Developed Countries

Please note that there will no US Bond Strategy publication next week. Our regular publishing schedule will resume on September 6th with our Portfolio Allocation Summary for September. Executive Summary This report describes a framework for implementing long/short positions in the TIPS market relative to duration-matched nominal Treasuries. The framework is modeled after the Golden Rule of Bond Investing that we use to implement portfolio duration trades. The TIPS Golden Rule states that investors should buy TIPS versus nominal Treasuries when their 12-month headline inflation expectations are above those priced into the market, and vice-versa. We demonstrate a method for forecasting headline CPI inflation and conclude that it will fall into a range of 2.4% to 4.8% during the next 12 months, with risks to the upside. This suggests a high likelihood that headline inflation will exceed current market expectations. The TIPS Golden Rule’s Track Record Bottom Line: We see value in TIPS on a 12-month investment horizon but anticipate that an even better entry point to get long TIPS versus nominal Treasuries will emerge during the next couple of months as headline CPI weakens. We recommend a neutral allocation to TIPS for now, though we are looking for a good opportunity to increase exposure. Feature Regular readers will no doubt be familiar with our Golden Rule Of Bond Investing, the framework we use to think about our portfolio duration recommendations. In brief, the Golden Rule states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. Our research shows that this investment strategy has a strong historical track record.1 The thing we like most about the Golden Rule framework is that it provides us with a good method for filtering incoming information. Does this new piece of news or economic data change our 12-month rate expectations? If not, then we probably don’t want to assign much weight to it when setting our portfolio duration. In this Special Report we demonstrate that the same Golden Rule logic that we apply to duration trading can also be applied to the TIPS market. Specifically, it can be applied to long/short positions in TIPS versus duration-matched nominal Treasuries. Developing The TIPS Golden Rule Before diving into the TIPS Golden Rule, it’s worth running through the logic that underpins this investment strategy. The logic starts with the Fisher Equation – the well-known formula that relates nominal bond yields to real bond yields. Simply, the Fisher Equation can be stated as follows:     Nominal Yield = Real Yield + The Cost Of Inflation Protection In financial market terms, we can re-write the equation as:     Nominal Treasury Yield = TIPS Yield + TIPS Breakeven Inflation Rate Two of the three variables in this equation have what we call valuation anchors. The nominal Treasury yield’s valuation is anchored by expectations about the future path for the federal funds rate. Put differently, if you buy a 5-year Treasury note and hold it until maturity, your excess returns versus a position in cash are purely determined by the path of the federal funds rate over that 5-year investment horizon. Similarly, the TIPS breakeven inflation rate’s valuation is anchored by expectations about CPI inflation. If held to maturity, the profits from an inflation protection position (long TIPS/short nominals or short TIPS/long nominals) are purely determined by the path of CPI inflation during the investment horizon. It’s worth noting that, unlike the nominal Treasury yield and the TIPS breakeven inflation rate, the TIPS yield has no independent valuation anchor. Within our framework, the best way to forecast the TIPS yield is to follow a 3-step process: Forecast the nominal yield based on a view about the fed funds rate. Forecast the TIPS breakeven inflation rate based on a view about inflation. Use the Fisher Equation to combine the results from steps 1 and 2 into a forecast for the TIPS yield. As an aside, while our framework relies on viewing the nominal Treasury yield and the TIPS breakeven inflation rate as reflective of expectations for the fed funds rate and CPI inflation respectively, we do not argue that those bond yields can be used to accurately forecast the fed funds rate or CPI inflation. In fact, history tells us that bond markets are usually poor predictors of future outcomes for the fed funds rate and for CPI inflation. Chart 1 shows that there is only a loose correlation (R2 = 22%) between 12-month bond-market implied expectations for the change in the fed funds rate and the actual change in the fed funds rate. Similarly, Chart 2 shows that there is hardly any correlation (R2 = 3%) between market-implied inflation expectations and the 12-month rate of change in headline CPI. Chart 1Market Prices Are A Poor Predictor Of The Fed Funds Rate Chart 2Market Prices Are A Poor Predictor Of Inflation In other words, it’s more advisable to view the expectations priced into bond markets as a breakeven threshold for trading, not as a tool for forecasting. Stating The TIPS Golden Rule To apply the TIPS Golden Rule, investors should follow these three steps: Calculate market-implied expectations for what headline CPI inflation will be over the next 12 months. This can be done by looking at the 1-year CPI swap rate or the 1-year TIPS breakeven inflation rate.2 Develop an independent forecast for 12-month headline CPI inflation. We demonstrate one method for doing this later in the report.3 Compare your own headline CPI forecast with the forecast that is priced in the market. If your own forecast is higher, then you should go long TIPS/short nominal Treasuries. If your own forecast is lower, then you should go short TIPS/long nominal Treasuries. Testing The TIPS Golden Rule Chart 3 shows the historical track record of the TIPS Golden Rule going back to 2005.4 The top panel shows 12-month excess returns from the Bloomberg Barclays TIPS index relative to a duration-matched position in nominal Treasuries. The bottom panel shows whether inflation surprised market expectations to the upside or to the downside during the investment horizon. We can see that, visually, it looks as though TIPS tend to outperform nominal Treasuries when there is an inflationary surprise and underperform when there is a deflationary surprise. Chart 3The TIPS Golden Rule's Track Record Chart 4 shows the same relationship in a little more detail. The 12-month inflation surprise is placed on the x-axis and 12-month TIPS excess returns are on the y-axis. For the TIPS Golden Rule to be useful, we would need to see most of the datapoints in the top-right and bottom-left quadrants of the chart, and indeed this is the case. Chart 412-Month TIPS Excess Returns Vs. Inflation Surprises Finally, Table 1 shows the relationship in even more detail. It shows that inflationary surprises coincide with positive TIPS excess returns 73% of the time for an average excess return of 2.6%. It also shows that deflationary surprises coincide with negative TIPS excess returns 80% of the time, for an average excess return of -3.2%. Table 112-Month TIPS Excess Returns* And Inflation Surprises (2005 – Present) Please note that all the above return calculations are performed on the overall Bloomberg Barclays TIPS Index relative to a duration-matched position in nominal Treasuries. However, the TIPS Golden Rule also performs well when applied to TIPS of any maturity. The Appendix of this report replicates the above analysis for every point along the TIPS curve and shows that the results are consistently excellent. Applying The TIPS Golden Rule Now that we have stated the TIPS Golden Rule and demonstrated its effectiveness as an investment strategy, it is time to apply it to the current market. To do that, we first determine 1-year market-implied inflation expectations by looking at the 1-year CPI swap rate. As of last Friday’s close, the 1-year CPI swap rate is 3.16%. This means that if we think headline CPI inflation will be above 3.16% during the next 12 months, then we should go long TIPS versus duration-matched nominal Treasuries. If we think headline CPI inflation will come in below 3.16% during the next 12 months, then we should go short TIPS versus duration-matched nominal Treasuries. Next, we must build up our own forecast of headline CPI inflation for the next 12 months. To do this, we follow a bottom-up approach where we split the CPI basket into five components (energy, food, shelter, core goods, and core services ex. shelter) and model each one individually. Energy Inflation (9% Of Headline CPI) Chart 5Modeling Energy Inflation Energy accounts for roughly 9% of headline CPI, though its often violent price swings mean that this component usually accounts for a much larger percentage of the volatility in headline CPI. In practice, we can accurately model Energy CPI using the prices of retail gasoline, natural gas, and heating oil (Chart 5). To get a 12-month forecast for Energy CPI we therefore need forecasts for the prices of retail gasoline, natural gas, and heating oil. In this analysis, we will consider two possible scenarios for energy prices. First, a benign ‘low oil price’ scenario where we assume that the prices of retail gasoline, natural gas and heating oil follow the paths discounted in their respective futures curves. Second, we consider a ‘high oil price’ scenario that incorporates the view of our Commodity & Energy Strategy service that a drop in Russian oil supply, among other factors, will cause the Brent crude oil price to reach $119 per barrel by the end of this year and average $117 per barrel in 2023.5 To incorporate this outlook into our model, we regress the prices of retail gasoline, natural gas and heating oil on the Brent crude oil price and extrapolate forward using our commodity strategists’ forecasts. The ‘low oil price’ scenario has Energy CPI inflation falling from its current 32.9% level all the way down to -9.9% during the next 12 months. In contrast, our ‘high oil price’ scenario has it falling to just 15.8%. Food Inflation (13% Of Headline CPI) Chart 6Modeling Food Inflation Our Food CPI model is based on the cost of fertilizer, agricultural commodity prices and diesel prices. This model has done a reasonably good job explaining trends in Food CPI inflation over time, but the last few months have seen food inflation jump well above the levels suggested by our model (Chart 6). Given that the inputs to our Food CPI model are highly correlated with the oil price, we also apply the ‘low oil price’ and ‘high oil price’ scenarios discussed above to our Food CPI forecast. Using this method, the ‘low oil price’ scenario has Food CPI inflation falling to 3.8% during the next 12 months and the ‘high oil price’ scenario has it coming down to 4.2%. One key risk to these forecasts is that they both assume that the current gap between food inflation and our model’s fair value will close. It’s possible that other factors not included in our model could prevent the gap from closing. We therefore consider our Food CPI forecast to be quite optimistic. Core Goods Inflation (21% Of Headline CPI) Chart 7Modeling Goods Inflation Core goods inflation, currently running at 6.9%, appears to have already peaked following its post-pandemic surge. We model Core Goods CPI using the New York Fed’s Global Supply Chain Pressure Index, as it is the supply chain constraints that arose during the pandemic that explain the bulk of the movement in core goods prices since that time (Chart 7).6 To forecast Core Goods CPI, we assume that global supply chain constraints continue to ease and that the New York Fed’s index reverts to its pre-pandemic level during the next 12 months. This gives us a forecast for 12-month Core Goods CPI inflation of 0%. Shelter Inflation (32% Of Headline CPI) Chart 8Modeling Shelter Inflation We model shelter inflation, currently running at 5.6%, using the unemployment rate, rental vacancy rate and home prices (Chart 8). Except for the unemployment rate, all our model’s independent variables enter with a lag of at least 12 months. In other words, we wouldn’t expect any near-term change in home prices to impact Shelter CPI for at least a year. To forecast Shelter CPI, we assume that the unemployment rate rises to 4% during the next 12 months. This results in a shelter inflation forecast of 4.7% for the next 12 months. Much like with food inflation, we tend to view this forecast as relatively optimistic as it assumes a large reversion from the current rate of shelter inflation back to our model’s fair value. It’s conceivable that other factors not included in our model, such as rapid wage growth, could prevent this reversion from occurring. Services ex. Shelter Inflation (24% Of Headline CPI) Chart 9Modeling Services Inflation This final component of CPI is a bit of a hodgepodge of different service industries that may not have much in common. However, we find that wage growth does a good job of tracking its trends (Chart 9). We therefore model Services ex. Shelter CPI using the Employment Cost Index, which enters our model with a 10 month lag. To forecast Services ex. Shelter CPI, we assume that the Employment Cost Index holds steady at its current growth rate. This gives us a Services ex. Shelter CPI inflation forecast of 5.5% for the next 12 months. Combining Our Bottom-Up Inflation Forecasts & Investment Conclusions Combining our bottom-up forecasts, we calculate a 12-month headline CPI inflation rate of 2.4% for the ‘low oil price’ scenario and a rate of 4.8% for the ‘high oil price’ scenario. For core CPI inflation, we calculate a 12-month forecast of 3.6%. Given the optimistic assumptions that we incorporated into our forecasts, particularly the large reversions of food and shelter inflation back to our estimated fair value levels, we view the risks to our forecasts as heavily tilted to the upside. We also acknowledge that the re-normalization of global supply chains may not proceed as smoothly as the scenario that is baked into our forecasts. Any hiccup in that process would cause our goods inflation forecast to be too low. Chart 10Inflation Forecasts Chart 10 shows our 12-month headline and core CPI forecasts alongside the market-implied forecast from the CPI swap curve, currently 3.16%. Notice that the market-implied inflation forecast is much closer to the bottom-end of our range of headline CPI estimates, and we have already acknowledged that a lot of things will have to go right for our estimates to pan out. In other words, we see a high likelihood that 12-month headline CPI will be above 3.16% for the next 12 months which, according to our TIPS Golden Rule, tells us that we should go long TIPS versus duration-matched nominal Treasuries. While we acknowledge that there is likely some value in going long TIPS versus nominal Treasuries today, we are inclined to maintain our recommended neutral allocation to TIPS versus nominals for now. Given the recent drop in oil prices, we anticipate further weakness in headline inflation during the next couple of months. This could push TIPS breakeven inflation rates even lower in the near term, creating even more value. The bottom line is that we see attractive value in TIPS versus nominal Treasuries on a 12-month investment horizon. While we maintain a neutral allocation to TIPS for now, we anticipate turning more bullish in the near future, hopefully from a better entry point after one or two more weak CPI prints. Appendix Chart A112-Month TIPS Excess Returns Vs. Inflation Surprises (1-3 Year Maturities) Table A112-Month TIPS Excess Returns* And Inflation Surprises (1-3 Year Maturities) Chart A212-Month TIPS Excess Returns Vs. Inflation Surprises (3-5 Year Maturities) Table A212-Month TIPS Excess Returns* And Inflation Surprises (3-5 Year Maturities) Chart A312-Month TIPS Excess Returns Vs. Inflation Surprises (5-7 Year Maturities) Table A312-Month TIPS Excess Returns* And Inflation Surprises (5-7 Year Maturities) Chart A412-Month TIPS Excess Returns Vs. Inflation Surprises (7-10 Year Maturities) Table A412-Month TIPS Excess Returns* And Inflation Surprises (7-10 Year Maturities) Chart A512-Month TIPS Excess Returns Vs. Inflation Surprises (10-15 Year Maturities) Table A512-Month TIPS Excess Returns* And Inflation Surprises (10-15 Year Maturities) Chart A612-Month TIPS Excess Returns Vs. Inflation Surprises (15+ Year Maturities) Table A612-Month TIPS Excess Returns* And Inflation Surprises (15+ Year Maturities) Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. 2 In this report we use the 1-year CPI swap rate because it is easier to access. 3 To make the TIPS Golden Rule easy to implement, we use seasonally adjusted headline CPI for all our calculations even though TIPS are technically linked to the non-seasonally adjusted index. We also ignore the fact that TIPS coupons adjust to CPI releases with a lag. Our analysis shows that the rule works very well even without incorporating these complications. 4 CPI swap rates are only available from 2004 onwards, so this is the largest historical sample we can use. 5 Please see Commodity & Energy Strategy Weekly Report, “EU Russian Oil Embargoes, Higher Prices”, dated August 18, 2022. 6 For more details on the Global Supply Chain Pressure Index: https://www.newyorkfed.org/research/policy/gscpi#/overview Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The Fed Versus The Market In today’s report, we summarize the arguments of bulls and bears to examine the possible longevity of the rally. The Bulls’ view is centered around several key themes:  Inflation has turned.  The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker.  The economy is resilient, and consumers are spending.  Corporate earnings will surprise on the upside thanks to consumer strength. Meanwhile, the bears argue that:  Growth is slowing and a soft landing is elusive, which will lead to earnings disappointment.  Valuations and Technicals are no longer attractive – the best part of the rally is likely over, and risk-reward is skewed to the downside.  Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may continue.  We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. Feature The fast and furious rally off the June 16 lows has taken many investors by surprise. Over the past two months, the S&P 500 has rebounded by 17%, the NASDAQ is up 22%, while Growth has outperformed Value by 9%. Thematic small-cap growth ETFs have fared even better (Chart 1) with Cathie Wood’s ARKG and ARKK up nearly 50%. The Technology and Consumer Discretionary sectors are up 23% and 28% respectively, while Energy and Materials are relatively flat, showcasing a rotation away from the inflation winners to losers. In this week’s report, we will “dissect” the rally and its key drivers to better understand what can bring this rally to a halt. We will also summarize the arguments of the bulls and present our “bearish” rebuttal to some of the assumptions. Sneak Preview: After the powerful rebound, the market is fragile, and risks are skewed to the downside. By summarizing the arguments of bulls and bears, we are offering our take on what can bring this rally to a halt, i.e., hawkish Fed speeches, disappointing inflation readings, rising rates, and bad earnings. However, a positive surprise along each of these dimensions may also result in the next leg up. Chart 1ETF Universe Overview Anatomy Of The Rally To understand what fuels the rally, we need to understand what its key catalysts are. Oversold: First and foremost, in mid-June, US equities were severely oversold – the BCA Capitulation Indicator hit levels last seen in the spring of 2020 (Chart 2). The BoA institutional survey has also reported an extreme level of bearishness. Pull back in the price of energy: This created fertile ground for a rebound, but the catalyst came from the turn in commodities and energy prices. Extreme pessimism about global growth after the Fed’s aggressive response to a disappointing inflation print has triggered a sell-off in oil and metals. Since mid-June, the GSCI Commodities and the GSCI Energy index are in a bear market downtrend, 21% and 25% off their peaks. Inflation moderating: This disinflationary development has unleashed a positive reinforcement loop: Lower energy prices led to a turn in the CPI print. And many still believe that, after all, inflation is transitory: With supply disruptions clearing and prices of energy and commodities turning, inflation will dissipate just as fast as it arrived. We know this because inflation breakevens are currently at levels last seen a year ago (Chart 3). Chart 2Capitulated Chart 3Cooling Off : Back To 2021 Gentler Fed: That is when the market decided that easing price pressures in concert with slowing growth would compel the Fed to pursue a shallower and shorter path of interest rate increases than initially expected – rate increases derived from OIS started to undershoot the “dot plot” (Chart 4). Effectively, the bond market started to forecast that the Fed will end the year at 3.5% and ease as soon as early 2023. In other words, the Fed is nearing the end of the hiking cycle. Naturally, the long end of the Treasury curve has pulled back to April levels, despite a much higher Fed rate. One way or another, yields have stabilized. Lower rates are a boon for equities: As a long-duration asset, equity valuations are inversely correlated with long yields (Chart 5). A better-than-expected Q2 earnings season was the icing on the cake. Chart 4The Market Expects Cuts As Soon As Early 2023 Chart 5Falling Yields Propelled Equities Higher Was The Rally Surprising? The rally itself did not surprise us – after all, we did expect the market to turn on a dime at the earliest whiff of falling inflation (Chart 6). Admittedly, we were taken aback by its strength and longevity. With inflation turning, we also expected a change in leadership from the Energy and Materials sectors to Technology and Consumer Discretionary (Chart 7). We also predicted back in January in our “Are We There Yet?!” report that, based on the previous hiking cycles, Tech would rebound roughly three months after the first rate hike (Chart 8), which was taking us to June. Chart 6When Inflation Turns, Equities Rebound Chart 7Turn in Inflation Triggers A Change In Sector Leadership Chart 8A Closer Look At Technology In early July, we upgraded Growth to overweight as an asset that would benefit from an anticipated turn in CPI, rate stabilization, and slowing growth (Chart 9). We have also reaffirmed our overweight in Software and Services as a way to play Growth on a sector level. We have downgraded Energy to underweight to reduce exposure to Value. Chart 9Growth And Quality Lead Markets Higher When Inflation Abates What The Bulls Think Let’s summarize what the bulls think are the catalysts for the next leg up: Inflation has turned. Looking for further signs that inflation is easing. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. Looking for signs that the Fed is getting closer to the end of the hiking cycle. So far, the economy is resilient, and consumers are spending – excess savings and excess demand for labor will soften the blow. Looking for signs that the recession can be avoided. Corporate earnings will surprise on the upside thanks to consumer strength. In the next section, I will juxtapose these optimistic expectations with those of a bear, i.e., of yours truly. A full disclosure – I am not a perma-bear but even eight weeks into the best recovery rally ever, I can’t shake off my pessimism. After all, I am used to the markets going up on injections of liquidity and expect them to shudder when liquidity is mopped out of the system. What The Bears Think, Or A Litany Of Worries Inflation is embedded and broad-based Broad-based: While headline inflation is turning, mostly thanks to prices of energy and materials, it will take a long time for core inflation to revert to the desired 2% as it is broad-based. This is evident from trimmed and median CPI metrics, which continue their ascent. Inflation has also spilled into sticky service items, such as rent (Chart 10). Wage-price spiral: Then there is that pesky wage-price spiral that is manifesting itself in soaring labor costs (Chart 11), which companies pass on to their customers. In the meantime, productivity is falling, and unit labor costs are increasing at 9.5% per year, a rate of growth last seen in 1980s (Chart 12). Demand for labor still exceeds supply with 1.8 job openings for every job seeker, and much more tightening is required to bring supply and demand into balance. Chart 10Entrenched? Chart 11Wage-price Spiral Chart 12ULC Soaring Wages and service inflation are more important to structural inflation than energy. Rent and its equivalents constitute 30% of the CPI basket, while wages are roughly 50% of corporate sales and by far the largest component of the cost structure. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. What Does The Fed Think? Fed minutes: Fortunately, we don’t need to guess. The Fed minutes state that "participants agreed that there was little evidence to date that inflation pressures were subsiding" and that inflation “would likely stay uncomfortably high for some time.” Further, “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities … Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said. The Fed minutes state that in moving expeditiously to neutral and then into restrictive territory, “the Committee was acting with resolve to lower inflation to 2% and anchor inflation expectations at levels consistent with that longer-run goal.” In its previous communications, the Fed emphasized that its commitment to a 2% target is unconditional. Is powell more like burns or volcker? In addition, there is an ongoing debate between bulls and bears on the character of the Fed – is Jay Powell a strong-willed hawk like Paul Volker, or more of a waverer like Arthur Burns, who presided over the relentless march of inflation in the seventies? We think that the Chairman can channel Paul Volcker. After all, the Fed has surprised investors by acting swiftly and decisively. Back in March, the Fed dot plot indicated that by the end of the year, the target rate will reach a mere 1.75%. However, we hit a 2.25%-2.50% rate range as soon as July. Jay Powell is concerned about his legacy: He would not want to be remembered as a Chair who mishandled inflation by keeping rates too low despite historically low unemployment and resilient consumers whose accounts are padded with excess post-pandemic savings. The Fed is more hawkish than what the majority of market participants, unscathed by the inflation of the seventies and eighties, believe. The Fed dot plot, to which the Chairman referred on multiple occasions, projects a Fed funds rate of 4% at year-end and of 4.5-5.0% next year (Chart 13). Meanwhile, Fed funds futures are only pricing a rate of about 3.4% for December 2022, even after the hawkish talk from both ex-dove Kashkari and a hawk Bullard (3.75%-4.0% by year-end and 4.4% by the end of 2023). Further, the Fed itself states in its minutes that rates would have to reach a "sufficiently restrictive level" and remain there for "some time" to control inflation that was proving far more persistent than anticipated. The Chicago Fed President Charles Evans has also affirmed that the Fed is definitely not cutting rates in March 2023. Chart 13The Fed Versus The Market Doves latch on to comments from the meeting that the Fed will be data-driven, and that it is concerned about overtightening. To us, these are just the musings of the “responsible grown-ups.” Quantitative Tightening: Now let’s not forget another leg of the stool – Quantitative Tightening. QT has been very tame so far and, since the program commenced, the size of the Fed’s balance sheet, $8.9 trillion, has barely budged. In September, the Fed is scheduled to step up QT to a maximum pace of $95 billion from $47.5 billion— running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Shortages of securities available for run-off due to a dearth of refinancing may trigger a shift to outright selling, further tightening financial conditions. Equities are at odds with the Fed: Last, but not least, equity markets are on a collision course with the Fed. Since June, financial conditions have eased as opposed to tightened, making the Fed’s job so much harder (Chart 14). Chart 14The Rally Eased Financial Conditions The Fed may prove to be more hawkish than in the past as it is on a quest to combat inflation and takes its mission very seriously. “Don’t fight the Fed” the adage holds. Economic Growth Is Slowing The BCA Business Cycle Indicator signals that economic growth is slowing (Chart 15), which is also evident from a host of economic data releases, ranging from GDP growth to business surveys to housing data. One of the few data series that has defied gravity so far is the jobs report, but the job creation rate is a coincidental indicator at best, and a lagging one at worst. Jobs are usually lost after the start of a recession (Chart 16). Chart 15Economy Is Slowing Chart 16Unemployment Never "Just Ticks Up" Can consumers save the day? After all, $2.2 trillion in excess savings should help to handle the pressures of negative real wage growth and income growth that is below trend. Yes and no. Gasoline savings can certainly support increases in discretionary spending, all else equal. As for excess savings – adding this money back into the economy may ignite another bout of inflation, working against the Fed, and triggering more rate increases. Many clients ask us if we anticipate a recession. Broadly speaking we do, as the Fed has an arduous task ahead of it in balancing the supply and demand of labor. However, we do not expect a recession in 2022 or even early 2023. Can the Fed succeed by only reducing excess job openings from 1.8 to 1, thus avoiding a rise in unemployment? This is possible, but the probability of such an outcome is low as unemployment never “just ticks up” (Chart 16). However, what the market is pricing is also important. At the moment, the rally shows that it considers the current growth slowdown just a growth scare to be shrugged off. Will there be more disappointments? We think so, as the US economy is facing multiple headwinds from slowing demand for exports due to geopolitical turbulence and payback of overstimulated consumer demand at home. And it is not a recession per se, but a growth disappointment, that may take equities on the next leg down. Growth is slowing and a soft landing is illusive. Earnings Growth Will Continue Its March Towards Zero We believe that earnings growth will continue to slow into year-end – flagging consumer demand at home and abroad, a strong dollar, and soaring unit labor costs that can no longer be fully passed on to stretched consumers, as corporate pricing power is decelerating. Even in Q2-2022, ex-Energy EPS growth is already negative at -1.5%, with Consumer Discretionary, Financials, Communications, and Utilities reporting an earnings contraction. As we predicted back in October, the S&P 500 margins are also compressing, currently at 50bps off their peak, with consensus expecting them to lose another two points within the next 12 months as companies are grappling with rising costs (Chart 17). Analysts are finally in a downgrading mode (Chart 18), with growth over the next 12 months now expected to be 7.7% compared to 10% earlier this summer. Analyst downgrades will continue, and an earnings recession is highly probable as early as Q4-2022. Chart 17Profitability Is Under Pressure Chart 18Earnings Are Finally Being Downgraded In terms of the durability of the rally – earnings growth disappointment will be enough to cause equities to pull back. Earnings growth is slowing and more disappointments may be in store. Valuations And Technicals The S&P 500 is currently trading at 18x forward earnings, which is nearly a two-point rebound off the market trough of 15.8x. This is roughly where PE NTM was in April when the 10-year yield stood at 2.80%. Therefore, the multiple reverted on the back of falling rates, and the market is fairly valued considering where rates are now. And another factor to consider: Analysts are slashing earnings expectations, and with E in a P/E likely to be downgraded further – the “true” forward multiple is likely higher than it appears. The BCA Valuation Indicator is also flashing “overvalued” (Chart 19). From the equity risk premium standpoint, 3% is low by historical standards (Chart 20). And if we consider Shiller PE, it has come down from an eye-watering 38x to a still elevated 29x. Chart 19Pricey Again? Chart 20Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Therefore, it is hard to call equities cheap at this point. But being generous, we will call them “fairly priced.” Regardless – at these levels of valuations, the best part of the rally is likely over, and risk-reward is no longer favorable. From a technical standpoint, this rally is broad-based with nearly 90% of the S&P 500 industries trading above their 50-day moving average (Chart 21). But according to the BCA Technical Indicator, equities are no longer oversold and have just crossed into neutral territory (Chart 22). Interestingly, once the Technical indicator starts to rise, it usually ascends for a while, making us wary to boldly call an immediate end to this rally. Chart 21Thrusting Chart 22No Longer Oversold? Valuations and Technicals are no longer attractive – the best part of the rally is likely over and risk-reward is skewed to the downside. Investment Implications Or Can This Rally Continue? Timing the market is hard at best, impossible at worst. After a 17% rise from the bottom, the S&P 500 is no longer cheap or oversold. Buying equities for valuations or technical reasons is too late – risks are skewed to the downside. Our working assumption is that the rally will pause waiting for the new data that will trigger a new leg up or down. Further, as we pointed out in the Fat and Flat report, the current period is reminiscent of the 1980-1982 Volcker era. So far, the market is following this pattern to a T (Chart 23). The problem is that each leg of the up-and-down market may take months. As such, being (eventually) right and principled does not pay off. After all, the economy is not a market. Therefore, until one of the following happens, the music will continue and the markets can keep dancing, which may be for a while. Chart 23Volcker Era Redux The rally will continue until: There is a communication from the Fed re-emphasizing its hawkish stance and determination to get inflation back to 2%. It may be as one of the FOMC member’s speeches broadcast at Jackson Hole. Long-term Treasury yields pick up either because of the Fed’s actions or speeches or because the economy is overheating. Negative inflation surprise – it may come as either a higher-than-expected inflation reading or evidence that inflation is entrenched, such as rising service or rent inflation, soaring wages, a pick-up in the price of oil or commodities, or a growth surprise out of China, to name but a few. Negative earnings surprise – guidance from a number of companies indicating that economic growth is slowing, and earnings will disappoint. A negative economic surprise may be perceived by the market as “bad news is good news.” We recommend the following: Maintain a well-diversified portfolio, with sufficient allocation to both cyclicals and defensives. Increase exposure to Growth sectors, such as Technology. We particularly favor Software and Services as it leverages the pervasive theme of digitization and migration to the cloud. Reduce allocation to Energy and Materials – these sectors tend to underperform when inflation turns. They are also quintessential value sectors. Maintain some allocation to cyclicals – we are overweight the Industrial sector as it leverages a long-term theme of onshoring and automation. We may be upgrading the Consumer Discretionary sector in the near future. We are also overweight Banks and Insurance for portfolio diversification – these sectors benefit from rising rates and positive growth surprise. Markets turn on a dime and it is good to be prepared. Allocate capital to long-term investment themes: Green and Clean and EV, benefiting from the funds allocated by the IRA bill, Cyber Security, and Defense. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may still continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. In the meantime, overweight Growth and maintain a well-diversified portfolio.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation   Recommended Allocation: Addendum 

Executive Summary Definitions Matter Year-to-date, cyclical stocks have underperformed their defensive counterparts. It is difficult to quantify this underperformance precisely considering the divergence in definitions of what makes a sector cyclical or defensive. We offer a novel way to classify sectors based on a combination of equity beta coefficients and correlations with global macro and financial variables. Importantly, we acknowledge the importance of granularity by looking at the GICS2 sectors. This new approach leads to a cyclicals/defensives equity performance that is superior and more in line with the global economic cycle. Bottom Line: A proper definition of what constitutes a cyclical and a defensive equity sector is essential – whether a recession is around the corner and investors adopt a more defensive portfolio tilt or markets are just responding to what might simply be a mid-cycle slowdown.   Investors around the globe are holding their breath over two questions: Has inflation peaked? And will the US and Europe enter a recession? A peak in inflation may be enough to avoid a hard landing, as it would allow the Federal Reserve and the ECB to moderate their policy tightening. However, if inflation is not peaking, central banks will be forced to engineer recessions. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks In turn, the answers to these questions will determine how cyclical equities perform relative to defensives. So far, the underperformance of cyclical sectors relative to defensives has mostly reflected a valuation squeeze. But if a recession takes place, relative profits will drive the next phase of this market cycle. For now, European defensive sectors are likely to retain the upper hand until EM/China economic activity recovers enough to provide a lift to cyclical sectors, and/or the US dollar rally reverses course on a sustained basis. Chart 1Definitions Matter Despite their recent rebound, Euro Area cyclical stocks have underperformed relative to their defensive counterparts over the past nine months. However, quantifying this underperformance depends on how one defines cyclicals and defensives (Chart 1). The aim of this Special Report is to address this issue. There is no perfect way to define a sector as a cyclical or a defensive. In this piece, we review the generally accepted definitions. We draw two conclusions from our assessment; (i) the GICS1 sectors are too broad to get an accurate representation of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD Composite Leading Indicator (LEI), is lacking. We propose a different approach, which looks at the GICS2 sectors and applies an average of the market beta and the correlations to a set of global macro as well as financial variables sensitive to the global economy. This novel approach leads to a cyclicals/defensives equity performance that is more properly aligned with the global economic cycle. Challenging the Accepted Approach Each of the definitions of the cyclicals/defensives split has its own merit. For example, our own preferred definition of cyclical equities excludes the tech sector, because it sports a negative correlation with interest rates.     Finance theory posits that companies (or sectors) may be categorized based on how they perform in different phases of the business cycle. Consequently, cyclical companies should perform better in the first stages of a new business cycle (especially coming out of a recession) and defensive companies should shine during downturns. Table 1Definitions Matter MSCI defines cyclical and defensive sectors by measuring the correlation between sectors’ relative annual performance to the annual change in the OECD Composite Leading Indicator (LEI) of the corresponding region.1 Table 1 presents the current MSCI classification. There are two issues with this approach. First, results differ substantially depending on the sample period (Table 2). GICS1 sectors match their definitions when using the full history available (from 1995 to present). However, on shorter samples, starting for example from 2005 or 2015, the correlations do not necessarily support the current MSCI classification; the communication services sector correlates negatively with the Euro Area OECD LEI from 2005 to present,2 while the energy sector displays a positive correlation since 2015. Table 2Cyclicality Changes Over Time Looking at the five-year moving correlation of the relative performance of European sectors to the annual change in OECD LEI, four things stand out (Chart 2). First, the energy sector displays a positive correlation, meaning that it behaves as a cyclical. Second, it is not clear that communication services should be labeled a cyclical sector. Third, although tech has on average displayed a five-year moving correlation with activity of around 0.5, it is increasingly behaving like a defensive sector. And fourth, over the past 20 years, all sectors have at one point or another moved from a positive (negative) correlation to a negative (positive) one. Chart 2Cyclicality Is Not Static The second issue with the MSCI approach is the use of the OECD LEIs. While the OECD LEIs are satisfactory at capturing the peaks and troughs in economic activity, we have some concerns over relying on this measure alone to label a sector as cyclical or defensive. Many of the country’s LEIs already include stock prices. Moreover, academic studies have found that the LEIs performed worse than some of their single component indicators, but displayed more accuracy – that is, fewer false signals. In particular, financial components used in some of the country’s LEIs, such as interest rates, spreads, and credit indicators, proved to be better classifiers of both growth and business cycles than the overall LEIs. Chart 3Global Growth Sensitivity Finally, many (if not most) of the components of the LEIs are domestic variables. As a result, they may not properly reflect how the global economic and trade cycles affect an economy such as that of the Euro Area. In fact, the correlation between the relative performance of Euro Area cyclicals versus defensives and the annual change in the US and Global LEIs is similar to the correlation between the cyclical/defensive split and the Euro Area LEI (Chart 3).3  Reclassifying Cyclicals And Defensives We may draw two conclusions from our earlier assessment; (i) the GICS1 sectors are too broad to secure an accurate definition of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD LEI, is insufficient. Granularity Holds The Key Many industries or sectors have experienced profound changes over the past decades. Industries evolve and new ones emerge that may disrupt the status quo. For instance, today’s tech sector shares few similarities with its past-self twenty years ago. Chart 4AMore Granularity Needed (I) Without getting to the company level, many GICS2 sectors already exhibit characteristics deviating substantially from those of the GICS1 sectors of which they are a part (Chart 4A & 4B). Most noticeably: Within industrials: commercial and professional services (9% weight) have a negative correlation with the LEI of -0.23 (Chart 4A, top panel). Within consumer discretionary: the correlation of the retailing sector with the LEI (15% weight) went from 0.75 in the early 2010s to -0.5 in 2018 and has since been trending toward 0 (Chart 4A, third panel). Within tech: software and services (46% weight) sport a negative moving correlation of -0.25, and highlight that this sector has effectively become akin to “digital utilities.” Meanwhile, technology hardware and equipment display a correlation close to 0 (Chart 4A, fourth panel). Chart 4BMore Granularity Needed (II) Within communication services: telecommunication services (78% weight) still behave like a defensive sector, and it appears that the cyclicality of the GICS1 sector is driven by media and entertainment stocks (Chart 4B, top panel). Within consumer staples: food beverage and tobacco (53% weight) now display a positive correlation of 0.1 with the LEI, whereas it used to have a -0.8 correlation until 2018 (Chart 4B, second panel). Within energy: GICS2 sectors have displayed positive correlations since 2015 (Chart 4B, third panel). For the remaining GICS1 sectors, namely materials, financials, utilities, and healthcare, except for large swings observed in the past, their respective GICS2 sub-sectors currently display correlation coefficients sharing the same sign as their broader aggregates. Thus, adding granularity by looking at the GICS2 sector level instead of the GICS1 classification when creating cyclical and defensive baskets offers a more accurate picture. Good Old Beta Is the market itself the best indicator of a stock’s cyclicality? The returns on the stocks of cyclical (defensive) sectors should reflect high (low) correlation with the market index’s returns. Table 3A presents the beta coefficients obtained from linearly regressing the monthly equity returns of European GICS1 sectors on the monthly equity returns of the All-Country World benchmark. We run into the same issue of getting different results based on the sample period. Historically, the energy sector has had a beta coefficient below 1, but, from 2005, its beta has risen to 1.12. Meanwhile, communication services has a beta coefficient below 1 across all three sample periods selected. Table 3AGICS1 Beta Coefficients We perform the same exercise at the European GICS2 sector level (Table 3B). The results reify the benefit of additional granularity when defining cyclicals and defensives. Table 3BGICS2 Beta Coefficients Combining Correlations With Macro And Financial Variables While stock prices are certainly anticipatory, at times they can also decouple from the business cycle. Equity markets and stock indices are becoming more concentrated, which means that measuring cyclicality through beta alone is no longer sufficient. We complement the use of the beta coefficients with a composite measure of cyclicality based on correlations with global macro and financial variables. We select the following global macro variables (Chart 5A):​​​​​​​ Global Manufacturing PMI Global Industrial Production G3 Capital New Orders Global Exports Chart 5AGlobal Macro Variables Selected Chart 5BFinancial Variables Selected And we opt for the following high-frequency financial variables (Chart 5B): Trade-weighted USD: The cyclicals-to-defensives ratio and the trade-weighted US dollar display a robust negative correlation. A strong dollar both tightens global financial conditions and indicates weaker economic growth. GS Commodity Price Index: Commodity prices reflect both global supply and demand dynamics. Strong economic activity usually lifts commodity prices, while a slowdown hurts commodity demand. US 10-year Treasury Yield: The relationship with the US 10-year Treasury yield is somewhat more complex. At the beginning of a new business cycle, higher yields reflect reflation and usually correlate with an outperformance of cyclical equities. However, if yields rise too much, they start hurting growth prospects and end up damaging cyclicals. If they fall, it usually reflects increasing growth fears, which is negative for cyclical shares. Junk Spreads: US high-yield corporate bond spreads and the cyclicals/defensives ratio have a strong negative correlation. Widening junk spreads coincide with the end of the business cycle when fears of rising default risk precede a recession. Although these financial variables are highly anticipatory, they are also prone to whipsaws. Consequently, they must be viewed in conjunction with macro variables. We also compute the five-year moving correlations between monthly equity returns of European sectors relative to the ACW benchmark and the two sets of macro and financial variables (Table 4A & 4B). The results are broadly consistent between the long-term correlations with macro and financial variables, as well as with the beta coefficients,4 which comforts us into using a simple average of the three. Table 4ACombining Coefficients For GICS1 Sectors Table 4BCombining Coefficients For GICS2 Sectors At the GICS1 sector level, our new approach indicates that the energy sector should be treated as a cyclical, not a defensive. In fact, it displays more cyclicality than the tech sector. Communication services should also be defined as cyclicals, although it is less of a clear cut than for the other sectors since the adjusted beta coefficient is the culprit behind the negative sign. Taking a closer look at the GICS2 sector level once again provides valuable insight. The computed mean correlation for cyclical GICS2 sectors is 0.34, with a variance of 0.04 and standard deviation of 0.2. For defensive GICS2 sectors, the computed mean correlation is -0.23, with a variance of 0.02 and a standard deviation of 0.13. Assessing This New Approach Having reclassified the GICS2 sectors as cyclicals or defensives, the next step is to assess how this approach performs compared to the MSCI definition of cyclicals/defensives. To do so, we use the average coefficients displayed on Table 4B to create a dynamic basket of cyclicals and defensives GICS2 sectors. These baskets are weighted by market capitalization and are updated monthly. Chart 6New Baskets Of Cyclicals/Defensives Chart 6 shows how the novel cyclical vs. defensives performs over time in the Euro Area relative to the other definitions. Next, we perform a simple back-testing exercise to assess the performance over time of the new cyclicals-to-defensives ratio, with the Global Manufacturing PMI as a control variable. A superior definition of cyclicals vs. defensives should lead to a better performance of cyclicals when the PMI is above its 50 boom/bust line and improving, and to a better performance of defensives when the PMI is below 50 and deteriorating. We look at coincident equity returns (Table 5A). Overall, the results indicate that our new approach is superior and more accurate, both on a 3- and 12-month time horizon. This is especially true when the global economy is deteriorating. When the PMI is below 50 and falling, our basket of defensives outperforms our basket of cyclicals on average by 20% on a 12-month horizon, compared to 14% using the MSCI definition. Table 5AAssessing The Performance (I) The subsequent performance of cyclicals relative to defensives following certain thresholds for the PMI also reinforces our new approach (Table 5B). Interestingly, our new basket of defensives is the only one to outperform cyclicals twelve months after the Global Manufacturing PMI deteriorated over several months and is below 50. Table 5BAssessing The Performance (II)​​​​​​​ Bottom Line: We are introducing a new approach to defining cyclical versus defensive equities. GICS1 sectors are too broad to achieve an accurate definition of cyclicality. However, the GICS2 classification offers the necessary level of granularity to do so. Moreover, we broaden the set of variables used to determine whether a GICS2 sector is cyclical or defensive. This new approach offers tighter links with the state of the global economy when selecting cyclical or defensive portfolio biases. For now, since EM economies and China remain under duress and the USD has yet to roll over clearly, we maintain our preference for defensive stocks over their cyclical counterparts within equity portfolios.   Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Amr Hanafy Associate Editor AmrH@bcaresearch.com Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     Applied Research MSCI, “Index Performance in Changing Economic Environments,” 2014, p. 4. 2     Admittedly, communications services – formerly known as telecommunication services – was removed from the list of defensive sectors and classified as a cyclical one following the 2018 GICS structure adjustment. 3    In the remainder of the report, the relative equity performance of European sectors is measured against the ACW index. 4    We normalized the beta coefficients to have a mean of zero, to be comparable with correlation coefficients.

Executive Summary We continue to recommend overweighting risk assets in multi-asset portfolios over the next six months because we believe financial markets have prematurely priced in too much pessimism. Against a particularly uncertain macroeconomic backdrop, we think all investors should have reduced conviction in their views. Asking how one could be getting it wrong is especially relevant today. We identify seven prominent risks to our view, with unanchored inflation expectations and consumer retrenchment posing the biggest threats to our risk-friendly recommendations. The former would imply economic overheating that would prompt the Fed to squash the expansion; the latter would herald a period of insufficient growth. Inflation Expectations Are Still Contained Bottom Line: We are on the alert for several ways our glass-half-full view could be disappointed but none of them has yet emerged. We continue to recommend positioning a portfolio in line with it. Feature We will be taking our summer vacation this week and will not publish next Monday, August 29th. We will resume our regular publication schedule on September 5th. Chart 1Overdone We held our quarterly webcast last week, in which we reiterated three main points that will be familiar to US Investment Strategy readers. One, the demise of the American consumer has been greatly exaggerated. Two, monetary policy works with a lag. Three, stubbornly high inflation will bring about the end of the expansion and the bull markets in equities and credit, but not just yet. Those points reinforce our view that equities and credit will outperform Treasuries and cash over the rest of the year and place us at the more bullish end of the continuum inside and outside of BCA for the near term, though we are much more circumspect about the prospect for risk assets over the next twelve months and beyond. We also spent some time digging into the reasons that we are more constructive than the average bear. Those reasons largely revolved around the idea that financial markets prematurely discounted the negative effects that will follow sometime after the Fed flips monetary policy settings from easy to tight. After tightening sharply over the first half of the year (Chart 1, top panel), we think financial conditions are due for a break as Treasury yields settle into a well-defined range (Chart 1, second panel), credit spreads consolidate their retracement after sharply widening (Chart 1, third panel), the S&P 500 finds a footing and retraces more of its first half losses (Chart 1, fourth panel) and the dollar, cooling off after a torrid run (Chart 1, bottom panel), prepares to weaken over the intermediate term. We did not have time to answer all the questions from the webcast Q&A before the hour was up and we spent much of the week replying to them over email. Several of the questions asked what we are most worried about, or which indicators are most likely to signal that we are getting the outlook wrong. We ask ourselves these questions continuously and they are an ideal way to conclude a gathering like last Monday’s. Although we didn’t get to address them live, examining the biggest risks to our view as a coda in this week's bulletin is the next best thing. Risk #1: Unanchored Inflation Expectations We view a breakout in inflation expectations as the biggest risk to our view. If households, businesses and investors were to expect that inflation would inflect meaningfully higher over the long term, they would adjust their behavior in ways that could make high inflation beget still higher inflation. The ensuing self-reinforcing cycle would become much more difficult for the Fed to break and would presumably involve a stark repricing of Treasury securities and risk assets. Related Report  US Investment StrategyRisks To Our View We have been warily monitoring inflation expectations over the near term (0-2 years, top panel in Charts 2 and 3), the intermediate term (3-5 years, middle panel) and the long term (6-10 years, bottom panel), as has the Fed. We have become increasingly emboldened by the stability of the intermediate- and long-term series, even in the face of the highest measured inflation in 40-plus years. Now that near-term expectations have rolled over, some of the risk that elevated current inflation will begin to bleed into long-run expectations is fading. We remain relieved that businesses, investors and consumers (Chart 4) have not yet assumed high inflation will persist but if longer-run inflation expectations threaten to become unanchored, we will abandon our constructive take on the economy and risk assets. Chart 2High Reported Inflation ...​​​​​​ Chart 3... Has Yet To Translate Into ...​​​​​​ Chart 4... Meaningfully Higher Long-Run Inflation Expectations Risk #2: A Renewed COVID Breakout The other risks are not as significant as unmoored inflation expectations but they are meaningful nonetheless. A renewed COVID breakout that imposed the de facto equivalent of rolling blackouts in production and transportation would partially undo the supply chain improvements that have helped relieve some of the upward pressure on goods inflation while hampering global growth. That could have the doubly negative impact of squeezing S&P 500 earnings while rekindling inflation pressures, nudging the US and global economies toward stagflation. Effective vaccinations and treatments have rendered COVID little more than a nuisance in the States (Chart 5) and other developed nations, but if the pandemic surges back to life elsewhere in the world, we would have to reconsider our more constructive take. Chart 5Initially A Scourge, COVID Is Now An Annoyance Risk #3: Geopolitical Pressures Our in-house geopolitical experts were among the first to sound the alarm on Ukraine early in the year. A worsening of the conflict there, or anything that imperils Europe’s access to energy supplies or further restricts global supplies of grain, will also cloud the picture for risk assets. Our geopolitical team has long viewed the Taiwan Strait as a potential major geopolitical flashpoint and a sharp increase in Sino-American tensions would make us reconsider our thesis as well. Our in-house team warns that Iran could be another source of instability and we will have to remain aware of the potential for geopolitics to throw a wrench into otherwise neutral-to-bullish macro conditions. Risk #4: US Consumers Lose Their Nerve Though we haven’t tried to rank the risks beyond a breakout in inflation expectations, a big pickup in the savings rate is the second largest risk on our list. If households reverse field and start saving their disposable income at a rate above their post-crisis/pre-pandemic average (Chart 6), it would signal that their aggregate consumption decisions were beginning to match their gloomy responses to confidence surveys. That would erode our conviction that they will deploy their excess pandemic savings to keep consumption – and the US economy – expanding near its trend rate. If consumers begin to circle the wagons in paradox-of-thrift fashion, it would present a nearly insurmountable obstacle for our thesis. Chart 6A Massive Savings Cushion To Support Consumption ... Risk #5: Consumer Credit Deterioration As SIFI bank executives noted in last month’s second quarter earnings calls, consumer credit has performed spectacularly well. Credit card net charge-offs are hovering at all-time lows, mortgage foreclosure rates are microscopic, and the only signs of stress have emerged, faintly, at the lowest ends of the wealth and income distributions. The very gentle softening in consumer credit that lenders have seen so far (Chart 7) could turn into something more worrisome if inflation fails to moderate and/or the jobs market goes south. If consumer credit begins palpably deteriorating, it would signal that the excess savings buffer does not offer as much protection as we thought. Chart 7... And Consumer Credit Risk #6: A Softening Labor Market Chart 8Still A Lot Of Help Wanted An extremely robust labor market has helped solidify our conviction that a sizable moat protects the US economy from unwelcome near-term surprises. Despite evident deceleration in growth over the first half of the year, net payrolls have continued to grow at a rapid clip and ongoing demand for additional hires (Chart 8) remains strong. The labor market could soften more rapidly than it has so far or than we project it will in the near term. Risk assets’ window for outperformance will shorten the faster the labor demand moat shrinks. Risk #7: Technical Support Could Prove Fleeting We have been further encouraged by the ease with which the S&P 500 sliced through resistance around 4,175 on its second try last week and has remained above that level (Chart 9). We see 4,175 providing tactical support to the index, limiting its near-term downside. If the support were to fail a test, we will be forced to re-evaluate US equities’ near-term risk-reward profile. Chart 9The S&P 500 Appears To Have Some Near-Term Technical Support A client alerted us last week to a longer-term technical pattern that might serve to put a bottom under equities. Since 1950, no bear market has made new lows after retracing at least 50% of its decline. We explored the pattern beginning with the November 1968-May 1970 bear market and found that tests of the 50% retracement level were few and far between. The bear market action of the last 50-plus years by no means guarantees that the S&P 500 will encounter difficulty punching back through the 50% threshold (4,231.67) it crossed on Friday August 12th, but the index has gathered some positive technical omens during its two-month rally. Investment Implications There is no shortage of potential risks right now and we reiterate our heightened vigilance. Investors must contend with the combination of a once-in-a-century global pandemic, the unprecedented fiscal and monetary responses to its outbreak, the first major cross-border war in Europe since 1945 and four-decade highs in inflation across major developed economies. Our conviction levels are lower than normal and our inherent compulsion to ask where we could be getting it wrong now verges on paranoia. Though we are continuously looking over our shoulder, we are comforted by nearly unanimous glass-half-empty sentiment. We still believe that it won’t take much for corporate earnings and the economy to surprise to the upside. The latest iteration of the Bank of America Merrill Lynch portfolio manager survey revealed that sentiment is no longer “apocalyptically bearish,” but we still expect that relative performance pressures will prod many bearishly positioned managers to cover their risk asset underweights. We remain constructive on risk assets over the next six months, though we will likely take some chips off the table if the S&P 500 rallies into the 4,500-to-4,600 range as we expect. It is a core part of our process to seek out information that may invalidate our hypotheses and we don’t even have to venture beyond the confines of BCA to gather it right now. Our differences with our colleagues are not as large as they might seem in our daily BCA Live and Unfiltered live stream, however, as they boil down to timing. We are neutral-to-bearish twelve months out, as we anticipate another equity bear market will begin around the second half of next year once it becomes apparent that the FOMC will not stand down from its 2% inflation goal. We simply think there’s money to be made from the long side in the interim.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com