Policy

Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in  the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity.  Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year.   Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

The Global Investment Strategy service tactically downgraded equities in February but then upgraded them in May. The decision to upgrade equities to overweight in May was clearly premature, as stocks fell significantly in June. However, the rally in July has brought stocks back above the level where we upgraded them. Hence, we are using this opportunity to shift our recommended equity allocation back to neutral. While our base case forecast still foresees no recession in the US over the next 12 months, the risks to this view have increased. In Europe, we see a recession as more likely than not. China’s economy will remain under pressure due to Covid lockdowns, a shift in global spending away from manufactured goods, and a weakening property market. Even if the US avoids a recession, this could prove to be a bittersweet outcome for stocks: While earnings will hold up, the Fed is unlikely to cut rates next year, as markets are currently discounting. Real bond yields, which have already risen steeply this year, will rise further, weighing on equity valuations.  Time to Take Some Chips Off the Table The consensus view among investors these days seems to be that the US is heading into a recession (or may already be in one), which will cause stocks to fall during the remainder of the year as earnings estimates are slashed. Looking out to 2023, most investors expect stocks to recover as the Fed begins to cut rates. I have the opposite view. While the risks to growth have increased, the US will probably avoid a recession over the next 12 months. This will allow stocks to rise modestly from current levels into year-end. However, as we enter 2023, it will become obvious that the Fed has no reason to cut rates. This could cause stocks to give up some of their gains, thus producing a fairly flat profile for equities over a 12-month horizon. In past reports, we have argued that the neutral rate of interest – the interest rate consistent with full employment and stable inflation – is higher than widely believed in the US. The nice thing about a high neutral rate is that it insulates the economy from tighter monetary policy: Even if the Fed raises rates to 3.8% next year, as the dots are currently forecasting, that will only put rates in the middle of our fair value range of 3.5%-to-4% for the US neutral rate. The downside of a high neutral rate is that eventually, investors will need to value stocks using a higher discount rate. The 10-year TIPS yield has already increased from -0.97% at the start of the year to +0.36% today. It will rise to 1%-to-1.5% by the middle of 2023. A higher-than-expected neutral rate also raises inflation risks because it could cause the Fed to inadvertently keep monetary policy too loose. Inflation is likely to fall significantly over the coming months as supply-chain bottlenecks ease. However, this decline in inflation could sow the seeds of its own demise: As inflation falls, real wage growth – which is now negative – will turn positive. Rising real wages will booster consumer confidence and spending. A reacceleration in inflation in the second half of next year could prompt the Fed to start hiking rates again in late 2023, thus producing a recession not in 2022 but in 2024. Outside the US, the outlook is more challenging. In Europe, a recession is more likely than not in the second half of the year. We expect the recession to be fairly short-lived, with European governments moving aggressively to mitigate the fallout from gas shortages through various income support schemes for the private sector. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. We will have much more to say about this view change early next week. In the meantime, please review our report from last week entitled “The Downside Of A Soft Landing” for further color on some of the points made in this short bulletin. Tomorrow, my colleague Ritika Mankar will be sending you a Special Report making the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter.

Special Report

Executive Summary Dollar Still The Largest Global Reserve Currency The rise of cryptocurrencies like stablecoins theoretically pose risks to fiat currencies and their general use. In the US, the Federal Reserve will look to adopt a Central Bank Digital Currency (CBDC) – a digital dollar – this decade, to stave off these risks and usher in a new era of central bank money. A digital dollar would likely be integrated as seamlessly as possible into the current monetary regime, thereby maintaining an intermediated role played by existing financial sector actors as well as operating alongside existing circulating currency. The US dollar will eventually face rising competition from digital currencies, both at home and abroad. While other central banks make headway into developing their own CBDCs, China is by far the most advanced. China’s digital yuan will not resolve all of China’s problems with internationalizing its currency but it will create new opportunities. Public and political pushback will occur and will slow adoption of a digital dollar. Gridlock in 2023 may prove to be another headwind. To adopt a digital dollar, politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation, especially as foreign competition on CBDCs rises. Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 10.7% Bottom Line: Policymakers will adopt a CBDC – a digital dollar – this decade. Political pushback may slow adoption, but foreign competition will overcome domestic constraints. Feature Technological innovation over the past decade has given rise to a new asset class – digital assets. Investors are most familiar with cryptocurrencies, and to a lesser extent, non-fungible tokens and decentralized finance-based lending, among others. These assets have witnessed a boom and bust over the past few years (Chart 1). Chart 1Manias: Then And Now Cryptocurrencies have been touted to have money-like characteristics, the most popular being Bitcoin, and others like stablecoins. Stablecoins are mostly used as a medium of exchange between fiat money and cryptocurrencies and vice versa. They are pegged to fiat money and often backed by highly liquid traditional assets1 to maintain their pegs. But cryptocurrencies do not exhibit the traits of durable money today. However, the technological innovation of digital currency represents a natural evolution of money that is irreversible and could someday possess the main characteristics of money: a medium of exchange, a unit of account, and store of value. Cryptocurrencies with money-like qualities theoretically pose a challenge to fiat currencies, i.e. those issued by governments that are not backed by any underlying real asset but rather by trust in government institutions, including the treasury and central bank. Not that trust is a poor basis for a currency. But that trust could fail and new trust could be placed in cryptocurrencies. Governments could eventually lose control of the money supply and payments system, suffer from financial instability, fail to provide regulatory oversight, or fail to prevent the illicit use of digital assets for criminal gain. The same technology driving growth in digital assets has led central banks the world around to research and in some cases develop CBDCs. For an introductory guide to CBDCs, see BCA’s “The Investor’s Guide To Central Bank Digital Currencies.” CBDC research and development are at varying stages across the world’s central banks.2 In the US, the Federal Reserve (Fed) continues to research a CBDC (digital dollar) and its use-case, or justification for being. The Fed has made no commitment to designing a digital dollar anytime soon. But we bet that the Fed’s position will change in coming years. Introducing a digital dollar will reduce the various risks associated with cryptocurrencies whilst also creating efficiencies in the US economy. These efficiencies will also transverse into cross-border efficiencies. Globally, central banks are showing increasing activity in developing CBDCs and introducing a digital dollar would help the Fed maintain monetary dominance across the world while staving off cryptocurrencies, especially stablecoins. The Fed won’t sit idle as a global monetary revolution unfolds. But the policy front is fraught with challenges. Policy makers in the US have expressed mixed views on adopting a digital dollar. Some suggest the Fed would exercise even more control over monetary policy than it does today. Others note risks to consumer data privacy, which could be exploited by government. Public opinion is also mixed with no clear understanding of or need for a digital dollar. Commercial bank business interests may come under attack too, with a digital dollar scalping profit margins from banks, depending on the type and extent of the CBDC operating model employed. Ultimately, the US will want to maintain its position as the global monetary leader. Continued dollar dominance in the global economy is strategically advantageous for the US, especially in a hypo-globalizing world (Chart 2). Ensuring ongoing monetary dominance while rooting out domestic competition from stablecoins will be aided by adopting a digital dollar. Chart 2Dollar Still Dominating Global Reserves Bottom Line: The Fed will most likely adopt a digital dollar within the decade. The Fed And A Digital Dollar The Fed has been actively researching a digital dollar for several years with growing research on design, implementation, and necessity. As it stands, the Fed has not committed to introducing a digital dollar in the foreseeable future. But what would a digital dollar look like and what role would it play in the economy if the Fed decided to introduce one? CBDC Model Briefly, the Fed could choose from three different CBDC operating models: unilateral, synthetic, or intermediated (Diagram 1). A unilateral model would mean the Fed performs all CBDC related functions including direct interaction with end-users. A synthetic model would mean non-Fed actors issuing money backed by Fed assets. Diagram 1Three CBDC Operating Models Realistically, a unilateral and synthetic digital dollar are unlikely. The former would crowd out traditional banking services, while the latter would let actors other than the Fed issue money, violating the Federal Reserve Act. Hence the Fed will most likely pursue an intermediated CBDC model. This model entails digital dollar issuance by the Fed but includes a role for private sector firms to interact with end-users. The intermediary role would be filled by financial firms but also other types of companies such as payment service providers and mobile phone operators. This means the Fed would not totally crowd out existing players across the payment and financial services space. An intermediated model would require the central bank to regulate and oversee other actors, which adds an extra layer of legal and operational complexity to implementation. But it is the model most consistent with the US’s combination of federal government and liberal capitalism, and the model cited by the Fed to most likely be adopted.3 The intermediated model will align with the current two-tier system currently in place (Diagram 2). Digital dollars will feature in both wholesale and retail transactions. Wholesale involves commercial banks and regulated financial intermediaries, while retail involves individuals and non-financial businesses. The model would also operate alongside existing paper money. A digital dollar would be a liability on the Fed, denominated in dollars, and would form an integral part of base money supply (M0). It would be distributed like, and act as a complement to, dollar bills and could be used in transactions conducted in currency and reserves. It would be legal tender just like the paper dollar. Diagram 2Two-Tier Monetary Regime System Digital Dollar Needs The Fed has stated that a digital dollar should, among other things, meet certain criteria before adoption (Table 1). Some of these criteria are already met. Others will be met with adoption. A digital dollar will benefit households, businesses, and the economy at large. For example, a digital dollar would enhance payment transparency, thereby supporting the Fed’s objective to promote safe and efficient payments. And depending on design choices, digital transactions could offer degrees of traceability and aggregate payment data could be analyzed in real time to provide insights into economic health and activity. Table 1Fed Criteria For CBDC Adoption Further, a digital dollar would promote diversification of the payments system, thereby increasing the safety and efficiency of US payment infrastructure. It may also attract new actors offering services related to the digital dollar, spurring financial innovation and fostering financial integration. The payments system is already broadly efficient but adding another layer of digitization with a digital dollar would mean that the US economy would be better positioned for the evolution of the digital economy over the next decade and beyond. The need for broad stakeholder support will be a difficult criterion to meet, however. There would need to be more engagement with the public, inter-government agencies, and Congress. For now, these “needs” outlined by the Fed are more than half met, signaling that a digital dollar could come to fruition within the decade from a policy perspective. International advances on this front will spur US policy makers into action even if they are disinclined. Bottom Line: The needs outlined by the Fed to adopt a digital dollar have been mostly met which ticks off one of the policy implementation checkboxes. There are gains to be had across the economy by introducing a digital dollar, ranging from a more efficient payments system to financial inclusion and decreasing transactions costs. Domestic Competition The proliferation of stablecoins has been noted by government agencies around the world. The Fed too has been keeping note. By the end of 2021, stablecoins had a relatively small market capitalization compared to the broader cryptocurrency market, approximately 6%. Now, stablecoins account for almost 16% of cryptocurrency market capitalization. But trading volumes point to stablecoins having a much larger role in transactions (Chart 3). Stablecoins resolve some of the problems of faith and trust that bedevil cryptocurrencies not backed by traditional assets. Chart 3Stablecoins Rise In Popularity Stablecoins pose two key threats that a digital dollar will essentially nullify: Systemic risk: A growing stablecoin market that is increasingly backed by traditional, high liquid assets could create systemic risk in traditional asset markets. An excessive rise or fall in demand for stablecoins would cause volatility in the liquid assets that back them. Moreover, for example, a fire sale in the stablecoin market would cause demand to fall excessively relative to the backing asset. Prices between stablecoins and the backing asset would diverge, potentially breaking the peg and resulting in further price divergence. And more broadly, high volatility from crypto markets can penetrate traditional or risk-free markets. A digital dollar would render stablecoins unnecessary, allowing cryptocurrency users to transact and convert digital dollars to cryptocurrency while enjoying the backing of the Fed on the value of digital dollars. Cross-border transactions: Stablecoins are also increasingly used for cross-border transactions. According to Fed data, the US pays 5.4% in fees on average per cross-border transaction, which also takes several days to settle. Stablecoins settle almost instantaneously and have much lower transaction fees. So too can a digital dollar. It would settle just as quickly as a stablecoin, if not quicker, and reduce transaction costs for cross-border payments. And because stablecoins are designed to maintain their pegs, they have more potential than cryptocurrencies to act as mediums of exchange outside of the crypto market and economy, potentially threatening the ongoing use of fiat money. Bottom Line: The Fed will design a CBDC around its existing monetary and payments system to allow for seamless integration. There are not many reasons holding back digital dollar adoption from a point of need and benefit. By adopting a digital dollar, the Fed will also fight off the growing risk of stablecoins, which could pose a threat to the use-case of fiat money in everyday life. Other Central Banks On The March The authority to issue money is an important element of economic power. History is replete with examples of currency competition both within countries and between them. CBDC research and development are picking up speed across central banks (Charts 4A and 4B). China is the world leader with its digital yuan, as we discuss below. Design and implementation of CBDCs will follow in coming years just like in the case of the digital yuan. If the theoretical payoffs to adopting a CBDC are met by real-world green shoots, then foreign CBDCs could pose a threat to continued dollar dominance in the global monetary and economic system, namely if countries can draw down their dependence on dollar reserves. Chart 4ACentral Banks Paying More Attention To CBDCs Chart 4BCentral Banks Paying More Attention To CBDCs Central Bank Competition Treasury Secretary Janet Yellen has noted this challenge in recent remarks explaining that any implementation of a “US central bank digital currency must support the prominent role the dollar plays in the global financial system.”4 The Fed is on the same page as the Treasury noting that any CBDC should be used to preserve the dominant international role of the dollar. The dollar is the world’s most widely used currency for payments and investments and serves as the world’s premier reserve currency. The dollar’s international role allows the US to influence the practices and standards of the global monetary and economic system. Basically, when the US constricts the supply of dollars in response to domestic conditions, the rest of the world suffers tighter monetary conditions, and when the US expands the supply, the rest of the world enjoys looser conditions, almost regardless of what other nations want or need. Central banks have made their policy goals clear in respect to developing a CBDC. Some central banks look to expand financial inclusion, market access, and their payments system while others are looking to compete with one another (Table 2). Canada, China, and Sweden want to gain a local and international market advantage for their currencies by introducing CBDCs. Table 2CBDC Policy Goals Of Central Banks China Leading CBDC Race, But… At this early stage, China’s digital yuan poses the largest threat to a digital dollar on the international stage. It is the most prominent CBDC project at this current juncture. The digital yuan entered beta testing at the end of 2020 in parts of the country. Wider testing across provinces is being phased in. China’s monetary endeavors began with the Cross-Border Inter-Bank Payment Service in 2015. The digital yuan will be positioned as an extension of this system to promote the national currency and fight global dollar dominance. But how big of a challenge could a digital yuan mount? The answer is not much, not now. China is the world’s largest trading partner but the renminbi accounts for less than 3% of the world’s reserve currency (Chart 5). The disparity between trade and currency status in the global economy reflects a lack of global trust in the renminbi and is a cause for concern for China. China is structurally invested in the dollar-dominated financial system and hence vulnerable to American influence by means of that system. Chart 5Global Renminbi Reserves Are Low The digital yuan would support more debt issuance based on cost and payment incentives to debt holders when financing BRI projects. This will help drive the use of the digital yuan going forward. For example, China can assert its influence over countries with Chinese debt by having them accumulate digital yuan reserves to pay back loans. China can even provide countries with concessions on loans to promote its digital yuan. Concessions on Chinese debt may lead to easier uptake, therefore promoting issuance. If the cost of switching to the digital yuan is low, countries will see no benefit in continuing their trade transactions with China in US dollars. Using the digital yuan as the currency of invoice to disburse loans can make these transactions more transparent and manageable. This could also allow for more state control over funds, an attractive scenario for China. However, China’s monetary ambitions face serious constraints. Lack of trust in the currency is the most critical challenge for internationalization of the yuan, digital or otherwise. Even if the digital yuan project is five to ten years ahead of the curve, countries still opt to hold the dollar over the yuan in any type of crisis, as has been amply demonstrated in history, and over a range of global shocks since 2019. Hence digital yuan adoption will require guarantees from Chinese institutions. But these same institutions have struggled to internationalize the paper renminbi. Lack of openness, transparency, and convertibility are persistent problems. Bottom Line: Central banks around the world are gearing up to introduce CBDCs in coming years. Some are looking to promote financial inclusivity. Others like China’s digital yuan want to chip away at the dollar’s global dominance. Digital versions of fiat currencies will have to demonstrate substantial economic and trade efficiencies in order to encourage diversification away from the US dollar, since there is no inherent reason a digital version of a nation’s currency would increase trust beyond what is already established. But those efficiencies could take shape, which would put pressure on the US to respond. The US faces significant monetary challenges over the long run, including from CBDCs. But the US is a technological power and will eventually respond by developing its own CBDC. Pushback Against A Digital Dollar The Fed has stated that it would only pursue a digital dollar in the context of broad public and cross-governmental support. However, neither the public nor congress broadly support one at present. Public opinion is uneducated on the issue and therefore highly malleable depending on leadership and events. Public Opinion Is Non-Supportive Across age groups, people do not know enough about digital currencies and think it is a bad idea to introduce a digital dollar (Chart 6). A 2020 poll found that only 13% of respondents approved of a digital dollar.5 Low approval is becoming a trend. However, the same poll showed that 38% of respondents think the US dollar is backed by gold, bonds, or oil. Addressing poor monetary literacy among the public would help to improve public support of a digital dollar. US households say they are more likely to trust traditional financial institutions than government agencies to safeguard their personal data (Chart 7). A digital dollar will grant the Fed and federal government far-reaching information regarding the everyday financial transactions of households. Trust in government has been declining and a digital dollar underpinned by a central ledger system would provoke consumer privacy lobby groups and government activists to fight and protest adoption (Chart 8). Chart 6Popular Support For A Digital Dollar Is Lacking Chart 7Households Trust Government Less Than Financial Institutions Chart 8Trust In Government Has Been Waning Chart 9Inflation Outbreak Will Limit Big Government About half of the US public already view the government as “doing too much” (Chart 9). The explosive inflation of 2020-22 will slow the underlying ideological shift to the political left, potentially limiting support for a digital dollar. Public opinion has been shifting for decades in favor of more government involvement in people’s day-to-day lives (Chart 10), but that trend may well stall now that excess of government creates tangible negatives for household pocketbooks (inflation). The bigger of a problem the Fed has in taming inflation in 2022-23, the bigger the political backlash will be. Federal solutions will suffer as a result. This is our theme of “Limited Big Government,” since the role of the state will increase relative to the past 40 years but still within an American context of checks and balances. Chart 10People Have Favored Government Involvement Bottom Line: There is no clear public demand for the digitization of the dollar at present. A major financial or economic disruption stemming from the monetary system or digital assets may be necessary to call public attention to the question. Meanwhile the private sector will drive innovation and the federal government will react to try to maintain domestic stability and international competitiveness. These data support the Fed taking an intermediated approach to cbdc when forced to take action. Policymakers Will Resist Policymakers are divided over the idea of a digital dollar. Senator Ted Cruz introduced a bill in March 2022 to “prohibit the Federal Reserve from offering products or services directly to individuals, maintaining accounts on behalf of individuals, or issuing a central bank digital currency directly to an individual.”6 Cruz has yet to receive widespread party support on the bill but he could get the backing from more GOP members if Republicans take over Congress, as expected, this November. Some Republicans and Democrats have favored cryptocurrencies while others have not, advocating for crypto-mining and crypto start-ups in progressive-left and libertarian right states. But the center-left and center-right might lean more toward cryptocurrency regulation and digital dollar adoption. Coalitions may need to be formed on the topic of a digital dollar, in parties and between parties. A digital dollar will cause a level of disruption, which will affect both the Democrats and Republicans. Government gridlock will create challenges to digital dollar adoption too. The upcoming mid-term elections favor the GOP. Both the House and the Senate are expected to flip in favor of the GOP in 2023. The “Blue Sweep” policy setting will end and only the White House will remain in Democrat control. Republicans have a shot at flipping the White House in 2024, which could see a “Red Sweep.” This scenario may slow adoption of a digital dollar but it will only preclude the unilateral cbdc model, not the intermediated model. The period of 2023-24 is too soon for adoption of a digital dollar anyway but the fact is that gridlock will delay the process until external factors force US action. Bottom Line: Public and political pushback will slow the adoption of a digital dollar. Politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation but this will be difficult in a highly polarized country and will likely depend on foreign competition. Investment Takeaways We avoided cryptocurrencies during the irrational exuberance over the past two years. We expect governments to regulate the sector in order to preserve a monopoly over money supply and hence geopolitical interests. With monetary conditions tightening, we expect continued volatility in the crypto space. The US dollar remains strong tactically but is nearing its peak cyclically. We remain long but have put the currency on downgrade watch as the market more fully prices a range of bad news this year. On the global stage, the US dollar will remain the premier reserve currency despite cyclical ups and downs. The current macroeconomic backdrop is negative for the US financial sector (Chart 11). Mergers and acquisitions are drying up while regulatory risks loom. Initial public offerings are also slowing, while trading volume is low. Consumers had already accumulated debt earlier in the cycle and with rising interest rates amid a more challenging job environment, growth in loans and ultimately bank profits will slow. The commercial banking sector faces challenges during the upcoming transitional period of disruptive innovation and regulatory uncertainty. We believe the Fed and policymakers in general will want to cause as little disruption as possible, by integrating any digital dollar with the traditional finance sector as seamlessly as possible. However, transitions, especially those digital in nature, bring with them high uncertainty in the financial sector and elsewhere. Chart 11Financial Sector Facing Macro Headwinds     Guy Russell Senior Analyst guyr@bcaresearch.com     Footnotes 1     Stablecoins are backed by various assets and means. Fiat money, commodities, other cryptocurrencies and by algorithmic means are some examples. 2     See The Bank For International Settlements, Central Bank Digital Currencies: Executive Summary, September 2021, bis.org. 3    See The Board of Governors of the Federal Reserve System, Money and Payments: The U.S.Dollar in the Age of Digital Transformation, January 2022, federalreserve.gov. 4    See U.S. Department Of The Treasury, Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets, April 2022, treasury.gov. 5    See Cointelegraph, Most Americans are against a digital dollar CBDC, survey reveals,september 25, 2020, cointelegraph.com 6    See Ted Cruz’s Proposed Bill to amend the Federal Reserve Act to prohibit the Federal reserve banks from offering certain products or services directly to an individual, and for other purposes, March 2022, cruz.senate.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary Peak Fed Funds? The bond market is priced for a fed funds rate that will peak in February 2023 at 3.44% before trending down. We survey several interest rate cycle indicators and conclude that the market’s expected peak is too low and occurs too early. These indicators include: the unemployment rate, financial conditions, PMIs, the yield curve and housing starts. We also update our default rate forecast and are now looking for the default rate to rise to between 4.7% and 5.9% during the next 12 months. While our default rate forecasts imply a reasonably attractive 12-month junk bond valuation, we hesitate to turn too bullish on high-yield given that the next peak in the default rate is still not in sight. Bottom Line: We recommend keeping portfolio duration close to benchmark for the time being, though we will be looking for opportunities to reduce duration in the second half of this year. Similarly, we recommend a neutral (3 out of 5) allocation to junk bonds but will recommend reducing exposure if spreads rally back to average 2017-19 levels. Feature Last week’s report presented three conjectures about the US economy.1 One of those was that a recession will be required to get inflation back to 2%. But when will that recession occur? The question of timing is a vital one for bond investors. Are we on the cusp of recession right now? If so, then bond investors should extend portfolio duration in anticipation of Fed rate cuts and a return to 2% inflation. Conversely, if the recession is delayed, interest rates probably move higher before the cycle ends and investors should consider reducing portfolio duration. This week’s report addresses the topic of timing the next recession and discusses the implications for bond portfolio construction. Timing The Interest Rate Cycle From a bond market perspective, the question of whether the economy is in recession is less important than whether the Fed is hiking or cutting rates. Therefore, for the purposes of this report we will define a “recession” as an economic slowdown that is significant enough for the Fed to start cutting interest rates. Chart 1Peak Fed Funds? Now, let’s start by looking at what sort of interest rate cycle is priced in the market. The overnight index swap curve is currently discounting a peak fed funds rate of 3.44% (Chart 1). It is also priced for that peak to occur in 7 months, or by February 2023 (Chart 1, bottom panel). As bond investors, the question we must ask is whether this pricing seems reasonable. To do so, we will perform a survey of different indicators that have strong track records of sending signals near the peaks of interest rate cycles. Unemployment The first indicator we’ll look at is the unemployment rate. Economist Claudia Sahm has shown that a recession always occurs when the 3-month moving average of the unemployment rate rises to 0.5% above its trailing 12-month minimum.2 Table 1 dispenses with the moving average and simply shows the deviation of the unemployment rate from its trailing 12-month minimum on the dates of first Fed rate cuts since 1990. We see that the Fed has typically started to cut rates once the unemployment rate is 0.3-0.4 percentage points off its low. The exception is 2019 when the unemployment rate was only 0.1% off its low, but when inflation was below the Fed’s 2% target. Table 1Unemployment And Inflation When The Fed Starts Easing At 3.6%, the unemployment rate is currently at its cycle low. Based on the numbers shown in Table 1, this means that we should only expect the Fed to cut interest rates if the unemployment rises to at least 3.9% or 4.0%. We say “at least” because it’s also important to note that the inflation picture is a lot different today than it was during the periods shown in Table 1. With inflation so much higher, it is reasonable to think that the Fed will tolerate a greater increase in the unemployment rate before pivoting to rate cuts. Looking ahead, initial unemployment claims appear to have bottomed for the cycle and changes in initial claims are highly correlated with changes in the unemployment rate (Chart 2). That said, the trend in claims is currently consistent with a leveling-off of the unemployment rate, not a large increase. Financial Conditions Second, we turn to financial conditions. Fed officials often assert that monetary policy works through its impact on broad financial conditions. Therefore, it’s not too surprising that rate cuts tend to occur only after the Goldman Sachs Financial Conditions Index has moved into restrictive territory. Currently, despite the Fed’s dramatic hawkish shift, the index still shows financial conditions to be accommodative (Chart 3). Chart 2Jobless Claims Moving Higher Chart 3Financial Conditions   The same caveat we applied to the unemployment rate applies to financial conditions. As long as inflation is above the Fed’s target, it’s highly likely that the Fed will be comfortable with financial conditions that are somewhat restrictive. Therefore, the Fed may not pivot as soon as the Goldman Sachs index moves above 100, as has been the pattern in the recent past. Yield Curve Third, we note that an inverted Treasury curve almost always precedes the start of a Fed rate cut cycle, and the Treasury curve is certainly inverted today (Chart 4). The logic behind this indicator is somewhat circular in the sense that an inverted Treasury curve simply tells us that the market anticipates Fed rate cuts. If data emerge to suggest that Fed rate cuts will be postponed, then the Treasury curve could re-steepen. It’s for this reason that the Treasury curve often inverts well in advance of an economic recession and Fed rate cuts. We explored the relationship in more detail in a recent Special Report.3 Chart 4Interest Rate Cycle Indicators Chart 5Manufacturing PMIs PMIs Typically, the ISM Manufacturing PMI is below 50 by the time of the first Fed rate cut (Chart 4, panel 3). Currently, the ISM Manufacturing PMI is a healthy 53.0, but it has been falling quickly and trends in regional PMI surveys suggest that it will dip below 50 within the next few months (Chart 5). Interestingly, both the ISM and regional PMI surveys show that manufacturing supplier delivery times have come down a lot (Chart 5, panel 2). This gives some hope that goods inflation will trend lower during the next few months, as is our expectation. Recently, there’s also been an unusual divergence between the employment components of the ISM and regional Fed surveys. The New York and Philadelphia Fed surveys are showing strength in their employment components. Meanwhile, the ISM employment figure is below 50 (Chart 5, bottom panel). This divergence likely boils down to labor shortages that complicate how firms are responding to the employment question in the surveys. For example, despite the sub-50 employment figure, the latest ISM release noted that “an overwhelming majority of panelists […] indicate that their companies are hiring.”4 Housing In a recent report, we developed a rule of thumb that says that Fed rate cuts typically don’t occur until after the 12-month moving average of housing starts falls below the 24-month moving average.5 That indicator is coming down, but it still has a lot of breathing room before it dips into negative territory (Chart 4, bottom panel). That same report also outlined that we see the housing market slowdown proceeding in three stages. First, higher mortgage rates will suppress housing demand. This is already happening at a rapid pace as indicated by trends in mortgage purchase applications and existing home sales (Chart 6A). Second, lower housing demand will push up inventories and send prices lower. This has not yet shown up in the data (Chart 6B). Finally, once lower prices and higher inventories sufficiently disincentivize construction, we will see a marked deterioration in housing starts. Currently we see that housing starts have dipped, and homebuilder confidence has plummeted, but starts still haven’t decisively broken their uptrend (Chart 6C). Chart 6AHousing Demand Chart 6BPrices & Inventories Chart 6CBuilding Activity Putting It All Together To make sense of all the different indicators that could signal a Fed pivot toward rate cuts, we turn to our Fed Monitor. The Fed Monitor is a composite indicator that includes many of the individual indicators we have already examined in this report, as well as some others. The Fed Monitor is constructed so that a positive reading suggests that the Fed should be hiking rates and a negative reading suggests the Fed should be cutting rates. As can be seen in Chart 7, the Monitor is currently deep in positive territory. Chart 7Fed Monitor Calls For Tighter Money The Fed Monitor consists of three main sub-components, an economic growth component, an inflation component and a financial conditions component (Chart 7, bottom 3 panels). We see that the economic growth component of the Monitor is consistent with a neutral Fed policy stance – neither hikes nor cuts - and financial conditions point to a mildly restrictive stance. However, unsurprisingly, the inflation component is the highest it has been since the early-1980s and this is applying a ton of upward pressure to the Monitor. While our Fed Monitor is not a perfect indicator, it does speak to the tradeoff between inflation and economic growth that we have already hinted at in this report. Specifically, the Monitor illustrates that as long as inflation remains elevated it will take a significant deterioration in economic growth and financial conditions before the overall Monitor recommends a dovish Fed pivot. To us, this argues for a higher and later peak in the fed funds rate than is currently priced in the curve. Bottom Line: The peak fed funds rate that is currently priced in the market for 2023 is too low, and the funds rate will also likely peak later than what is priced in the curve. That said, falling inflation and economic growth concerns will probably keep a lid on bond yields during the next few months. We advise investors to keep portfolio duration close to benchmark for the time being, but to look for opportunities to reduce exposure. We will consider reducing our recommended portfolio duration stance to ‘below-benchmark’ if the 10-year Treasury yield falls to 2.5% or if core inflation reverts to our estimate of its 4%-5% underlying trend. Timing The Default Rate Cycle The interest rate cycle is not the only important one for bond investors. The default rate cycle is also crucial for spread product allocations because default trends are responsible for a significant amount of the volatility in corporate bond spreads. In this section we consider the outlook for corporate defaults and high-yield bond performance. We model the trailing 12-month speculative grade default rate using gross leverage (total debt over pre-tax profits) and C&I lending standards (Chart 8). Conservatively, if we assume 5% corporate debt growth for the next 12 months and corporate profit growth of between -10% and -20%, our model projects that the default rate will rise to between 4.7% and 5.9% (Chart 8, top panel). It’s notable that, like us, banks are also preparing for an increase in corporate defaults by raising their loan loss provisions (Chart 8, panel 2). Meanwhile, job cut announcements – another reliable indicator of corporate defaults – still don’t point to a higher default rate (Chart 8, bottom panel). Chart 8The Default Rate Has Troughed Interestingly, our model’s conservative projections suggest that in 12 months the default rate will be lower than its typical recession peak. Given today’s cheap junk valuations, this sort of analysis is encouraging a lot of people to turn bullish on high-yield bonds. Chart 9Default-Adjusted Spread This line of reasoning is not totally unfounded. Using the same forecasted default rate scenarios from Chart 8 along with an assumed 40% recovery rate on defaulted debt, we calculate that the excess spread available in the junk index after subtracting 12-month default losses is between 136 bps and 208 bps. This is below the historical average (Chart 9), but still above the 100 bps threshold that often delineates between junk bond outperformance and underperformance versus duration-matched Treasuries.6 More specifically, Chart 10 shows the relationship between our default-adjusted spread and high-yield excess returns versus Treasuries for each calendar year going back to 1995. We see that, in general, there is a positive relationship between spread and returns and that excess returns are more often positive than negative whenever the default-adjusted spread is above 100 bps. However, Chart 10 also shows periods when a pure analysis of junk bond performance based on the 12-month default-adjusted spread didn’t pan out. The year 2008 is a prime example. The default-adjusted spread came in at 249 bps for 2008, above the historical average. However, junk spreads widened dramatically in 2008 and excess returns were dismal. Chart 10The Default-Adjusted Spread And High-Yield Returns The reason the default-adjusted spread valuation framework failed in 2008 is that while the default rate only moved up to 4.9% in 2008, it wasn’t done increasing for the cycle. In fact, the rise in the default rate accelerated in 2009 until it hit 14.6% in November of that year. So, while default losses were low compared to the starting index spread in 2008, junk index spreads widened sharply in 2008 as the market prepared for worse default losses in 2009. The lesson we draw from the 2008 example is that even if the junk bond market is attractively priced relative to expected default losses on a 12-month horizon, unless we can forecast a peak in the default rate it is unwise to be overly bullish on high-yield bonds. Even if a recession doesn’t occur within the next 6-12 months, it will likely occur within the next 12-24 months. In that environment, investors are unlikely to realize the full potential of today’s attractive 12-month junk bond valuations. Chart 11Junk Spreads The bottom line is that we maintain a neutral (3 out of 5) allocation to high-yield within US fixed income portfolios for now. Junk spreads are elevated compared to past rate hike cycles and could tighten during the next few months as inflation converges to its underlying 4%-5% trend. That said, we will not turn outright bullish on junk bonds until we can reasonably forecast a peak in the default rate. In the meantime, a sell on strength strategy is more appropriate. We will reduce our recommended allocation to high-yield bonds if the average index spread tightens to its average 2017-19 level (Chart 11) or once inflation converges with its underlying 4%-5% trend. Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1     Please see US Bond Strategy Weekly Report, “Three Conjectures About The US Economy”, dated July 19, 2022. 2     https://www.hamiltonproject.org/assets/files/Sahm_web_20190506.pdf 3    Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 4    https://www.ismworld.org/supply-management-news-and-reports/reports/ism… 5    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6    For a more complete analysis of the link between the default-adjusted spread and excess high-yield returns please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds,” dated April 12, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Executive Summary Iran Reaches Nuclear Breakout The next geopolitical crisis will stem from the Middle East. The US, Russia, and China are striving for greater influence there and Iran’s nuclear quest is reaching a critical juncture. The risk of US-Israeli attacks against Iran remains 40% over the medium term and will rise sharply if Iran attempts to construct a deliverable nuclear device. Saudi Arabia may increase oil production but only if global demand holds up, which OPEC will assess at its August 3 meeting. Global growth risks will prevail in the short term and reduce its urgency. Russia will continue to squeeze supplies of energy and food for the outside world. The restart of Nord Stream 1 and the Turkey-brokered grain export proposal are unreliable signals. Russia’s aim is victory in Ukraine and any leverage will be used. The US may be done with the Middle East but the Middle East may not be done with the US. Structurally we remain bullish on gold and European defense stocks but we are booking 17% and 18% gains on our current trades. The deterioration in global growth and likely pullback in inflation will temporarily undercut these trades. Tactical Recommendation Inception Date Return LONG GOLD (CLOSED) 2019-06-12 17.1% LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (CLOSED) 2022-03-18 17.9% Bottom Line: Global demand is weakening, which will weigh on bond yields and commodities. Yet underlying oil supply constraints persist – and US-Iran conflict will exacerbate global stagflation. Feature Chart 1Equity Volatility And Oil Price Volatility US President Joe Biden visited Saudi Arabia last week in a belated attempt to make amends with OPEC, increase oil production, and reduce inflation ahead of the midterm election. Biden also visited Israel to deter Iran, which is the next geopolitical crisis that markets are underrating. Meanwhile Russian President Vladimir Putin went to Iran on his second trip outside of Russia since this year’s invasion of Ukraine. Putin sought an ally in his conflict with the West, while also negotiating with Turkish President Recep Erdogan, who sought to position himself as a regional power broker. In this report we analyze Biden’s and Putin’s trips and what they mean for the global economy and macro investors. Macroeconomics is bearish for oil in the short term but geopolitics is bullish for oil in the short-to-medium term. The result is volatility (Chart 1). OPEC May Pump More Oil But Not On Biden’s Time Frame Here are the important developments from Biden’s trip: A credible threat against Iran: The US and Israel issued a joint declaration underscoring their red line against Iranian nuclear weaponization.1 Meanwhile the Iranians claimed to have achieved “nuclear breakout,” i.e. enough highly enriched uranium to construct a nuclear device (Chart 2). A balance-of-power coalition to contain Iran: Israel and Saudi Arabia improved relations on the margin. Each took action to build on the strategic détente between Israel and various Arab states that is embodied in the 2020 Abraham Accords.2 This strategic détente has staying power because it is a self-interested attempt by the various nations to protect themselves against common rivals, particularly Iran (Chart 3). Biden also tried to set up a missile defense network with Israel and the Arabs, although it was not finalized.3 Chart 2Iran Reaches Nuclear Breakout A reaffirmed US-Saudi partnership: The US and Saudi Arabia reaffirmed their partnership despite a rocky patch over the past decade. The rocky patch arises from US energy independence, China’s growth, and US attempts to normalize ties with Iran (Chart 4). These trends caused the Saudis to doubt US support and to view China as a strategic hedge. Chart 3Iran: Surrounded And Outgunned​​​​​​ President Biden came into office aiming to redo the Iran deal and halt arms sales to Saudi Arabia. Since then he has been chastened by high energy prices, a low approval rating, and hawkish Iranian policy. On this trip he came cap in hand to the Saudis in a classic example of geopolitical constraints. If the US-Iran deal is verifiably dead, then US-Saudi ties will improve sustainably. (Though of course the Saudis will still do business with China and even start trading with China in the renminbi.) What global investors want to know is whether the Saudis and OPEC will pump more oil. The answer is maybe someday. The Saudis will increase production to save the global business cycle but not the Democrats’ election cycle. They told Biden that they will increase production only if there is sufficient global demand. Global Brent crude prices have fallen by 6% since May, when Biden booked his trip, so the kingdom is not in a great rush to pump more. Its economy is doing well this year (Chart 5). Chart 4Drivers Of Saudi Anxiety​​​​​ Chart 5Saudis Won't Pump If Demand Is Weak​​​​​​ At the same time, if global demand rebounds, the Saudis will not want global supply constraints to generate punitive prices that cap the rebound or kill the business cycle. After all, a global recession would deplete Saudi coffers, set back the regime’s economic reforms, exacerbate social problems, and potentially stir up political dissent (Chart 6). Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Hence the Saudis will not increase production substantially until they have assessed the global economy and discussed the outlook with the other members of the OPEC cartel in August and September, when the July 2021 agreement to increase production expires. We expect global demand to weaken as Europe and China continue to struggle. Our Commodity & Energy Strategist Bob Ryan argues that further escalation in the energy war between the EU and Russia could push prices above $220 per barrel by Q4 2023, whereas an economic collapse could push Brent down to $60 per barrel. His base case Brent price forecast remains $110 per barrel on average in 2022 and $117 per barrel in 2023 (Chart 7). Chart 6Saudis Will Pump To Prevent Recession​​​​​​ Chart 7BCA's July 2022 Oil Price Forecast​​​​​​ The geopolitical view suggests upside oil risks over the short-to-medium time frame but the macroeconomic view suggests that downside risks will be priced first. Bottom Line: Saudi Arabia may increase production but not at any US president’s beck and call. The Saudis are not focused on US elections, they benefit from the current level of prices, and they do not suffer if Republicans take Congress in November. The downside risk in oil prices stems from demand disappointments in global growth (especially China) rather than any immediate shifts in Saudi production discipline. Volatility will remain high. US-Iran Talks: Dying But Not Dead Yet In fact the Middle East underscores underlying and structural oil supply constraints despite falling global demand. While Iran is a perennial geopolitical risk, the world is reaching a critical juncture over the next couple of years. Investors should not assume that Iran can quietly achieve nuclear arms like North Korea. Since August 2021 we have argued that the US and Iran would fail to put back together the 2015 nuclear deal (the Joint Comprehensive Plan of Action or JCPA). This failure would in turn lead to renewed instability across the Middle East and sporadic supply disruptions as the different nations trade military threats and potentially engage in direct warfare. This forecast is on track after Biden’s and Putin’s trip – but we cannot yet say that it is fully confirmed. Biden’s joint declaration with Israeli Prime Minister Yair Lapid closed any daylight that existed between the US and Israel. Given that there was some doubt about the intentions of Biden and the Democrats, it is now crystal clear that the US is determined to prevent Iran from getting nuclear weapons even if it requires military action. The US specifically said that it will use “all instruments of national power” to prevent that outcome. Chart 8Iran Not Forced To Capitulate Judging by the tone of the statement, the Israelis wrote the document and Biden signed it.4 Biden’s foreign policy emphasizes shoring up US alliances and partnerships, which means letting allies and partners set the line. Israel’s Begin Doctrine – which says that Israel is willing to attack unilaterally and preemptively to prevent a hostile neighbor from obtaining nuclear weapons – has been reinforced. The US is making a final effort to intimidate Iran into rejoining the deal. By clearly and unequivocally reiterating its stance on nuclear weapons, and removing doubts about its stance on Israel, there is still a chance that the Iranian calculus could change. This is possible notwithstanding Ayatollah Khamenei’s friendliness with Putin and criticisms of western deception.5 After all, why would the Iranians want to be attacked by the US and Israeli militaries? Iran will need to think very carefully about what it does next. Khamenei just turned 83 years old and is trying to secure the Islamic Republic’s power transition and survival after his death. Here are the risks: Iran’s economy, buoyed by the commodity cycle, is not so weak as to force Khamenei to capitulate. Back in 2015 oil prices had collapsed and his country was diplomatically isolated. Today the economy has somewhat weathered the storm of the US’s maximum pressure sanctions (Chart 8). Iran is in bad shape but it has not been brought to its knees. Another risk is that Khamenei believes the American public lacks the appetite for war. Americans say they are weary of Middle Eastern wars and do not feel particularly threatened by Iran. However, this would be a miscalculation. US war-weariness is nearing the end of its course. The US engages in a major military expedition roughly every decade. Americans are restless and divided – and the political elite fear populism – so a new foreign distraction is not as unlikely as the consensus holds. Moreover a nuclear Iran is not an idle threat but would trigger a regional nuclear arms race and overturn the US grand strategy of maintaining a balance of power in the Middle East (as in other regions). In short, the US government can easily mobilize the people to accept air strikes to prevent Iran from going nuclear because there is latent animosity toward Iran in both political parties (Chart 9). Chart 9Risk: Iran Overrates US War-Weariness Another risk is that Iran forges ahead believing that the US and Israel are unwilling or unable to attack and destroy its nuclear program. The western powers might opt for containment like they did with North Korea or they might attack and fail to eliminate the program. This is hard to believe but Iran clearly cannot accept US security guarantees as an alternative to a nuclear deterrent when it seeks regime survival. At the same time Russia is courting Iran, encouraging it to join forces against the American empire. Iran is planning to sell drones to Russia for use in Ukraine, while Russia is maintaining nuclear and defense cooperation with Iran. Putin’s trip highlighted a growing strategic partnership despite a low base of economic ties  (Chart 10).6 Chart 10Russo-Iranian Ties​​​​​​ Chart 11West Vulnerable To Middle East War While Russia does not have an interest in a nuclear-armed Iran, it is not afraid of Iran alone, and it would benefit enormously if the US and Israel got bogged down in a new war that destabilized the Middle East. Oil prices would rise, the US would be distracted, and Europe would be even more vulnerable (Chart 11). Chart 12China's Slowdown And Dependency On Middle East China’s interest is different. It would prefer for Iran to undermine the West by means of a subtle and long-term game of economic engagement rather than a destabilizing war in the region that would upset China’s already weak economy. However, Beijing will not join with the US against Iran, especially if Iran and Russia are aligned. Ultimately China needs to access Iranian energy reserves via overland routes so that it gains greater supply security vis-à-vis the American navy (Chart 12). Since June 2019, we have maintained 40% odds of a military conflict with Iran. The logic is outlined in Diagram 1, which we have not changed. Conflict can take various forms since the western powers prefer sabotage or cyber-attacks to outright assault. But in the end preventing nuclear weapons may require air strikes – and victory is not at all guaranteed. We are very close to moving to the next branch in Diagram 1, which would imply odds of military conflict rise from 40% to 80%. We are not making that call yet but we are getting nervous. Diagram 1Iran Nuclear Crisis: Decision Tree Moreover it is the saber rattling around this process – including an extensive Iranian campaign to deter attack – that will disrupt oil distribution and transport sooner rather than later. Bottom Line: The US and Iran could still find diplomatic accommodation to avoid the next step in our decision tree. Therefore we are keeping the odds of war at a subjective 40%. But we have reached a critical juncture. The next step in the process entails a major increase in the odds of air strikes. Putin’s Supply Squeeze Will Continue As we go to press, financial markets are reacting to President Putin’s marginal easing of Russian political pressure on food and energy supplies. First, Putin took steps toward a deal, proposed by Turkish President Erdogan, to allow Ukrainian grain exports to resume from the Black Sea. Second, Putin allowed a partial restart of the Nord Stream 1 natural gas pipeline, after a total cutoff occurred during the regular, annual maintenance period. However, these moves should be kept into perspective. Nord Stream 1 is still operating at only 40% of capacity. Russia reduced the flow by 60% after the EU agreed to impose a near-total ban on Russian oil exports by the end of the year. Russia is imposing pain on the European economy in pursuit of its strategic objectives and will continue to throttle Europe’s natural gas supply. Russia’s aims are as follows: (1) break up European consensus on Russia and prevent a natural gas embargo from being implemented in future (2) pressure Europe into negotiating a ceasefire in Ukraine that legitimizes Russia’s conquests (3) underscore Russia’s new red line against NATO military deployments in Finland and Sweden. Europe, for its part, will continue to diversify its natural gas sources as rapidly as possible to reduce Russia’s leverage. The European Commission is asking countries to decrease their natural gas consumption by 15% from August to March. This will require rationing regardless of Russia’s supply squeeze. The collapse in trust incentivizes Russia to use its leverage while it still has it and Europe to try to take that leverage away. The economic costs are frontloaded, particularly this winter. The same goes for the Turkish proposal to resume grain exports. Russia will continue to blockade Ukraine until it achieves its military objectives. The blockade will be tightened or loosened as necessary to achieve diplomatic goals. Part of the reason Russia invaded in the first place was to seize control of Ukraine’s coast and hold the country’s ports, trade, and economy hostage. Bottom Line: Russia’s relaxation of food and energy flows is not reliable. Flows will wax and wane depending on the status of strategic negotiations with the West. Europe’s economy will continue to suffer from a Russia-induced supply squeeze until Russia achieves a ceasefire in Ukraine. So will emerging markets that depend on grain imports, such as Turkey, Egypt, and Pakistan. Investment Takeaways The critical juncture has arrived for our Iran view. If Iran does not start returning to nuclear compliance soon, then a fateful path of conflict will be embarked upon. The Saudis will not give Biden more oil barrels just yet. But they may end up doing that if global demand holds up and the US reassures them that their regional security needs will be met. First, the path for oil over the next year will depend on the path of global demand. Our view is negative, with Europe heading toward recession, China struggling to stimulate its economy effectively, and the Fed unlikely to achieve a soft landing. Second, the path of conflict with Iran will lead to a higher frequency of oil supply disruptions across the Middle East that will start happening very quickly after the US-Iran talks are pronounced dead. In other words, oil prices will be volatile in a stagflationary environment. In addition, while inflation might roll over for various reasons, it is not likely to occur because of any special large actions by Saudi Arabia. The Saudis are waiting on global cues. Of these, China is the most important. We are booking a 17% gain on our long gold trade as real rates rise and China’s economy deteriorates (Chart 13). This is in line with our Commodity & Energy Strategy, which is also stepping aside on gold for now. Longer term we remain constructive as we see a secular rise in geopolitical risk and persistent inflation problems. Chart 13Book Gains On Gold ... For Now We are booking an 18% gain on our long European defense / short European tech trade. Falling bond yields will benefit European tech (Chart 14). We remain bullish on European and global defense stocks. Chart 14Book Gains On EU Defense Vs Tech ... For Now​​​​​​ Chart 15Markets Underrate Middle East Geopolitical Risk ​​​​​ Stay long US equities relative to UAE equities. Middle Eastern geopolitical risk is underrated (Chart 15). Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      The White House, “The Jerusalem U.S.-Israel Strategic Partnership Joint Declaration,” July 14, 2022, whitehouse.gov. 2     Israel and the US will remove international peacekeepers from the formerly Egyptian Red Sea islands of Tiran and Sanafir, which clears the way for Saudi Arabia to turn them into tourist destinations. Saudi Arabia also removed its tight airspace restrictions on Israel, enabling civilian Israeli airlines to fly through Saudi airspace on normal basis. Of course, Saudi allowance for Israeli military flights to pass through Saudi airspace would be an important question in any future military operation against Iran. 3     The US has long wanted regional missile defense integration. The Biden administration is proposing “integrated air defense cooperation” that would include Israel as well as the Gulf Cooperation Council (GCC). A regional “air and missile defense architecture” would counter drones and missiles from rival states and non-state actors such as Iran and its militant proxies. Simultaneously the Israelis are putting forward the proposed Middle East Air Defense Alliance (MEAD) in meetings with the same GCC nations. Going forward, Iran’s nuclear ambitions will give more impetus to these attempts to cooperate on air defense. 4     This is apparent from the hard line on Iran and the relatively soft line on Russia in the document. Israel is wary of taking too hard of a line against Russia because of its security concerns in Syria where Russian forces are present. See footnote 1 above. 5     Khamenei called for long-term cooperation between Russia and Iran; he justified Russia’s invasion of Ukraine as a defense against NATO encroachment; he called for the removal of the US dollar as the global reserve currency. See “Khamenei: Tehran, Moscow must stay vigilant against Western deception,” Israel Hayom, July 20, 2022, israelhayom.com. 6     Russia’s natural gas champion Gazprom signed an ostensible $40 billion memorandum of understanding with Iran’s National Oil Company to develop gas fields and pipelines. See Nadeen Ebrahim, “Iran and Russia’s friendship is more complicated than it seems,” CNN, July 20, 2022, cnn.com. However, while there are longstanding obstacles to Russo-Iranian cooperation, the West’s tough new sanctions on Russia and EU diversification will make Moscow more willing to invest in Iran. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment Chart 7Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble Chart 12Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year Chart 20Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores    

Executive Summary We posit three conjectures about the US economy: Inflation has an easy path back to 4%, but a move to 2% will require a higher unemployment rate. It will be more difficult to raise the unemployment rate than many anticipate. The Fed will tolerate a higher unemployment rate than many anticipate. Taken together, these conjectures point to a higher fed funds rate in 2023 than is currently discounted in the market. This suggests that investors should be bearish bonds on a 12-18 month investment horizon. While we are bearish bonds in the medium-to-long term, we retain an ‘at benchmark’ portfolio duration stance for the time being because numerous indicators point to lower bond yields during the next few months. We also recommend an underweight allocation to spread product versus Treasuries, though we highlight the potential for solid near-term junk bond returns. Rate Expectations: Market Versus Fed Bottom Line: Maintain an ‘at benchmark’ portfolio duration stance. We will recommend reducing portfolio duration if the 10-year Treasury yield falls to 2.5% or if core inflation converges with our 4%-5% estimate of its underlying trend. Feature Uncertainty in bond markets remains elevated as investors seemingly can’t decide whether the US economy is in the midst of an inflationary boom or hurtling towards recession. This week’s report details our view of the current macroeconomic environment by offering three conjectures about the state of the US economy and monetary policy. We conclude by explaining how these conjectures shape our recommended investment strategy. Conjecture #1: Inflation Has An Easy Path Back To 4%, The Path To 2% Will Be More Difficult At 5.9%, core CPI inflation is running well above the Fed’s 2% target. However, we know that some portion of that 5.9% reflects supply side constraints related to the pandemic and some portion reflects an overheating of the demand side of the US economy. This distinction is important because the pandemic-related inflation will eventually subside on its own, without the need for materially slower economic growth. In contrast, a significant economic slowdown and a higher unemployment rate will be required to tame any inflation driven by strong US demand. Chart 1Estimating Trend Inflation In a recent report we looked at three different techniques for distinguishing between these two types of inflation.1First, we considered the Atlanta Fed’s decomposition of core inflation into flexible and sticky components. At present, the volatile core flexible CPI is running at an 8.4% annual rate and the core sticky CPI stands at 5.4% (Chart 1). Second, we noted that the New York Fed’s Underlying Inflation Gauge is running at 4.8% (Chart 1, bottom panel). Finally, we used wage growth net of trend productivity growth as an estimate of inflation’s underlying trend and calculated that to be 3.7% (Chart 1, bottom panel). From this analysis, our general conclusion is that core CPI inflation can fall into a range of 4%-5% just from the unwinding of pandemic-induced supply-side effects. After that, the Fed will be forced to engineer an economic slowdown to bring inflation from the stickier 4% level back down to its 2% target. Inflation Progress Report Last week’s June CPI report shows that even progress back to our 4%-5% estimate of inflation’s underlying trend is proving difficult. Core CPI rose 0.71% in June, well above expectations, and monthly trimmed mean CPI was an even stronger 0.80% (Chart 2A). Base effects led to a small drop in the annual core CPI number – from 6.0% to 5.9% - but annual trimmed mean CPI moved up to 6.9% (Chart 2B). The strong CPI print has led to increased speculation that the Fed will raise rates by 100 bps this month (see Box). Chart 2AMonthly Inflation Chart 2BYearly Inflation Turning to the three major components of core inflation, we see that shelter, goods, and services ex. shelter contributed roughly equal amounts to the June core CPI reading (Chart 3). The elevated reading from core goods inflation is particularly notable because this is one area where we have been anticipating that easing supply-side constraints will send prices lower. Car prices, specifically, have been one of the principal drivers of high inflation and they remained stubbornly high in June (Chart 4). Chart 3Monthly Core CPI Inflation By Major Component Chart 4Contribution To Month-Over-Month Core Goods CPI Chart 5Supply-Side Constraints Are Easing While it has taken much longer than expected for core goods and other pandemic-driven components of inflation to turn down, leading indicators still suggest that these prices are more likely to fall than rise during the next few months. The New York Fed’s Global Supply Chain Pressure Index has clearly rolled over and supplier delivery times, as measured by both the ISM manufacturing and non-manufacturing surveys, have shortened (Chart 5). While core goods and autos are representative of the sort of inflation that will ease naturally as supply chain constraints abate, shelter inflation is representative of the sort of inflation that will be stickier. That is, a higher unemployment rate will be required to significantly lower shelter inflation. Chart 6Shelter CPI Model Shelter inflation, currently running at 5.6%, can be modeled using the unemployment rate, rental vacancies and home prices (Chart 6). Given that shelter is such a large component of core inflation, it must fall if the Fed is going to achieve its 2% inflation target. That will certainly require a higher unemployment rate and very likely a recession. Bottom Line: Core inflation will move down in the second half of this year, as easing supply-side constraints lead to lower goods prices. Inflation’s downtrend will subside once it reaches its trend level of 4%-5%, at which point a higher unemployment rate and economic recession will be required to move it even lower, back to the Fed’s 2% target. BOX 75 bps Or 100 bps At The Next FOMC Meeting? Guidance provided by Fed Chair Jay Powell at the last meeting FOMC meeting suggested that the committee will choose between lifting rates by 50 bps or 75 bps when it meets later this month. The implication was that any negative inflation surprise would push the committee towards 75 bps. Certainly, last month’s strong employment report and hot CPI print justify a 75 bps move within Powell’s framework. But is it possible that Powell’s guidance from the June FOMC meeting is already stale? Chart B1July FOMC Expectations Investors are increasingly betting that it is, and the market is now discounting some chance of a 100 bps rate hike this month (Chart B1). The reason for this pricing is that the Fed has already backtracked on its guidance once before. Powell ruled out 75 bps rate hikes at the May FOMC press conference. Then, the committee delivered a 75 bps increase in June after core CPI came in hot. Kansas City Fed President Esther George dissented from the June decision because she objected to the Fed flip-flopping on its guidance so quickly. George explained her dissent in a recent speech by saying that “communicating the path for interest rates is likely far more consequential than the speed with which we get there.”2 Where does this leave us for the July meeting? Our expectation is that the Fed will stick to its guidance and deliver a 75 bps increase this month. However, if the market moves to fully price-in a 100 bps move then the committee may be tempted to deliver on those expectations. In other words, the Fed’s recent track record of abandoning its forward rate guidance means that both a 75 bps rate hike and a 100 bps rate hike are in play for July. Conjecture #2: The Labor Market Will Be More Resilient Than Is Widely Believed Chart 7An Extremely Tight Labor Market Our second conjecture is that it will be more difficult to lift the unemployment rate than many people think. This view stems from the fact that the labor market is incredibly tight. As Fed officials have often pointed out, there are currently almost two job openings for every unemployed worker in the country (Chart 7). Further, we noted in last week’s report that while the employment readings from both ISM surveys are in contractionary territory, respondents to those surveys were much more likely to cite concerns about the supply side of the labor market than they were to cite concerns about hiring demand.3 In other words, an economy where there are twice as many job openings as unemployed workers and where firms are complaining about a shortage of labor is not one where we are likely to see an immediate surge in layoffs, even as demand starts to soften. Conjecture #3: The Fed Will Tolerate A Higher Unemployment Rate Than Is Widely Believed Chart 8Optimal Control Monetary Policy Our final conjecture is that the Fed will persistently run a much more restrictive monetary policy than many investors anticipate. We detailed our logic in a recent report where we argued that the Fed will adopt an optimal control approach to monetary policy.4 An optimal control strategy is employed when the Fed is unlikely to perfectly hit both its full employment goal and its 2% inflation target. In such environments, Janet Yellen has argued that the Fed should set monetary policy to minimize the joint deviations of inflation from target and of the unemployment rate from estimates of its full employment level.5 Chart 8 presents an example of an optimal control loss function that consists of adding together the squared deviations of inflation from 2% and of the unemployment rate from the Congressional Budget Office’s estimate of NAIRU. Using this framework, the Fed’s goal is to minimize the output of the loss function shown in the top panel. The dashed lines in Chart 8 illustrate a scenario where core PCE inflation falls to 4% but where the output from the loss function is held flat. That scenario implies an increase in the unemployment rate from its current level of 3.6% all the way up to 6.7%! This exercise demonstrates that, under an optimal control framework, the Fed would be willing to tolerate an unemployment rate of 6.7% or lower in order to move core inflation back to 4%. We don’t see the unemployment rate hitting 6.7% any time soon. The main point of this analysis is to illustrate that Fed policy is likely to retain a restrictive bias until inflation returns to 2% or lower. It won’t move toward easing policy at the first sign of a higher unemployment rate, as has been the pattern in recent years when inflation was much more contained. Investment Implications To summarize, our three conjectures about the US economy are that: (i) a higher unemployment rate will be required to move inflation from 4% to the Fed’s 2% target, (ii) a lot of demand destruction will be required before we see a significant rise in the unemployment rate and (iii) in its pursuit of lower inflation, the Fed will tolerate a higher unemployment rate than many people expect. Taken together, these three conjectures imply that the fed funds rate will be higher in 2023 than what is currently priced in the curve. At present, the market is priced for the fed funds to peak at 3.67% in March 2023 and then fall back to 3.13% by the end of the year (Chart 9). If our three conjectures pan out, then we think it’s likely that the fed funds rate will move above 4% next year and that it will be higher than 3.13% by the end of 2023. Chart 9Rate Expectations: Market Versus Fed Portfolio Duration Chart 10High-Frequency Bond Yield Indicators Obviously, this view makes us inclined toward a ‘below-benchmark’ portfolio duration stance on a 12-18 month investment horizon. That said, we recommend keeping portfolio duration close to benchmark for now because many indicators suggest that bond yields could fall during the next few months (Chart 10). More specifically, with core CPI still above our 4%-5% estimate of its underlying trend, we see inflation as more likely to fall than rise during the next six months. At the same time, aggregate demand will be slowing as the Fed tightens policy and the unemployment rate is more likely to rise than fall. These factors will keep bond yields contained between now and the end of the year. While we recommend an ‘at benchmark’ portfolio duration stance on a 6-12 month horizon, we will reduce portfolio duration if the 10-year Treasury yield moves back to 2.5% or once core inflation converges to our 4%-5% estimate of trend. At that point, we think inflation will be stickier and it will make sense to position for higher bond yields. Spread Product Our three conjectures also imply a negative environment for spread product. Monetary policy will become increasingly restrictive, and it will be a long time before the Fed moves toward interest rate cuts – the traditional signal to pile into spread product. We therefore advocate an underweight allocation to spread product versus Treasuries in US bond portfolios. One exception to our underweight spread product allocation is that we retain a neutral allocation to high-yield. Our reasoning is that high-yield spreads are elevated and they have the potential to tighten during the next few months as inflation converges toward our estimate of trend. As inflation falls and fears of immediate recession abate, it’s conceivable that junk spreads could revert to their 2017-19 average, the level that prevailed during the previous tightening cycle (Chart 11), and such a move would lead to roughly 8.4% of excess return.6 If such a move were to occur within the next six months, then we would be inclined to reduce our junk bond exposure to underweight. A Quick Note On 2-Year TIPS Chart 11Junk Spreads Are Elevated Chart 122-Year TIPS Yield Is Positive In last week’s report we recommended upgrading TIPS from underweight to neutral relative to duration-matched nominal Treasuries. However, given that the 2-year TIPS yield was still negative, we did not close our recommendation to short 2-year TIPS or our recommended 2/10 real yield curve flattener and 2/10 inflation curve steepener positions. The 2-year real yield has continued to rise during the past week and, at +9 bps, it is now in positive territory (Chart 12). We were confident that the 2-year TIPS yield would turn positive because the Fed has implied that it is targeting positive real yields across the entire curve. But now that the yield is positive, we are no longer confident in the trade’s upside. Bottom Line: Investors should close out their short 2-year TIPS positions, as well as their 2/10 real yield curve flatteners and 2/10 inflation curve steepeners. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 2     https://www.kansascityfed.org/Speeches/documents/8875/2022-George-MidAm… 3    Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 4    Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 5    https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 6    Return estimate assumes default losses of 1.8% and that the spread tightening occurs over a six month period.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns