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S&P 500 Chart 1Macroeconomic Backdrop Chart 2Profitability Chart 3Valuations And Technicals Chart 4Uses Of Cash Cyclicals Vs Defensives Chart 5Macroeconomic Backdrop Chart 6Profitability Chart 7Valuation And Technicals Chart 8Uses Of Cash Growth Vs Value  Chart 9Macroeconomic Backdrop Chart 10Profitability Chart 11Valuations And Technicals Chart 12Uses Of Cash Small Vs Large Chart 13Macroeconomic Backdrop Chart 14Profitability Chart 15Valuations and Technicals Chart 16Uses Of Cash Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation  

Executive Summary The constructive economic view that has us at odds with the consensus rests on three premises: excess pandemic savings will allow consumption to grow at trend, despite inflation; inflation will soon peak, moving to around 4% by year end; and inflation expectations will remain well anchored, keeping the Fed from moving immediately to stifle the economy. Our consumption thesis remains intact. Real consumption has kept pace despite falling real incomes, thanks to a steady, modest drawdown of excess savings. Though our calls for an inflation peak have been consistently premature, recent data suggest that inflation pressures are abating. Gasoline prices have been falling for seven weeks; the fever has broken in ISM survey price measures; and the labor market, notwithstanding July's potent employment report, is becoming less tight. Longer-run inflation expectations have resisted becoming unmoored despite soaring measured inflation and a breakout does not appear to be imminent. A Mighty Savings Cushion Bottom Line: We continue to expect the economy will be surprisingly resilient, allowing equities to rally further before the Fed squashes the expansion. We doubt the rally will persist very far into 2023, however, so we are reducing equities to equal weight over a twelve-month timeframe. Feature We will be holding our quarterly webcast next Monday, August 15th at 9:00 a.m. Eastern time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 22nd. Last week, an investor we were meeting for the first time asked us how anyone could have published on a weekly basis this year. “Things are so uncertain and they’re moving so fast, how do you keep up? What have you been writing about?” At long last, we felt seen. Feeding the weekly beast is not easy under the best of circumstances and investors know that this year has been far from ideal. Related Report  US Investment StrategyThe High Bar For Getting Worse Once the warm glow of unexpected empathy receded, we replied that we’ve been doing our best to anticipate how the key macro issues will impact financial markets over our cyclical 3-to-12-month timeframe, paying particular attention to consumers, inflation and the Fed. The outlook for consumption has been our primary focus from a growth perspective; we’ve been trying to assess how representative the key drivers of inflation are and how persistent they’ll be; and we’ve continuously monitored longer-run inflation expectations to determine if inflation has gotten far enough into economic agents’ heads to become self-reinforcing and compel the Fed to dislodge it, no matter the near-term economic cost. We review what we see on all three fronts in today’s report, and how events are unfolding relative to our expectations. The direction remains especially uncertain, but our theses remain intact, and we are sticking with our constructive outlook on risk assets and the economy for the rest of the year. We are pulling in our horns on our twelve-month optimism, however, in line with the BCA house view and the dawning realization that twelve months of equity outperformance is overly ambitious. We continue to believe the recession will arrive too late for the gloomy consensus of investors judged by their quarterly performance, forcing them back into risk assets, but the rebound may not persist beyond the FOMC’s first 2023 meeting at the beginning of February. The Consumer’s Staying Power Since CARES Act transfer payments began driving a surge in personal savings, we have viewed them as dry powder to support consumption once households regained the freedom to spend as they see fit. When the payments stopped flowing and the pandemic continued to delay a return to normal, that view came under some fire. We are of the mind that households merely deferred much of the services demand they would otherwise have slaked in 2020 and 2021; others argue that consumption deferred is consumption destroyed, as households will be reluctant to spend windfall transfers that they’d mentally sorted as savings. While it will take a while for data to confirm either thesis, we are encouraged by what we’ve seen so far. The savings rate has declined considerably so far in 2022, supporting the view that households would be willing to reach into their savings to maintain trend consumption (Chart 1). It dipped to 5.2% in the second quarter from 5.6% in the first quarter, well below February 2020’s 8.3% pre-pandemic level and 2011 to 2019’s 7.4% quarterly mean (Chart 2). Based on the series’ stability over the previous nine years, 2020’s and 2021’s forced savings rates amounted to 11- and 6-sigma post-crisis events and this year’s approximately -2.5-sigma drawdown suggests the pendulum has further to swing in the direction of dissaving. We disagree with knee-jerk conclusions that spending in excess of income is unsustainable – it’s plenty sustainable for households who socked away a mountain of savings over the previous eight quarters while bars, restaurants, stadiums, concert venues and resorts were idled. Chart 1Right On Target Chart 22020 And 2021 Savings Were Enormous The estimates of excess savings that we’ve been calculating every month since the summer of 2020 peaked just above $2.3 trillion last August and remained around that level before embarking on a steady decline in the first half to reach our current estimate above $2 trillion (Chart 3, bottom panel). Quoting that figure has been nagging at us lately, however, as one of the two assumptions we used to calculate households’ no-pandemic savings baseline – annualized disposable income growth of 4% – took 2% annual inflation as given, a condition that no longer applies after a twelve-month stretch in which year-over-year CPI inflation has averaged 7.1%. Chart 3Nominal Excess Savings To determine how much households' purchasing power has eroded, we deflated our monthly excess savings estimates to a level equating to 2% annualized inflation (Chart 4, top panel). The adjustment knocked $450 billion off our current estimate, trimming it to $1.6 trillion (Chart 4, bottom panel). Perhaps more importantly for the outlook, our adjustment doubled the year-to-date burn rate to $500 billion. We have always worked with the (deliberately conservative) assumption that households would spend half of their excess savings; if inflation doesn’t decelerate soon, their cushion may not last very far beyond the end of the year. Chart 4Adjusted Excess Savings Bottom Line: Households have been willing to dip into savings to maintain trend consumption so far this year, in line with our hypothesis. We expect they will continue to do so, and the savings rate will remain around 5% or fall even lower, but inflation has eaten up some of their dry powder. Will Inflation Ever Peak? Shredding widely shared expectations that inflation would peak sometime in the first half, the year-over-year increase in headline CPI has kept climbing, all the way to 9% in June. July should finally provide some relief, as the average national retail gasoline price has fallen for seven consecutive weeks and ended July 13% below its June 30 level (Chart 5). Last week’s ISM manufacturing and services PMIs also suggested that inflation has begun to ease its grip somewhat, with the manufacturing input prices series plunging by nearly 20 points to its two-decade mean (Chart 6, top panel) and the services prices component cooling by 8 points, though it remains quite high (Chart 6, bottom panel). Chart 5Four Bucks A Gallon Is High, But Not Unfamiliar Chart 6The Fever May Have Broken ...​​​​​​ Chart 7... Though The Job Market Is Still Quite Hot​​​​​ The tight-as-a-drum labor market has been a fertile source of inflation worries, but there are signs that it is becoming less tight. Job openings remain 40% above their pre-COVID high but declined by 600,000 in June and are 10% off of March’s all-time peak (Chart 7). Elevated quits reveal that it's still easy to get a job, but the net share of small businesses in the NFIB survey planning to hire in the next three months is down 40% from its peak last summer (Chart 8). The July employment report challenged the under-the-radar indicators’ implication that the labor market is cooling, as net payroll expansion reaccelerated along with average hourly earnings growth (Chart 9). We are confident that net payroll growth will slow but compensation clearly has the cyclical wind at its back, and it is not certain that labor’s structural headwind will largely offset it, as per our thesis.   Chart 8Hiring Intentions Are Back To More Normal Levels ... Chart 9... But Wage Growth Remains Elevated Inflation Expectations Longer-run inflation expectations are a critical piece of the puzzle because they are the pathway for rising inflation to become self-reinforcing. If they expect persistently higher inflation, workers will negotiate more fiercely for larger compensation increases to stay ahead of it; businesses will push more vigorously to pass on their increased costs to preserve profit margins; lenders and bond investors will demand higher interest rates to protect their real returns; and consumers will seek to buy more now to get the most from their dwindling purchasing power, exacerbating supply-demand imbalances and keeping the heat on near-term inflation readings. We are therefore closely watching inflation expectations. Market-based measures like TIPS break-evens and CPI swaps shed some light on investor and business expectations, while the monthly University of Michigan consumer sentiment survey offers insight into households’ views. Market-based measures remain well-anchored: intermediate-term expectations as implied by TIPS break-evens are just nosing above the top of the Fed’s preferred 2.3-2.5% range (Chart 10, middle panel) while long-term expectations remain below it, as they have for most of the year (Chart 10, bottom panel). Intermediate- and long-term expectations derived from CPI swaps remain 20 to 30 basis points higher but are in the same position relative to their year-to-date path (Chart 11, bottom two panels). Chart 10Market-Based Inflation Expectations ...​​​​​​ Chart 11... Are Not Problematic​​​​​​ Chart 12Just Say No (To Bottleneck Prices) The Michigan survey doesn’t betray any pressing long-run concerns. The preliminary 3.3% June reading hinting at a breakout turned out to be a false alarm, as June’s final figure was 3.1% and July’s was 2.9%. Survey respondents continue to shun big-ticket purchases because they expect prices will fall from their current levels (Chart 12). 2-year TIPS and swaps price in an optimistic near-term outlook that is likely to be disappointed, as we think inflation will prove to be sticky around the 4% level, and that disappointment could bleed into higher longer-run expectations. While expectations are not problematic now, investors will need to watch them carefully going forward. Investment Implications It was policy, monetary and fiscal, that inspired our bullish turn in 2020 once we digested the COVID shock. We thought the macro backdrop would come down to policymakers versus the virus and our money was on the former. We remained bullish across 2021 on the idea that monetary and fiscal support would remain in place well after they ceased to be necessary. Mindful that there is no such thing as a free lunch, we expected that the emergency pandemic measures would ultimately have the effect of overstimulating demand, but we entered 2022 thinking that equities and credit would enjoy one more year of sizable excess returns over Treasuries and cash before the overstimulation manifested itself. Overweighting (underweighting) equities in a multi-asset portfolio is our default position when monetary policy is easy (tight), though we will override that default when appropriate. We have no appetite for overriding it once it becomes clear that market expectations for 2023 rate cuts are going to be disappointed and tight policy is just around the bend. Given our view that inflation will linger around 4% after easing smartly over the rest of this year, we expect that the Fed will impose restrictive monetary policy settings by the second half of 2023 in its quest to drive inflation back down to its 2% target. Markets’ overly rosy Fed expectations look sure to be disappointed and they could face a reckoning after the FOMC’s January 31-February 1 meeting. Chart 13Consolidation Now, 10%+ By The End Of The Year That meeting could herald an inflection for risk assets’ relative performance and we are therefore joining our colleagues in adopting a neutral 12-month view on equities. We continue to differ from the BCA consensus, however, in expecting a meaningful equity rally before year end. While we expect technical resistance at 4,200 will restrain the S&P 500 in the immediate term (Chart 13), we think it will find its way back into the mid-to-high 4,000s before the Fed signals that it will take the funds rate to 4% or above, dashing hopes for a February peak around 3.5%. We still want to overweight equities in multi-asset portfolios, but only until year-end or 4,500 to 4,600, whichever comes first.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com