Labor Market

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Bond investors can’t seem to decide whether the US economy is in the midst of an inflationary boom or hurtling toward recession. Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. The 5-year US Treasury yield has tightened relative to the rest of the curve in recent weeks, and the 2-year maturity now looks like the most attractive spot for investors. TIPS breakeven inflation rates have also declined markedly in recent weeks, and TIPS no longer look expensive on our models. TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Bottom Line: US bond investors should keep portfolio duration close to benchmark. They should also shift Treasury curve allocations from the 5-year maturity to the 2-year maturity and upgrade TIPS from underweight to neutral. Whipsaw Inflationary boom or recession? US bond investors can’t seem to decide and yields are swinging back and forth depending on the latest economic data. Just in the past month we’ve seen the 10-year US Treasury yield peak at 3.49%, fall to 2.82% and then finally move back above 3% following last week’s strong employment report. Not surprisingly, implied interest rate volatility is the highest it’s been since the Global Financial Crisis (Chart 1). Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. This is especially true because the Fed will tolerate a significant rise in the unemployment rate as long as inflation stays above target.1 Turning to the evidence, decelerating US economic activity is apparent in the manufacturing and non-manufacturing PMIs, which are both falling rapidly from high levels (Chart 2). Though both indexes remain firmly above the 50 boom/bust line, trends in financial conditions suggest that they could dip below 50 within the next few months. Chart 1A Highly Volatile Rates Market A Highly Volatile Rates Market A Highly Volatile Rates Market Chart 2US Growth Is Slowing US Growth Is Slowing US Growth Is Slowing The employment components of both indexes are already in contractionary territory (Chart 2, bottom panel), but this is due to concerns about labor supply, not demand. For example, last week’s ISM non-manufacturing PMI release included three representative quotes from respondents about labor market conditions.2 All three quotes reference concerns about labor supply: Unable to fill positions with qualified applicants. Extremely hard to find truck drivers. Demand for talent is higher, but availability of candidates to fill open roles continues to keep employment levels from increasing. This doesn’t sound like an economy that is on the cusp of surging unemployment, and this is exactly what the Fed is counting on. The Fed’s hope is that slower demand will bring down the large number of job openings without leading to a significant increase in layoffs or a significant rise in the unemployment rate. In that regard, it is notable that job openings ticked down in May, both in absolute terms and relative to the number of unemployed. Meanwhile, the rates of hiring and layoffs held steady (Chart 3). Chart 3Some Hope For A Soft Landing Some Hope For A Soft Landing Some Hope For A Soft Landing Investment Implications Our investment strategy hinges on two key economic views related to the labor market and inflation. First, while a surge doesn’t seem imminent, slowing economic activity means that the unemployment rate is more likely to edge higher between now and the end of the year than it is to fall. Second, as we’ve written in previous reports, US inflation has a relatively easy path back to its underlying trend of approximately 4%.3 After that, it will be more difficult for policymakers to bring inflation from 4% back down to 2%, and we could see the Fed push rates above 4% next year to accomplish this task. Taken together, these two views suggest that growth will be slowing and inflation falling between now and the end of the year. This combination could easily push bond yields lower, especially if recession worries flare up again. High frequency bond yield indicators such as the CRB Raw Industrials / Gold ratio and the relative performance of cyclical versus defensive equities also suggest that bond yields have room to fall (Chart 4). That said, the market is currently priced for the fed funds rate to peak at 3.74% in May 2023 and to fall back to 3.19% by the end of 2023. We see strong odds that inflation will be sticky enough (and the labor market resilient enough) for the Fed to push rates above those levels next year. This leaves us with an ‘at benchmark’ stance on portfolio duration for the time being, with an inclination to turn more bearish on bonds later this year if our base case forecast pans out. More specifically, we would likely reduce portfolio duration if the 10-year Treasury yield falls back to 2.5% or if inflation reverts to its 4% underlying trend. Conversely, we will turn more bullish on bonds if we see signs in the labor market data that point to a Fed pause (or Fed rate cuts) being necessary. For now, growth in nonfarm employment and aggregate weekly payrolls (wages x hours x employment) suggest we aren’t close to this outcome (Chart 5). Chart 4High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Chart 5The US Labor Market Is Strong The US Labor Market Is Strong The US Labor Market Is Strong Sliding Down The Yield Curve Since early April we’ve been recommending that investors position long the 5-year Treasury note and short a duration-matched barbell consisting of the 2-year and 10-year notes to take advantage of a US yield curve that was quite steep out to the 5-year maturity point and quite flat beyond that. That trade is now played out. The 5 over 2/10 butterfly spread has tightened back to zero and the 2-year note is now the most attractively priced security on the US Treasury curve. Chart 6 shows that the spread between the 2-year note and a duration-matched barbell consisting of cash and the 5-year note offers an extraordinary yield advantage of 92 bps. What’s more, Table 1 shows that, with the exception of the unloved 20-year bond, the 2-year note offers the most attractive 12-month carry on the curve, largely a result of the 18 bps of rolldown attributable to the still-steep slope between the 1-year and 2-year maturity points. Chart 6Shift Into 2s Shift Into 2s Shift Into 2s Table 112-Month Carry Across The US Treasury Curve A Low Conviction US Bond Market A Low Conviction US Bond Market This large shift in relative pricing compels us to close our prior position (long 5-year bullet versus 2/10 barbell) and open a new position: long the 2-year note and short a duration-matched cash/5 barbell. This new position (long 2yr over cash/5) offers attractive 12-month carry, but given the current volatile interest rate environment, it should mainly be expected to profit in the event of a steepening of the 2/5 Treasury slope. With that in mind, it’s notable that the 2/5 slope recently inverted. Inversions of the 2/5 slope are historically rare. They tend to occur near the end of Fed tightening cycles and, with the exception of the early-1980s, they tend to not last that long (Chart 7). Chart 72/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting Going forward, we see three plausible scenarios for the 2/5 slope during the next 6-12 months. First, the Fed achieves something close to the soft landing it is aiming for. Inflation starts to fall and the unemployment rate edges higher. However, unemployment never reaches levels that necessitate a complete reversal of Fed tightening. The 2/5 Treasury slope bear-steepens in this scenario as the market discounts that the Fed will have to push rates above 4% to hit its inflation target. Second, a deep recession and complete reversal of Fed tightening occur much more quickly than we anticipate. The 2/5 Treasury slope would bull-steepen in this scenario as the front-end of the curve is pulled down by the Fed’s pivot. Third, inflation shows no signs of reversing course. Long-dated inflation expectations jump and the Fed determines that it has no choice but to follow the example of Paul Volcker and tighten, even if the economy falls into a deep recession. As was the case in the early-1980s, the 2/5 Treasury slope could become deeply inverted in this scenario. Our sense is that the first two scenarios are much more likely than the third. We have written in prior reports about how the current spate of inflation is much different than what was seen in the early 1980s.4  This makes us willing to bet against a prolonged deep inversion of the 2/5 slope. Bottom Line: US Treasury curve investors should exit their positions long the 5-year bullet versus a duration-matched 2/10 barbell. They should initiate a position long the 2-year bullet versus a duration-matched cash/5 barbell. Upgrade US TIPS To Neutral Finally, we note that TIPS breakeven inflation rates have declined markedly during the past month. The 10-year TIPS breakeven inflation rate is currently 2.38%, near the lower-end of the Fed’s 2.3%-2.5% target range, and the 5-year/5-year forward TIPS breakeven inflation rate is a mere 2.12%, well below target (Chart 8). We also note that the 5-year/5-year forward TIPS breakeven inflation rate is back below survey estimates of what inflation will be 5-10 years in the future (Chart 8, bottom panel). Chart 8TIPS Breakevens TIPS Breakevens TIPS Breakevens We have been recommending an underweight position in TIPS versus nominal US Treasuries since early April, but the recent valuation shift means it’s time to add some exposure. Critically, our TIPS Breakeven Valuation Indicator has also increased to +0.6, moving into “TIPS cheap” territory (Chart 9). Historically, the 10-year TIPS breakeven inflation rate has averaged an increase of 28 bps in the 12 months following a reading between +0.5 and +1.0 from our Indicator (Table 2). Chart 9TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Table 2TIPS Breakeven Valuation Indicator Track Record A Low Conviction US Bond Market A Low Conviction US Bond Market The drop in TIPS breakeven inflation rates has been most prominent at the front-end of the curve. The 2-year TIPS breakeven inflation rate is down to 3.22% from a peak of 4.93%. The high correlation between short-maturity TIPS breakevens and realized CPI inflation means that short-dated breakevens can fall further as inflation continues to trend down, but already we see that 3.22% looks like a much more reasonable estimate of average inflation for the next two years than did the 4.93% peak. While we advise investors to upgrade TIPS from underweight to neutral relative to nominal US Treasuries, we continue to recommend an outright short position in 2-year TIPS. The 2-year TIPS yield has risen sharply since its 2021 low (Chart 10), but recent comments from Fed officials imply that the Fed would like to see positive real yields across the entire curve before it declares monetary policy sufficiently restrictive.5 This means that there is still some room for the 2-year TIPS yield to increase, from its current level of -0.10% back into positive territory. Such a move should also lead to more flattening of the 2/10 TIPS curve, and we continue to recommend holding that position as well (Chart 10, bottom panel). Chart 10Stay Short 2-Year TIPS Stay Short 2-Year TIPS Stay Short 2-Year TIPS Bottom Line: Investors should upgrade TIPS from underweight to neutral relative to nominal US Treasuries but maintain outright short positions in 2-year TIPS. 2/10 TIPS curve flatteners and 2/10 inflation curve steepeners also continue to make sense. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on how to think about the tradeoff between the Fed’s inflation and employment goals please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 2 https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/june/ 3 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 4 Please see US Bond Strategy Weekly Report, “No Relief From High Inflation”, dated June 14, 2022. 5 Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Feature Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.1 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation A Broad-Based Pickup in Inflation A Broad-Based Pickup in Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem July 2022 July 2022   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI July 2022 July 2022 Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.2 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market A Very Tight US Labor Market A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble The US Economy is in Trouble The US Economy is in Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue Inflation is a 'Modern' Issue Inflation is a 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance A Simple Measure of the Monetary Stance A Simple Measure of the Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Globalization in Retreat Globalization in Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.3 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt No Releveraging Cycle in Household Debt No Releveraging Cycle in Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? A Peaking in Supply Problems? A Peaking in Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher Inflation Expectations Spike Higher Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. Footnotes 1This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 2 Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 3 A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.

Highlights We now recommend that investors maintain a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds. We still believe that the US will likely avoid a recession over the coming year, but we are less convinced that this is true than we were a few months ago. The fact that mortgage rates have risen to neutral territory means it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand in the form of a sharp decline in real wages – are currently present or soon will be. In addition, the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Headline inflation has seemingly been a more impactful driver of long-term inflation expectations than core measures, implying that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints in order to contain rising inflation expectations. That would be clearly negative for economic growth and is potentially recessionary in nature. We see no compelling signs of an acceleration in European or Chinese growth that could act as a ballast to support the global economy. The European energy situation is worsening, China’s post-lockdown rebound has so far been tepid, and market-based indicators of Chinese economic growth are deteriorating. The US equity market is not priced for a typical “income-statement” recession induced by monetary policy. We expect the S&P 500 to fall to 3100 in a recession scenario, driven mostly by declining earnings. In a recession scenario, we do not expect long-maturity government bond yields to fall enough to offset a likely increase in the equity risk premium. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight, or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we soon see a substantial slowdown in the US headline inflation rate. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Downgrading Risky Assets To Neutral Every month, BCA strategists hold a house view meeting to discuss the most important issues driving the macroeconomy and financial markets. As highlighted in a recent Special Alert from our Global Investment Strategy service,1 BCA strategists voted at our June meeting to change our House View to a neutral asset allocation stance towards equities, with a slight plurality favoring an outright underweight. Table I-1We Now Recommend More Conservative Positioning Than We Did In May July 2022 July 2022 The view of the Bank Credit Analyst service is in line with the consensus of BCA strategists on this issue, and we consequently recommend a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds (Table I-1). We noted in our April report2 – when the S&P 500 index stood at 4530 – that the outlook for equities had deteriorated meaningfully since the beginning of the year and that investors should maintain at most a very modest overweight toward equities in a global multi-asset portfolio. A formal downgrade to neutral is thus not a large change in our recommended positioning, but it reflects what we view as a legitimate increase in the odds of a US recession over the coming year. It is not yet our view that a US recession is a probable outcome, but it is important to distinguish between one’s forecast of the economic outlook and the appropriate investment strategy. The unique inflationary pressure created by the COVID-19 pandemic has created a large confidence interval around our forecast, underscoring that an aggressive stance towards risky assets is not warranted. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see a substantial slowdown in the US headline inflation rate. But as we will discuss below, that slowdown will have to materialize soon in order for us to recommend an overweight risky asset stance. Reviewing Our Previously Constructive View On US Economic Growth Chart I-1Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Concerns about a potential US recession have been growing since the Fed’s hawkish pivot in November, especially following Russia’s invasion of Ukraine. Previously, these concerns centered around two core issues: the aggressive pace at which the Fed communicated it would raise the policy rate, and the fact that the 2-10 yield curve flattened sharply in the first quarter and finally inverted (based on closing prices) on April 1st (Chart I-1). We had pushed back against those concerns, for several reasons. Our deeply-held view is that recessions typically occur when a significant shock to aggregate demand emerges against the backdrop of tight monetary policy. Sometimes the debt-service and credit demand impact of high interest rates itself is the shock. In other cases, recessions have been triggered in an environment of restrictive monetary policy by a sudden change in key input costs (such as oil prices), the bursting of a financial asset bubble, or a major shift in fiscal spending (typically following a period of war). But the core point is that recessions rarely occur when monetary policy is easy, even when shocks to aggregate demand occur. We abstract here from special cases such as the recession that occurred during the early phase of the COVID-19 pandemic. That event saw the introduction of government policies that purposely arrested economic activity, which in our view would have caused a recession under any conceivable fiscal and/or monetary policy alignment. As a business cycle indicator, the yield curve is significant for investors because it essentially represents the bond market’s assessment of the monetary policy stance. The 2-10 yield curve inversion in early April occurred, in part, because of the speed at which the Fed signaled it would raise interest rates, but also because the 10-year Treasury yield stood just under 2.4% at the point of inversion. This level of long-maturity bond yields reflected the view of both the Fed and most investors that the neutral rate of interest permanently fell following the 2008/2009 global financial crisis (GFC), a view that we have argued against in several previous reports.3 As such, the first reason we pushed back against earlier recessionary concerns is that we believe that the natural/neutral rate of interest is higher than the Fed and investors believe (even though we warned that a recessionary scare was quite likely). Chart I-2A Large Portion Of Currently Elevated Inflation Is Due To Supply-Side And Pandemic-Related Factors July 2022 July 2022 The second reason that we had pushed back against recessionary concerns was our view that a meaningful portion of currently elevated US inflation is a function of supply-side and pandemic-related factors that will eventually abate. Chart I-2 highlights credible estimates showing that roughly half of the year-over-year change in the headline PCE deflator is the result of supply-side factors, versus 40-50% for core inflation. It has been and remains our view that a substantial portion of these supply-side and pandemic-related factors will dissipate as the pandemic continues to recede in importance, with several price categories likely to deflate outright. Chart I-3Excess Savings Should Still Support Higher Services Spending Excess Savings Should Still Support Higher Services Spending Excess Savings Should Still Support Higher Services Spending Finally, we have argued in several reports that US goods spending has been well above-trend and is likely to slow, but also that services spending is far too low and is likely to rise. Chart I-3 highlights that close to $3 trillion in excess savings have accrued during the pandemic, which formed because of a combination of rising disposable income and falling services spending. We noted that the continued transition of the US and global economies towards a post-pandemic state would boost services spending, providing (an admittedly atypical) source of support for overall aggregate demand.   Why The Odds Of A US Recession Have Increased We still believe that the US will more likely than not avoid a recession over the coming year, but it is true that the strength of all three of the arguments presented above has weakened. Regarding the stance of monetary policy, Charts I-4 and I-5 highlight that it is still true that the Fed funds rate and 5-year/5-year forward Treasury yields remain below our estimate of the neutral rate (nominal potential GDP growth). However, Chart I-6 highlights that the sharp rise in consumer price inflation has caused a substantial reduction in real wage growth, which certainly constitutes a non-monetary aggregate demand shock. Chart I-4The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are Chart I-5Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand... Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand... Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand...       Chart I-6...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages ...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages ...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages Panel 2 of Chart I-4 also shows that the 30-year mortgage rate in the US is now at neutral levels, in contrast to government bond yields and the US policy rate. Chart I-7 highlights that our models for US home sales and starts, featured in last month’s report,4 are still not pointing to a severe slowdown in the housing market. However, the fact that mortgage rates have risen to neutral territory means that it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand – are currently present or soon will be. On the question of services spending acting as a support for US economic growth as goods spending slows, we continue to believe that services spending will recover back towards its pre-pandemic trend – funded by excess savings that accrued during the pandemic. However, Chart I-8, presented by my colleague Arthur Budaghyan in a recent Emerging Markets Strategy report,5 underscores the extent of the wealth destruction that has occurred because of the joint effect of falling stock and bond prices. At least some of the services-boosting effect of excess savings will likely be blunted by a negative wealth effect stemming from these financial market losses, especially since the remaining excess savings in the US are likely held by middle-to-upper income households – who are the disproportionate holders of publicly-traded financial assets. Chart I-7No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present Chart I-8A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic   On the inflation front, the May CPI release – and the Fed’s reaction to it – underscores that the US economy is at risk of a recession unless supply-side inflation dissipates quickly. Chart I-9 highlights that the May CPI release directly contradicted the view that the monthly rate of change in inflation has peaked. In addition, Chart I-10 presents a breakdown of the percent change in May’s headline consumer price index, with each bar in the chart representing the contribution of that category to headline CPI rising faster than 4% (annualized). The note next to each bar highlights our view of the main driver of that price category, and the color of the bars denotes how probable it is that we will soon see a significant easing in price pressure. Chart I-9The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative Chart I-10Some Elements Of Outsized CPI Will Dissipate Soon. Others May Not. July 2022 July 2022     The chart makes it clear that certain price categories that have been strongly contributing to outsized headline inflation are likely to peak or even turn deflationary over the next few months. Gasoline and fuel oil inflation is clearly being driven by the trend in crude oil prices, which in our view will likely be flat for the rest of the year. In addition, motor vehicles and parts inflation continues to be driven by the impact of supply-chain shortages on vehicle production. Over the past year, the volume of industrial production of motor vehicle assemblies has averaged just 83% of its pre-pandemic level, which we noted in last month’s report now finally seems to be normalizing (Chart I-11). And while airlines have experienced legitimate cost increases due to rising fuel prices and COVID-related labor shortages, panel 2 of Chart I-11 highlights that real airfares have risen well above their pre-pandemic level. This underscores that a moderation in airfares is quite likely over the coming several months. However, Chart I-10 also highlights that there are several price categories that are less likely to ease quickly. Outsized food and energy services inflation has recently been tied to natural gas prices, given that natural gas is used to generate electricity and is a key element used in the production of fertilizer. Chart I-12 highlights that food inflation has been strongly correlated with the producer price index for pesticide, fertilizer, and other agricultural chemicals, and that there is no sign yet of the latter abating. Despite the fact that global wheat prices have recently been falling, the recent increase in European natural gas prices is likely to exacerbate US food inflation, as fertilizer is used to produce all major planted crops. In addition, European energy insecurity has created an even stronger link between the US and European natural gas markets than what prevailed prior to the Ukrainian war, because of what is likely to be permanently higher LNG demand from Europe. Chart I-11Vehicle And Airfare Inflation Is Likely To Ease Soon Vehicle And Airfare Inflation Is Likely To Ease Soon Vehicle And Airfare Inflation Is Likely To Ease Soon Chart I-12Food Inflation May Remain Elevated For Some Time Food Inflation May Remain Elevated For Some Time Food Inflation May Remain Elevated For Some Time   On top of what is likely to be persistent food and energy services inflation, shelter inflation is likely to stay elevated for some time – a point highlighted by my esteemed former colleague, Martin Barnes, in Section 2 of this month’s report. The unemployment rate and house prices are the two main drivers of shelter inflation, and the effect of the latter clearly lags because owner’s equivalent rent is a surveyed measure. The fact that mortgage rates have risen so significantly points to a meaningful slowdown in house price appreciation and possibly even mild deflation, so shelter inflation will eventually slow. The Federal Reserve has made it clear, however, that they are now focused on quickly bringing down consumer prices, even at the cost of a recession. The justification for the Fed’s impatience comes straight from the Modern-Day Phillips Curve, which we discussed in great detail in our January 2021 Special Report.6 Economic theory dictates that inflation should be “normal” when the economy is in equilibrium – defined as economic growth in line with potential growth, no economic/labor market slack, and no supply-side shocks affecting prices. In the minds of many investors, “normal” inflation means the central bank’s target for inflation, but that is not necessarily the case. The experience of the 1970s highlighted that “normal” inflation is the rate that is expected by households and firms, and that the Fed will only succeed at achieving target inflation under normal economic conditions if inflation expectations are consistent with its target. The Fed’s failure to prevent inflation expectations from shifting higher on a structural basis led to two debilitating recessions in the early 1980s, and a prolonged period over which the Fed had to maintain comparatively tight monetary policy. This is a mistake that the Fed does not want to make again. Chart I-13Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Consistent with that view, Jerome Powell made it clear during the June FOMC meeting press conference that the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Powell implicitly referenced the University of Michigan’s 5-10 year median household inflation expectations survey during the press conference, which we have described in several previous reports as one of the most important macro data series for investors to monitor. The final reading for June came in materially lower than what was suggested by the preliminary report, but they were already at risk of a breakout even before the June release. In addition, Chart I-13 highlights that it is headline inflation (not core) that appears to be the main driver of rising long-term household inflation expectations, which raises a troubling point. If the Fed decides that inflation expectations need to be quickly reined in even at the cost of a higher unemployment rate, that decision implies that it is headline inflation that needs to return rapidly towards the Fed’s target, not just core. Given that some price categories shown in Chart I-10 are likely to be sticky for some time, and that the chart accounted for deviations in headline inflation from 4% (which itself is above the Fed’s target), the implication is that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints. That would be clearly negative for economic growth, and is potentially recessionary in nature. As a final point, it is not just the potential for future economic weakness that concerns us. The US economy was already slowing prior to the Fed’s hawkish pivot and Russia’s invasion of Ukraine, and important indicators for economic activity continue to deteriorate. Chart I-14 highlights that the S&P Global US manufacturing and services PMIs fell meaningfully in June, and Chart I-15 highlights that the Conference Board’s US leading economic indicator continues to deteriorate. In fact, the Conference Board’s LEI has now decreased for three consecutive months, and the bottom panel of Chart I-15 highlights that four consecutive month-over-month declines have all essentially been associated with a recession. 2006 seemingly stands out as an exception to this rule, but given the fact that the housing market downturn began two years before the recession officially started, we simply regard this as an early recessionary signal rather than a false one. Chart I-14The US Is Losing Economic Momentum The US Is Losing Economic Momentum The US Is Losing Economic Momentum Chart I-15The Conference Board's LEI May Soon Send A Recessionary Signal The Conference Board's LEI May Soon Send A Recessionary Signal The Conference Board's LEI May Soon Send A Recessionary Signal     No Help From Europe Or China An overweight stance towards global equities might still be warranted in the face of a significant slowdown in US economic activity if economic growth in Europe or China were accelerating. However, the European outlook has been strongly tied to natural gas flows from Russia since the invasion of Ukraine, which tightened meaningfully in June in response to Europe’s oil ban, the looming expansion of NATO, and Europe’s success at replenishing its amount of natural gas in storage. Russia has not fully weaponized its natural gas exports and its actions so far have fallen well short of a complete cutoff, but prices have risen close to 70% over the past month, forcing Germany to trigger the alert level of its emergency gas plan. Aside from the negative impact that higher natural gas prices will have on headline inflation globally, this is obviously incrementally negative for European economic activity. Chart I-16 highlights that the German IFO business climate indexes have led the S&P Global Germany PMI lower over the past few months, and that they imply further manufacturing weakness. And while the services climate index for Germany ticked higher, it remains meaningfully below the levels that prevailed last summer and implies a deterioration in German services activity over the coming few months. In China, we see no compelling signs of a sustainable pickup in economic activity that will provide a ballast to slowing growth in the DM world. We have seen a bounce back in some activity indicators following the significant easing of restrictions in Shanghai and Beijing (Chart I-17). These indicators, however, are still quite weak, and it is likely that China will experience significant further COVID outbreaks over the coming 6-12 months. Chart I-16Europe's Economy Is Likely To Slow Further Europe's Economy Is Likely To Slow Further Europe's Economy Is Likely To Slow Further Chart I-17China's Post-Lockdown 'Recovery' Remains Tepid China's Post-Lockdown 'Recovery' Remains Tepid China's Post-Lockdown 'Recovery' Remains Tepid   While Chinese stocks have been rallying in absolute terms over the past few weeks, Chart I-18 highlights that this is essentially the only positive market-based signal about the pace of economic activity in China. The chart highlights that our market-based China Growth Indicator has experienced a renewed down leg, and that the diffusion index never rose above the boom/bust line earlier this year. The recent decline in industrial metals prices is also not a positive market-based signal for Chinese economic activity (Chart 19). Some investors have argued that weak metals prices reflect growth concerns outside of China, but even if that is the case, it implies that China’s reopening will not be forceful enough to offset slowing global ex-China growth. Chart I-18Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Chart I-19Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears   Has The US Equity Market Already Priced In A Recession? One very important question for investors to answer is how much further downside is likely to occur for US equities in the event of a US recession. At its worst point in mid-June, the S&P 500 fell close to 24% from its early January high, and many investors have since questioned whether the US equity market is already priced for a potential contraction in output. Chart I-20The S&P 500 Is Not Currently Priced For A US Recession July 2022 July 2022 We disagree with this perspective, and believe that the S&P 500 would fall close to 3100 in a typical recession scenario. Chart I-20 presents a range of estimates for the S&P 500 based on a Monte Carlo approach, using what we believe are feasible ranges for the US equity risk premium, real 10-year government bond yields, and the extent of the decline in 12-month forward earnings per share. The chart shows that the equity market only has a positive return at the 5th percentile, which can be interpreted as just a 5% chance that the US equity market has already priced in the impact of a recession. Charts I-21 and I-22 highlight the range of possible outcomes that we used when modeling the likely decline in stock prices in a recession scenario. We assume that the equity risk premium, defined here as the difference between the S&P 500 12-month forward earnings yield and 10-year TIPS yields, rises on average to its early-March level in the wake of Russia’s invasion of Ukraine. We assume that both 10-year nominal Treasury yields and 10-year breakeven inflation rates fall to 2%, reflecting an expectation that 10-year TIPS yields will not return to negative territory in a recessionary scenario. Finally, we expect that S&P 500 forward EPS will decline by 15% from current levels, which is in line with the historical average decline in 12-month trailing operating EPS during recessions. Chart I-21We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario Chart I-22We Expect Earnings To Decline Between 10-20% In A Recession We Expect Earnings To Decline Between 10-20% In A Recession We Expect Earnings To Decline Between 10-20% In A Recession     One key takeaway from our analysis is that the likely recessionary equity market decline projected by our approach is fairly close to our estimate of the likely decline in earnings. One potential pushback against our view that earnings will fall in line with what usually occurs during recessions is the fact that nominal revenue growth may only mildly contract or may not contract at all in a recession that is occurring due to high rates of inflation (and thus higher prices charged by firms). Chart I-23 highlights that 12-month trailing S&P 500 sales per share growth never turned negative in the 1970s, even following the 1970 and 1974 recessions. Chart I-23Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... There are two counterpoints to this argument. First, the current risk of a recession mostly stems from the Fed’s determination not to repeat the mistakes that it made during the 1970s, meaning that inflation expectations are unlikely to rise to the level that they did during that period in advance of a recession. That implies that actual inflation, and thus corporate pricing power, will come down significantly during a recession. Second, even in a scenario in which a recession occurs and S&P 500 revenue growth contracts less aggressively than it has during previous recessions, Chart I-24 highlights that the mean-reversion risks to earnings from falling profit margins are quite high. The chart shows that even if profit margins were merely to return to their pre-pandemic levels during a recession (which would actually be a comparatively mild decline given the historical behavior of margins during recessions), it would imply close to a 20% contraction in earnings if sales per share growth were flat. Given this, we feel that our assumption of a 10-20% decline in earnings per share in a recessionary scenario is reasonable. Chart I-24But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts There is another important takeaway from our analysis, which is that the decline in bond yields that will occur in a recessionary scenario will likely be more than offset by a rise in the equity risk premium. Another potential pushback against our view that the US equity market has already priced in a recession is focused on our assumption that the 10-year US Treasury yield will only fall back to 2%, and that real 10-year yields will not return to negative territory. For some investors, this assumption seems far too high, given the structural decline in long-maturity bond yields over the past decade and the fact that the 10-year yield stood below 2% at the beginning of the year when the odds of a recession were lower than they are today. In response to this, we offer three points for structurally-bullish bond investors to consider. The first is that the decline in the nominal 10-year US Treasury yield to 0.5% in 2020 was extremely irregular and it occurred because of the extent of the essentially unprecedented economic weakness wrought by the pandemic. This is absolutely the wrong yield benchmark to use in a typical recession scenario, because the Fed’s response to the recession will be much less aggressive. The second point is related to the first, in that negative real 10-year government bond yields have been heavily driven by the secular stagnation narrative and the general view that the natural/neutral rate of interest has permanently fallen. We agree that the neutral rate of interest fell for a time following the global financial crisis, but we believe strongly that it rose in the latter half of the last economic expansion as US households aggressively deleveraged their balance sheets. Academic estimates of R-star, such as that derived from the previously popular (but now discontinued) Laubach-Williams model, continued to point to a low neutral rate from 2015-2019 because of the deflationary impact of an energy-driven decline in long-term inflation expectations on actual inflation, a factor that is clearly no longer present. Chart I-25We Doubt That The Fed Will Resort To QE When The Next Recession Occurs We Doubt That The Fed Will Resort To QE When The Next Recession Occurs We Doubt That The Fed Will Resort To QE When The Next Recession Occurs Finally, we agree that the existence of the Fed’s asset purchase program has likely had some impact on the 10-year term premium over the past decade. We doubt that the Fed would resort to QE as a monetary policy tool in response to a conventional recession, implying that the term premium will not fall as low as it has over the past decade when growth slowed or contracted. Chart I-25 highlights one important reason for this. Since 2008, the Fed’s use of asset purchases has been part of a strategy to ease monetary policy further when the policy rate had already fallen to zero, to meet its dual mandate of maximum employment and price stability. The chart highlights that even just prior to the pandemic, a persistent gap existed between the headline and core PCE deflator and the level that would have prevailed if both deflators had grown at a 2% annual rate since the onset of the 2008 recession. The chart makes it clear that this gap will completely disappear within the next 12 months for both the headline and core deflator, if the recent pace of change in prices is sustained. In effect, Chart I-25 highlights that the entire post-GFC missed inflation-target era is almost over, which severely undercuts the idea that the Fed will resort to QE as a monetary policy tool in a recession scenario unless the contraction is very severe as it was in 2008 and 2020. We doubt that this will be the case if a recession does occur, implying that both a deeply negative term premium and a significant decline in the 5-year/5-year forward bond yield in a typical recession scenario is unlikely. Investment Conclusions Wayne Gretsky’s famous quotation, that he “skate[s] to where the puck is going, not where it has been” is often invoked by BCA strategists. Successful active investing requires anticipation rather than reaction, and it is legitimate for investors to ask whether downgrading risky assets at the current juncture represents the latter rather than the former. We are cognizant of that risk, but we are also mindful of the importance of capital preservation. When we wrote our annual outlook last year, we believed fairly confidently that inflation would peak and specifically that supply-side inflation would wane. We still believe that pandemic-related effects on consumer prices will eventually dissipate, and it is still possible that inflation is in the process of peaking. Recent evidence, however, about the pace of price advances, the clear impact that high inflation is having on real wage growth, and the Fed’s desire to see consumer prices fall quickly back toward its target, means that the cyclical economic outlook is now highly dependent on the speed at which prices normalize – not just whether it will occur. To us, that implies that investors need to have a high-conviction view that supply-side inflation will normalize soon in order to stay overweight risky assets, and that the Fed will look through elevated housing-related inflation that is likely to persist for several months. At least in the case of supply-side inflation, we think normalization is probable but we no longer have high conviction about the speed of adjustment. As such, we recommend that investors maintain no more than a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds, as part of an overall shift towards more defensive positions. In terms of other important asset class allocations, we recommend the following: Within a global equity portfolio, maintain a neutral regional allocation, a neutral stance toward cyclicals versus defensives, and a neutral stance towards small-cap stocks versus their large-cap peers. Modestly favor value stocks over growth stocks, as most of the outsized outperformance of growth stocks during the pandemic has already reversed. Within a fixed-income portfolio, a modestly short stance is warranted over the coming 6- to 12-months. Extremely stretched technical and valuation conditions point to a bearish view towards the US dollar over the coming 6- to 12-months, but USD will likely remain well-bid over the nearer-term. We are only likely to upgrade our cyclical USD call in a scenario in which we recommend underweighting global equities within a multi-asset portfolio. As noted above, financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 30, 2022 Next Report: July 28, 2022 II.  Inflation Whipsaw Ahead Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.7 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation A Broad-Based Pickup in Inflation A Broad-Based Pickup in Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem July 2022 July 2022   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI July 2022 July 2022 Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.8 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market A Very Tight US Labor Market A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble The US Economy is in Trouble The US Economy is in Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue Inflation is a 'Modern' Issue Inflation is a 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance A Simple Measure of the Monetary Stance A Simple Measure of the Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Globalization in Retreat Globalization in Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.9 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt No Releveraging Cycle in Household Debt No Releveraging Cycle in Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? A Peaking in Supply Problems? A Peaking in Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher Inflation Expectations Spike Higher Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. III. Indicators And Reference Charts BCA’s equity indicators paint a bearish picture for stock prices. Our monetary indicator is now at its weakest in almost three decades and our valuation indicator highlights that stocks are still overvalued, albeit less so than they were last year. Meanwhile, both our sentiment and technical indicators have now broken down very significantly, and are not yet providing a contrarian buy signal. The odds of a US recession over the next 12 months have recently risen, and we now recommend a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being significantly revised up, but bottom-up analysts’ expectations for earnings are still too rosy. Although earnings growth is still likely to be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits. Within a global equity portfolio, we recommend a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. Within a fixed-income portfolio, investors should stay modestly short duration. The increase in commodity prices that followed Russia’s invasion of Ukraine has cooled, and prices are now rolling over significantly on the back of global growth concerns. Our composite technical indicator has dropped meaningfully, indicating that commodities are now no longer overbought. Our base-case view is that oil prices have peaked, but there some risk to that view given the current geopolitical situation. In addition, the recent rise in European natural gas prices suggests that global food inflation could remain elevated, given that natural gas is used in the production of fertilizer. We remain structurally bullish on industrial metals, but metals prices are likely to decline further until recessionary concerns abate. US and global LEIs have rolled over significantly and are now edging towards negative territory. The Conference Board’s LEI has now decreased for three consecutive months, and four consecutive month-over-month declines have historically been associated with a recession. Our global LEI diffusion index has bottomed, but we are not convinced that this heralds a major upturn in the LEI itself. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Content Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop   ECONOMY: Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Please see Global Investment Strategy Special Alert "Hard Or Soft Landing? BCA Strategists Debate The Question," dated June 21, 2022, available at gis.bcaresearch.com 2     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 3    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com; The Bank Credit Analyst "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com; The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 5    Please see Emerging Markets Strategy "A Conversation With Ms. Mea: Navigating An Inflation Storm," dated June 16, 2022, available at ems.bcaresearch.com 6    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 7     This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 8     Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 9    A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.

    Executive Summary At our monthly view meeting on Monday, BCA strategists voted to change the House View to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight. The view of the Global Investment Strategy service is somewhat more constructive, as I think it is still more likely than not that the US will avoid a recession; and that if a recession does occur, it will be a fairly mild one. Nevertheless, the risks to my view have increased. I now estimate 40% odds of a recession during the next 12 months, up from 20% a month ago. In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Bottom Line: With the S&P 500 down 27% in real terms from its highs at the time of the meeting, the view of the Global Investment Strategy service is that a modest overweight is appropriate. However, investors should refrain from adding to equity positions until more clarity emerges about the path for inflation and growth. Heading For Recession? Every month, BCA strategists hold a view meeting to discuss the most important issues driving the macroeconomy and financial markets. This month’s meeting, which was held yesterday, was especially pertinent as it comes on the heels of a substantial decline in global equities. The key issue that we grappled with was whether the Fed could achieve a proverbial soft landing or whether the US and the rest of the global economy were spiraling towards recession (if it wasn’t already there). I began the meeting by showing one of my favorite charts, a deceptively simple chart of the US unemployment rate (Chart 1). The chart makes three things clear: 1) The US unemployment rate is rarely stable; It is almost always either rising or falling; 2) Once it starts rising, it keeps rising. In fact, the US has never averted a recession when the 3-month average of the unemployment rate has risen by more than a third of a percentage point; and 3) As a mean-reverting series, the unemployment rate is most likely to start rising when it is very low. Chart 1In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Taken at face value, the chart paints a damning picture about the economic outlook. The US unemployment rate is near a record low, which means that it has nowhere to go but up. And once the unemployment rate starts going up, history suggests that a recession is inevitable. Five Caveats Despite this ominous implication, I did highlight five caveats. First, the observation that even a modest increase in the unemployment rate invariably heralds a recession is based on a limited sample of business cycles from the US. Across the G10, soft landings have occurred, Canada being one example (Chart 2). Second, unlike the unemployment rate, the employment-to-population ratio is still 1.1 percentage points below its pre-pandemic level, and 4.6 percentage points below where it was in April 2000. A similar, though less pronounced, pattern holds if one focuses only on the 25-to-54 age cohort (Chart 3). Chart 2G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment Chart 3The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels   While the number of people not working either because they are worried about the pandemic, or because they are still burning through their stimulus checks, has been trending lower, it is still fairly high in absolute terms (Chart 4). As my colleague Doug Peta discussed in his latest report, one can envision a scenario where job growth remains positive, but the unemployment rate nonetheless edges higher as more workers rejoin the labor force. Chart 4ALabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Chart 4BLabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II)     Third, the job vacancy rate is extremely high today – much higher than a pre-pandemic “Beveridge Curve” would have predicted (Chart 5). This provides the labor market with a wide moat against an increase in firings. As Fed governor Christopher Waller has emphasized, the main effect of the Federal Reserve’s efforts to cool labor demand could be to push down vacancies rather than to push up unemployment. Fourth, as we have highlighted in past research, the Phillips curve is kinked at very low levels of unemployment (Chart 6). This means that a decline in unemployment from high to moderate levels may do little to spur inflation, but once the unemployment rate falls below its full employment level, then watch out! Chart 5The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The converse is also true, however. If a small decrease in unemployment can trigger a large increase in inflation, then a small increase in unemployment can trigger a large decrease in inflation, provided that long-term inflation expectations remain reasonably well anchored in the meantime. In other words, it is possible that the so-called “sacrifice ratio” — the amount of output that has to be sacrificed to reduce inflation — may be quite low. Fifth, and perhaps most importantly, there is a lot of variation from one recession to the next in how much unemployment rises. In general, the greater the financial and economic imbalances going into a recession, the deeper it tends to be. US household balance sheets are in reasonably good shape these days. Households are sitting on $2.2 trillion in excess savings (Chart 7). Yes, most of those savings belong to relatively well-off households. But as Chart 8 illustrates, even rich people spend well over half of their income. Chart 7Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Chart 8Even The Rich Spend The Majority Of Their Income Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question     The ratio of household debt-to-disposable income in the US is down by a third since its peak in 2008. Despite falling equity prices, the ratio of household net worth-to-disposable income is still up nearly 50 percentage points since the end of 2019, mainly because home prices have risen (Chart 9). As is likely to be the case in many other countries, home prices in the US will level off and quite possibly decline over the next few years. In and of itself, that may not be such a bad outcome for equity markets since lower real estate prices will cool aggregate demand, thus lowering inflation without the need for much higher interest rates. The danger, of course, is that we could see a replay of the GFC. This risk cannot be ignored but is probably quite small. The quality of mortgage lending has been very strong over the past 15 years. Moreover, unlike in 2007, when there was a large glut of homes, the homeowner vacancy rate today is at a record low. Tepid homebuilding has pushed the average age of the US residential capital stock to 31 years, the highest since 1948 (Chart 10). Chart 9The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic Chart 10Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC   A Bleaker Picture Outside The US The situation is admittedly dicier outside the US. Putin’s despotic regime continues to wage war on Ukraine. While European natural gas prices are still well below their March peak, they have recently surged as Russia has begun to throttle natural gas exports (Chart 11). The euro area manufacturing PMI clocked in a respectable 54.6 in May but is likely to drop over the coming months as higher energy prices restrain production. The only saving grace is that fiscal policy in Europe has turned more expansionary. The IMF’s April projection foresaw the structural primary budget balance easing from a surplus of 1.2% of GDP between 2014 and 2019 to a deficit of 1.2% of GDP between 2022 and 2027, the biggest swing among the major economies (Chart 12). Even the IMF’s numbers probably underestimate the fiscal easing that will transpire considering the need for Europe to invest more in energy independence and defense. Chart 11The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices Chart 12Euro Area Fiscal Policy Is Expected To Be More Expansionary In The Years To Come Than Before The Pandemic Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The Chinese economy continues to suffer from the “triple threat” of renewed Covid lockdowns, a shift of global demand away from manufactured goods towards services, and a floundering property market. We expect the Chinese property market to ultimately succumb to the same fate that befell Japan 30 years ago. Chart 13Chinese Stocks Are Cheap Chinese Stocks Are Cheap Chinese Stocks Are Cheap Unlike Japanese stocks in the early 1990s, however, Chinese stocks are trading at fairly beaten down valuations – 10.9-times earnings and 1.4-times book for the investable index (Chart 13). With the Twentieth Party Congress slated for later this year and the population jaded by lockdowns, the political incentive to shower the economy with cash and loosen the reins on regulation will intensify. A Scenario Analysis For The S&P 500 Corralling all these moving parts is no easy matter. We would put the odds of a US recession over the next 12 months at 40%. This is double what we would have said a month ago when we tactically upgraded stocks after the S&P 500 fell below the 4,000 mark. The May CPI report was clearly a shocker, both to the Fed and the markets. The median dot in the June Summary of Economic Projections sees the Fed funds rate rising to 3.8% next year, smack dab in the middle of our once highly out-of-consensus estimate of 3.5%-to-4% for the neutral rate of interest. With interest rates potentially moving into restrictive territory next year, equity investors are right to be concerned. Yet, as noted above, if a recession does occur, it is likely to be a fairly mild one. At the time of the BCA monthly view meeting, the S&P 500 was already down 23% in nominal terms and 27% in real terms from its peak in early January. We assume that the S&P 500 will fall a further 10% in real terms over the next 12 months in a “mild recession” scenario (30% odds) and by 25% in a “deep recession” scenario (10% odds). Conversely, we assume that the S&P 500 will be 20% higher in 12 months’ time in a “no recession” scenario (60% odds). Note that even in a “no recession” scenario, the real value of the S&P 500 would still be down 12% in June 2023 from its all-time high. On a probability-weighted basis, the expected 12-month real return across all three scenarios works out to 6.5%, or 8% with dividends (Table 1). That is enough to justify a modest overweight in my view – but given the risks, just barely. Investors focused on capital preservation should consider a more conservative stance. Table 1S&P 500 Drawdowns Depending On Whether The US Will Enter A Recession And How Severe It Will Be Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Most of my colleagues were more cautious than me, as they generally thought that the odds of a recession were greater than 50%. They voted to shift the BCA house view to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight (10 for underweight; 9 for neutral; and 6 for overweight). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Special Trade Recommendations Current MacroQuant Model Scores Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question  

Executive Summary Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report  Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Worrying Signs For Global Growth Worrying Signs For Global Growth ​​​​​​ Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here ​​​​​​ Chart 4Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here ​​​​​​ For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed ​​​​​​ Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' ​​​​​​ Chart 7Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts ​​​​​​ Chart 11Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? ​​​​​​ The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? ​​​​​​ Chart 13Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a)     reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b)     the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Volcker's Ghost Volcker's Ghost The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Volcker's Ghost Volcker's Ghost Tactical Overlay Trades

Executive Summary Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Image Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure China: Less Stable, Less Secure China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 3BCyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 6China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe China Needs To Court Europe China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America China Stimulus Creates Opportunity For ... Latin America China Stimulus Creates Opportunity For ... Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Highlights Chart 1Wage Growth Is Cooling Wage Growth Is Cooling Wage Growth Is Cooling In a speech last week, Fed Governor Christopher Waller presented the theoretical underpinnings for how the Fed plans to achieve a soft landing for the US economy.1 The Fed’s hope is that tighter monetary policy will slow demand enough to reduce the number of job openings – of which there are currently almost two for every unemployed person – without leading to a significant increase in layoffs and the unemployment rate. A reduction in the ratio of job openings to unemployed will lead to softer wage growth and lower inflation. The May employment report – released last Friday – provides some evidence that the Fed’s plan may be working. In May, an increase in labor force participation led to strong employment gains and kept the unemployment rate flat. We also saw continued evidence of a deceleration in average hourly earnings (Chart 1). Fifty basis point rate hikes are all but assured at the June and July FOMC meetings, but softer wage growth and falling inflation make it more likely that the Fed will downshift to a pace of 25 bps per meeting starting in September. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance The Case For A Soft Landing The Case For A Soft Landing Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 79 basis points in May, bringing year-to-date excess returns up to -215 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 131 bps. Similarly, our quality-adjusted 12-month breakeven spread downshifted to its 45th percentile since 1995 (Chart 2). A recent report made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.2 The main rationale for this recommendation is that the slope of the Treasury curve is very flat, signaling that we are in the mid-to-late stages of the credit cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Despite our underweight 6-12 month investment stance, we see a high likelihood that spreads will narrow during the next few months as inflation falls and the Fed tightens by no more than what is already priced in the curve. That said, the persistent removal of monetary accommodation and flatness of the yield curve will limit how much spreads can compress. Last week’s report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.3  That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* The Case For A Soft Landing The Case For A Soft Landing High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 35 basis points in May, dragging year-to-date excess returns down to -316 bps. More specifically, high-yield sold off dramatically early in the month – the junk index lagged Treasuries by 368 bps between May 1 and May 20 – but then staged a rally near the end of May, outperforming Treasuries by 333 bps between May 20 and May 31. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – moved higher in May. It currently sits at 5.1% (Chart 3). Last week’s report reiterated our view that investors should favor high-yield over investment grade within an overall underweight allocation to spread product versus Treasuries.4 Our main rationale for this view is that there are historical precedents for high-yield bonds outperforming investment grade during periods when the yield curve is very flat but when corporate balance sheet health is strong. The 2006-07 period is a prime example. With that in mind, our outlook for corporate profit and debt growth is consistent with a default rate of 2.7% to 3.7% during the next 12 months, well below the 5.1% that is currently priced in the index. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 70 basis points in May, bringing year-to-date excess returns up to -109 bps. We discussed the outlook for Agency MBS in a recent report.5 We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see some potential for yields to fall somewhat during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector.ext 12 months, well below the 5.1% that is currently priced in the index. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market (EM) bonds outperformed the duration-equivalent Treasury index by 29 basis points in May, bringing year-to-date excess returns up to -565 bps. EM sovereigns outperformed the Treasury benchmark by 125 bps on the month, bringing year-to-date excess returns up to -664 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 28 bps, dragging year-to-date excess returns down to -501 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 27 bps in May. The yield differential between EM sovereigns and duration-matched US corporates remains negative (Chart 5). As such, we continue to recommend a maximum underweight allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index underperformed duration-matched US corporates by 109 bps in May, but it continues to offer a significant yield advantage (panel 4). As such, we maintain our neutral allocation (3 out of 5) to the sector. Despite modest weakness in the trade-weighted US dollar in May, EM currencies continue to struggle (bottom panel). If the Fed tightens no more quickly than what is already priced in the curve for the next six months – as we expect – it could limit the upward pressure on the US dollar and benefit EM spreads in the near term. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 61 basis points in May, bringing year-to-date excess returns up to -78 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread product volatility. As we noted in a recent report, state & local government revenue growth has been strong and yet governments have also been slow to hire.6 The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni/Treasury yield ratio is currently 83%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 85%. The same measure for 17-year+ Revenue bonds stands at 92%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-steepened in May. The 2-year/10-year Treasury slope steepened 13 bps on the month and the 5-year/30-year slope steepened 22 bps. The 2/10 and 5/30 slopes now stand at 30 bps and 16 bps, respectively. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.7 For example, the 5-year/10-year Treasury slope is currently 1 bp while the 3-month/5-year slope is 178 bps. The divergence is happening because the market has moved quicky to price-in a rapid near-term pace of rate hikes. However, so far, the Fed has only delivered 75 bps of tightening and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced but lasts longer. We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 144 basis points in May, dragging year-to-date excess returns down to +237 bps. The 10-year TIPS breakeven inflation rate fell 25 bps last month, but it remains above the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Our TIPS Breakeven Valuation Indicator shows that TIPS remain “expensive”, but not as expensive as they were a month ago (panel 2). While TIPS have become less expensive during the past month, we think TIPS breakeven inflation rates will continue to fall during the next few months as inflation moves lower. This will be particularly true at the front-end of the curve where breakevens remain disconnected from the Fed’s target (panel 4) and where breakevens exhibit a stronger correlation with the incoming inflation data. To take advantage of falling inflation between now and the end of the year, investors should position for a steeper TIPS breakeven curve (bottom panel) and/or a flatter real (TIPS) curve. We also recommend that investors hold outright short positions in 2-year TIPS.     ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in May, dragging year-to-date excess returns down to -63 bps. Aaa-rated ABS underperformed by 26 bps on the month, dragging year-to-date excess returns down to -59 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -88 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 4.4% in April, the lowest print since September 2008, and the amount of outstanding credit card debt has almost recovered its pre-COVID level. But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in May, dragging year-to-date excess returns down to -189 bps. Aaa Non-Agency CMBS underperformed Treasuries by 84 bps on the month, dragging year-to-date excess returns down to -152 bps. Non-Aaa Non-Agency CMBS underperformed by 165 bps on the month, dragging year-to-date excess returns down to -290 bps. CMBS spreads remain wide compared to other similarly risky spread products. However, after several quarters of easing, commercial real estate lending standards shifted closer to ‘net tightening’ territory in Q1 (Chart 10). This trend will bear monitoring in the coming quarters.  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 19 basis points in May, bringing year-to-date excess returns up to -23 bps. The average index option-adjusted spread tightened 2 bps on the month. It currently sits at 49 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 251 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Case For A Soft Landing The Case For A Soft Landing Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -51 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Case For A Soft Landing The Case For A Soft Landing Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/newsevents/speech/waller20220530a.htm 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 3 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 4  Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 5 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022.       Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The default take on the economy and financial markets has been tilting increasingly bearish although the ongoing data flow has yet to pick a side. The data in the stories from the front page of The New York Times'  Saturday Business section over the Memorial Day weekend nod in the direction of a Goldilocks outcome: households have been so well fortified by their pandemic savings that their spending is holding up despite stiff price increases but innovation and automation are allowing companies to protect their profits even in a tight labor market. We remain of the view that a wage-price spiral is unlikely and therefore see a plausible path for S&P 500 margins to hold up better than expected over the rest of the year. We are looking for an opportunity to add equity exposure to our ETF portfolio to restore its overweight allocation but we won't rush to do it while the S&P 500 is within 100 points of near-term technical resistance. Putting Excess Savings To Good Use Putting Excess Savings To Good Use Putting Excess Savings To Good Use Bottom Line: We remain constructive on financial markets and the US economy over the next twelve months but are content to wait for a better tactical entry point to increase our ETF portfolio's equity exposure. Feature The Internet has drastically curtailed newspapers’ influence, but Page 1 is still not the place to go for alpha-generating investment ideas. Nearly all the juice has been squeezed from an investment idea by the time it makes it to the front page; if there’s any alpha to be found in the paper, it will be on the vitamin pages – B7, B12, D3. As Don Coxe, a favorite mentor, put it throughout his five-decade career as an investment strategist, “We don’t invest on the basis of Page 1 stories. We invest on the basis of stories on Page D7 that are going to Page 1.” Lately, the stories getting the most media airtime have accentuated the negative. Inflation is making 40-year highs; consumers are in a grim mood, at least according to the University of Michigan’s sentiment survey; the Fed was napping and may not be able to catch up; corporate profits will be the next domino to fall. Against that backdrop, we thought the front-page New York Times Saturday Business section stories reporting on coincident indicators over the Memorial Day weekend provided an interesting corrective. The data are moving fast and their positive cast may be fleeting, but the latest batch makes the case that it’s too soon to abandon our constructive market and economic view. Declining Profit Margins Might Still Beat Expectations The entire space above the fold was filled by a photograph of workers harvesting radishes. There was a large machine with moving conveyor belts behind them and as the workers bound the radishes into clumps, they tossed them onto the belt without turning their heads. Under the headline, “Farming Transformation In the Fields of California,” the article began, “It looks like a century-old picture of farming in California: a few dozen Mexican men … plucking radishes from the ground [.] But the[se] crews … represent the cutting edge of how America pulls food from the land.” “For starters, the young men … are working alongside technology unseen even 10 years ago. … [W]hat looks like a tractor retrofitted with a packing plant … carries [the radishes] through a cold wash and delivers them to be packed into crates and delivered for distribution in a refrigerated truck.” “The other change is more subtle, but no less revolutionary. None of the workers are in the United States illegally.” “Both of these transformations are driven by the same dynamic: the decline in the supply of young illegal immigrants from Mexico, the backbone of the work force picking California’s crops since the 1960s.” “The new demographic reality has sent farmers scrambling to bring in more highly paid foreign workers on temporary guest-worker visas, experiment with automation wherever they can and even replace crops with less labor-intensive alternatives.” The drying up of its inexpensive labor supply would seem to pose a mortal threat to farming profit margins. Temporary workers covered by the H-2A visa program earn two-and-a-half dollars an hour more than the $15 minimum wage applicable to local workers and must be provided with room, board and transportation to and from the fields. The industry has adapted, however, finding ways to mechanize the harvesting of crops that don’t need to meet aesthetic standards while tinkering with planting and growing techniques and genetic modifications to reduce labor intensity. Crops that resist mechanization hacks are leaving the United States for lower-cost climes as evidenced by a doubling of fruit and vegetable imports over the last five years. California acreage given over to asparagus, an especially labor-intensive crop, has fallen to 4,000 acres in 2020 from 37,000 two decades ago, while the nearby Mexican state of Sinaloa picked up the slack by increasing its harvest by around 30,000 acres. The adaptations seem to be working well for all but the formerly essential undocumented agricultural work force. As a vineyard worker who illegally crossed the border nearly 20 years ago said, “It scares me that they are coming with H-2As and … robots. That’s going to take us down.” What does this specific story have to do with corporate profit margins, a general subject of vital importance to all investors? It illustrates the difficulty employees confront in capturing and maintaining leverage when employers can radically alter the dynamic with investment. The sub-headline sums up labor’s plight well: “Growers are turning more and more to workers on seasonal visas, and mechanizing where they can. Meanwhile, labor-intensive crops are shifting south of the border.” Chart 1Input Costs Are Surging, ... Input Costs Are Surging, ... Input Costs Are Surging, ... We reiterate that a wage-price spiral is not a foregone conclusion. Neither is an onshoring bonanza. Although the aggregate first-quarter S&P 500 profit margin narrowed versus the year-ago quarter (revenue-per-share growth (13.9%) outpaced earnings-per-share growth (11.2%) by nearly three percentage points), it managed to surprise to the upside (earnings’ 7% beat was over four percentage points wider than revenues’ 2.6%), and innovation and investment may allow it to do so going forward, despite soaring materials costs (Chart 1) and upward wage pressures. After an initial pandemic surge, however, wages have failed to keep pace with inflation for the last year (Chart 2) and growth in average hourly earnings, the most timely compensation series, may have peaked (Chart 3).   Chart 2... But Wages Aren't Keeping Pace With Inflation ... ... But Wages Aren't Keeping Pace With Inflation ... ... But Wages Aren't Keeping Pace With Inflation ... Chart 3... And They May Have Already Peaked ... And They May Have Already Peaked ... And They May Have Already Peaked Households Are Not At Risk Of Drowning In Debt … The other two front-page stories challenge the narrative that high inflation will choke off consumption. “U.S. Spending Is Up Even With Buying Power Low” discussed the previous day’s release of the April Personal Income and Outlays report. The article expressed surprise that consumption rose 0.9% month-over-month when disposable income rose just 0.3% and was flat in real terms. Households squared the circle by saving less of their income, with the savings rate shrinking to 4.4%, the lowest level since the subprime boom, when it put in its all-time bottom (Chart 4). Chart 4Putting Their Cushion To Good Use Putting Their Cushion To Good Use Putting Their Cushion To Good Use Leading up to the financial crisis, households took on increasing quantities of debt to maintain their spending and the article noted that revolving loan balances (primarily credit cards) grew at their fastest rate in 24 years in March. That narrow statement is true, strictly speaking, but an investor should place it in a fuller context. Outstanding credit card and other revolving debt held by banks remains shy of its post-crisis growth trend though it did just top its previous high set in early 2020 (Chart 5). Though the article quoted an economist tut-tutting that credit card-funded spending is unsustainable, household debt service payments as a share of disposable income remain below their pre-pandemic lows and miles from their subprime-era level (Chart 6). These are fraught times, but any comparison linking US households’ financial positions with 2007 is specious. Chart 5Outstanding Card Balances Are Still Below Trend ... Outstanding Card Balances Are Still Below Trend ... Outstanding Card Balances Are Still Below Trend ... Chart 6... And Households Have Plenty Of Capacity To Take On More ... And Households Have Plenty Of Capacity To Take On More ... And Households Have Plenty Of Capacity To Take On More … Because They Were Pre-emptively Insulated From Elevated Inflation We have been tracking households’ excess pandemic savings balance since CARES Act transfer payments began to flow into individual checking and savings accounts. We estimate that households ended April with between $2.1 and 2.2 trillion more in savings than they would have had if the pandemic had not occurred. They began dipping into their stash in last year’s fourth quarter, when the savings rate first edged below its 8.3% pre-pandemic level, and have done so with increasing zest this year, trimming almost $200 billion from the excess savings peak (Table 1). They drew down almost $60 billion in April alone, indicating that half of the excess savings (our working estimate of how much will be spent) would last for eighteen months if households saved at half their pre-pandemic rate, or another nine if they didn’t save anything at all. Table 1The Excess Savings Cushion Remains Quite Large Read All About It Read All About It That’s a handy reference point to keep in mind when assessing the third front-page story, headlined, “Gas Prices Keep Surging, But Demand Isn’t Falling.” The same headline could be repurposed to top an article reporting on American Airlines’ upwardly revised second-quarter revenue outlook. American said in a filing before Friday’s open that it now expects 2Q22 revenue to exceed 2Q19 revenue (the airlines’ last pre-pandemic comparison) by 11-13%, up from its previous 6-8% guidance. A real-time Bloomberg headline accompanying the story credited the increase to “continued strength in demand and pricing.” The bottom line is that households have the means to satiate pent-up pandemic demand despite significantly higher prices. Spirited internal debates have revolved around households’ willingness to use those means. Without a similar fiscal transfer precedent, neither side can argue its case with high conviction, but the accelerating dissaving of the last six months and mounting evidence of consumers’ low sensitivity to higher airfares and gasoline prices suggest that the spending camp has the upper hand for now. Under an Occam’s razor standard, we don’t think the analysis requires anything as fancy as mental accounting gymnastics or Friedman’s permanent income hypothesis when there’s an age-old phrase that should especially resonate with the YOLO set: Easy come, easy go. ETF Portfolio Update Our cyclical ETF portfolio outperformed its benchmark by 43 basis points (bps) in May, bringing its outperformance since its January 31st launch to 87 bps. Our equity holdings accounted for the lion’s share of the value-add. Energy (XLE), our sole sector overweight, outperformed the S&P 500 by nearly 16 percentage points, while our Staples (XLP, 4-ppt underperformance) and Utilities (XLU, 4-ppt outperformance) underweights offset each other. Allocating some Discretionary exposure to outperforming homebuilders (ITB) was successful but was offset by concentrating all of our Materials exposure in metals and miners (XME). The Pure Value Index (RPV) and SmallCap 600 (IJR) overweights made undiluted positive contributions. Our high yield (JNK) overweight helped our fixed income performance, though it was held back by the allocation to variable-rate preferreds (VRP). VRP has struggled, but we still see going to the back of the creditor priority line at overcapitalized large banks as a source of alpha, and we maintain our modest allocation. We continue to seek an opportune time to remove some of the tactical restraints we imposed on the portfolio in early March. We are eager to bring the portfolio in line with BCA’s recent tactical equity upgrade to overweight but are reluctant to increase our equity exposure so close to the 4,200 resistance level that we expect will repel S&P 500 rallies in the immediate term. Friday’s selloff gave a buyer an additional 1% of headroom from the level we passed up on May 27th, but we intend to hold out for something in the neighborhood of 4,000. Investment Implications Viewed through a contrarian’s magazine-cover-indicator lens, the risk/reward profile of our constructive view has improved as the headlines’ bearish bias has become more pronounced. The zeal with which those in the bearish economic camp seized upon Walmart’s and Target’s first-quarter disappointments was revealing. Both companies’ earnings stunk – Walmart missed expectations by 12% and Target by 29% – but both companies beat revenues, by around 2%, just like their dollar-store and price-club peers who met or beat earnings expectations. Though it gave the commentariat something to do for a few days, the debate over the existence of a retail inventory glut isn’t supported by the aggregate data (Chart 7). Chart 7Retail Inventory Glut? Seriously? Retail Inventory Glut? Seriously? Retail Inventory Glut? Seriously? No one knows what’s coming next against the unprecedented macro backdrop and everyone involved in forecasting and investing should approach their work with humility right now. For an investor, that means staying within sight of the shore in terms of deviations from benchmark indexes and managing portfolios more tactically by reducing holding periods and setting, and abiding by, tight stops on opportunistic plays. A preponderance of data has yet to cast doubt on our constructive take on the economy and markets (nor has it conclusively validated it, alas). The sense that we increasingly find ourselves in the minority makes us feel better about the potential returns to our view, however, and we are sticking with it. We continue to recommend overweighting equities in a balanced portfolio, and high yield within fixed income portfolios (NB: our US Bond Strategy team recommends an equal-weight allocation to high yield) over a twelve-month time frame and are looking for a better entry point to increase our equity exposures within our ETF portfolio. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Cyclical ETF Portfolio Read All About It Read All About It