five-six months’ supply of new home inventory on average since 2012, the median number of months required to sell a new home rarely exceeded four. In early-2019 the monthly supply of new homes also spiked, and a relatively modest and nonrecessionary slowdown in housing starts was sufficient to prevent any meaningful rise in the amount of time required to sell a newly completed home. Notably, the models that we presented in Chart II-9 led the slowdown in total home sales and starts in late-2018/early-2019, and they are not pointing to a major contraction today. The key point for investors is that while a slowdown in the housing market is clearly underway, it is not occurring after a period of excessive housing construction. In fact, the opposite is true: despite a surge in construction during the pandemic, it remains below its historical average relative to the population and especially the number of households. This should act to limit the drag on economic growth from housing-related activity, and therefore reduces the odds that a housing market slowdown will morph into a housing-driven US recession. Investment Implications We noted in our May report that the inversion of the 2-10 yield curve has set a recessionary tone to any weakness in US macroeconomic data, and that a recession scare was likely. Recent negative housing market data surprises underscore that a slowdown in the US housing market is clearly underway, and that this will likely feed recessionary concerns for a time. Investors should continue to be highly focused on the evolution of US macro data when making asset allocation decisions over the coming 6-12 months, as the current economic and financial market environment remains highly uncertain. This should include a strong focus on the housing market, as consumer surveys highlight that the overall impact of falling real wages and high house prices could cause a more pronounced slowdown in housing-related activity than we expect – and that the change and level of interest rates would imply. Nevertheless, our analysis of the historical predictors of housing construction and sales points to the conclusion that the ongoing housing market slowdown is not likely to be recessionary in nature. This, in conjunction with the factors that we noted in Section 1 of our report, support maintaining a modest overweight towards stocks within a multi-asset portfolio over the coming 6-12 months. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     This is aside from the contribution to growth from imports, which mechanically subtract from consumption and investment when calculating GDP.