Developed Countries

Executive Summary Small Do Poorly During The Slowdown Phase Small Caps are a more cyclical and high-octane version of Large Caps. Small underperforms Large during the slowdown stage of the business cycle. The yield curve is flattening and is close to inversion – a signal that does not bode well for the outperformance of Small vs. Large either. Rising high-yield spreads are a bad omen for the outperformance of small caps. Small caps are incredibly cheap both in real and absolute terms. They are also oversold. The profitability of both small and large companies is under pressure, but small companies have fewer resources and are less resilient. Earnings growth estimates for both Large and Small are unrealistically high and misleading. We expect an earnings recession, and negative earnings growth is likely for both asset classes. Bottom Line: Small caps are a more cyclical, lower quality, high-octane asset class than Large caps and face significant macroeconomic headwinds from slowing economic growth. We recommend underweighting Small relative to Large, despite attractive valuations, until macroeconomic uncertainty dissipates, inflation turns, and earnings deceleration gets priced in. Feature In the front section of our June 6, Style Chart Pack, we upgraded Growth and downgraded Value both to equal weight, making the case that Growth vs Value divergence in performance has likely run its course – with economic growth slowing, companies with strong fundamentals and stable earnings are much more valuable. We also stated that once macroeconomic uncertainty dissipates, we will be able to pounce and shift Growth to overweight, and Value to underweight. In this week’s report, we will revisit our overweight Small/underweight Large allocation – a position that has been bleeding red ink since November. The question on our mind is what to do with an underperforming position – be patient or have losses? We ground this report in an analysis we conducted a year ago in the “Is It A Small World After All” report. Sneak Preview: The macroeconomic backdrop for Small is unfavorable, and its earnings growth is about to decelerate – yet much of the bad news is already priced in. However, Small is unlikely to outperform in a sustainable way until inflation turns, and economic uncertainty dissipates. We shift Small to underweight and Large to overweight. Premise For Our Call Last Fall We will start this report by reviewing the history of the call. We upgraded the allocation of Small vs. Large to overweight, making a case based on valuations, strong earnings growth, and demonstrated ability to outperform under duress. We also relied on the empirical analysis that showed that Small held its own in the environment of rising rates. In the “2022 Outlook” report, we highlighted risks to our call. We quote: ”If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take.” Unfortunately, most of the risks we highlighted have come to pass. Since October 4, the S&P 600 has underperformed the S&P 500 by 5.5%, with most losses accumulating between December and February  (Chart 1). Small is down 26% off its peak in November, 2021. However, recently its relative performance has stabilized (Table 1). What’s next? Chart 1Small Outperformed On The Back of Post-Covid Recovery, But Has Been Lagging Ever Since Table 1Performance Summary Small Vs. Large Sector Composition The differences in sector composition of the S&P 500 vs. the S&P 600 have profound implications for relative performance during different stages of the business cycle and various macroeconomic regimes. On a sector level, Small has a higher allocation to Financials, Industrials, and Real Estate, while Large has more weight in Technology and Healthcare (Chart 2). Chart 2Small Vs. Large Sector Breakdown By grouping sectors into the cyclical vs. defensive categories, we observe that Small has a lower allocation to Defensives, and a higher allocation to Cyclicals: The Cyclical/Defensive gap between the asset classes is roughly 18%. This also indicates that Small has higher operating leverage than Large. Small is also overweight early cyclical sectors by 8% (Chart 3), which explains the underperformance of small-capitalization stocks at times of strain (corrections, economic contraction, a risk-off environment), as well as the “out-of-the-gate” behavior during recoveries and bear market rallies. Small’s higher weight in Financials increases its sensitivity to the slope of the yield curve. Chart 3Small Vs. Large Style Breakdown Bottom Line: Small is a more cyclical and high-octane version of Large. Macroeconomic Backdrop Nothing matters more for the relative performance of Small vs. Large than a macroeconomic backdrop that highlights differences in sector composition, credit quality, and intrinsic profitability of these asset classes. Large Caps Reign During The Slowdown Stage Of The Business Cycle The May inflation surprise has solidified the Fed’s resolve to fight inflation, which it executes by aggressive tightening of monetary conditions. A tighter monetary policy is designed to slow economic growth and curtail demand (Chart 4). As we have written over the past several months, US economic growth is already slowing and is surprising on the downside (Chart 5). Bloomberg consensus expects the economy to grow at 2.5% over the next 12 months, which is a sharp slowdown from 2021. Chart 4Financial Conditions Are Tight... Chart 5...And Economic Growth Is Slowing Small caps tend to underperform larger companies during the slowdown stage of the business cycle (Chart 6) due to their overweight in Early Cyclicals and shortage of Defensive Growth. In addition, slower economic growth hits smaller and less profitable companies much harder than their larger brethren. Bottom Line: Small underperforms Large during the slowdown stage of the business cycle. Chart 6Small Do Poorly During The Slowdown Phase Yield Curve Flattening Is Unfavorable For The Outperformance Of Small Small caps thrive in an environment of accelerating growth, which is a necessary tailwind for smaller, younger, and less profitable companies. A flatter yield curve signals upcoming growth deceleration, which is a drop of poison in the outlook for Small (Chart 7). In addition, small caps have a higher allocation to regional banks, which are extremely sensitive to the shape of the yield curve. The spread between the borrowing rate (the short-term rate on deposits) and the lending rate (on long-term loans) is the source of profitability and determines the bank’s net income margins. Prior empirical analysis validates this: During periods of a flattening yield curve, Small underperformed Large over the following three months (Chart 8). Chart 7Flattening Yield Curve Drags Down Relative Performance Of Small Vs Large Chart 8Small Underperforms When Yield Curve Is Flattening Recently the Treasury 10-2Y curve has flattened, coming down from 0.9% in January to 0.1% by the end of June, and is dangerously close to inversion, which is a classical predictor of a looming recession. Bottom Line: The yield curve is flattening and is close to inversion – a signal that does not bode well for the outperformance of Small vs. Large. HY Spreads Also Signal Underperformance Another important signal for Small vs. Large is the direction of change in HY spreads. Small caps are riskier and more leveraged than their large-cap peers (Chart 9). Not surprisingly, they also tend to have lower credit ratings: Indeed, the median rating for a small-cap stock is B+, which falls straight into the high-yield territory. As a result, the fate of small caps is closely tied to that of HY debt and is linked to both its spreads and its default trends. Higher yields and higher defaults would be a sign of distress for the small-cap universe. Therefore, the relative performance of small caps is inversely correlated to HY spreads (Chart 10A). Chart 9Small Caps Are More Leveraged Than Large Caps Over the past several months, HY spreads have blown out from 2.8% to 5.2% and will continue widening in the near future: As the US economy is edging towards a recession, historically low default rates are likely to rise. Spreads widening off an already high level of 500 bps historically have been followed by relative underperformance of Small over the next three months 60% of the time (Chart 10B). Bottom Line: Rising high yield spreads are a bad omen for the outperformance of small caps. Chart 10ASmall Caps Performance... Chart 10B...Is Inversely Correlated With HY Spreads Inflation Regimes Having razor-thin margins, smaller companies hate inflation. Not only do they have difficulty budgeting and planning ahead but also they are often not able to convert sales growth into earnings growth, i.e., their costs may grow faster than their revenues. According to the most recent NFIB survey, 28% of small businesses consider inflation their biggest problem compared to 1-2% in 2019 (Chart 11). The second largest problem is labor quality concerns at 23%. Of course, these two problems are inherently interlinked, igniting a wage-price spiral. Empirical analysis of the relative performance of Small vs. Large in different inflation regimes since 1984 suggests that unless inflation rolls over, Small is likely to continue to underperform (Chart 12). Bottom Line: Small will outperform once inflation turns the corner. Until then, it will lead bear market rallies that will be spurred by hopes of falling inflation and a less hawkish Fed. Chart 11No Comments Needed Chart 12Inflation Is A Major Headwind Valuations And Fundamentals Small Caps’ Valuations Are At The Lowest Level In A Decade Small caps were very cheap back in October, but they have gotten even cheaper since then. Yet another example of valuation being a poor timing tool: All too often, cheap assets just keep getting cheaper, and expensive assets get more expensive. Currently, small caps trade with a nearly 30% discount to Large both on a forward and on a trailing earnings basis, while historically, a small-cap premium was more of the norm (Table 2). The small caps’ valuations have hit the lowest level in 10 years, both on an absolute and relative basis. The BCA valuations indicator is trading more than two standard deviations below its historical average (Chart 13, top panel). The BCA technical indicator signals oversold conditions (Chart 13, bottom panel). Chart 13Cheap For A Reason Table 2Valuations Summary Bottom Line: Small caps are incredibly cheap both in real and absolute terms. They are also oversold. Small-Cap Margins Are Under Pressure Small companies are always less profitable than their large-cap brethren as they lack economies of scale, and many of these companies are either younger or less successful than bigger companies. As a result, the margins of smaller companies are usually about 500 bps lower than those of their larger peers (Chart 14). Having thin margins, small caps don’t have much room for error in dealing with the same challenges larger companies are facing, i.e., rising costs of transportation, raw materials, and energy. Yet, it is the cost of labor, which is stickier than other components and is the largest component of cost structure, that has the potential to dent the profitability of small caps. The NFIB survey shows that 25% of small businesses intend to raise employee wages, which are growing at over 5.5%. It is not surprising, that on a net basis, nearly 25% of small companies reported declining profitability (Chart 15). Therefore, it is unsurprising that margins of Small have also started to contract. Chart 14Margins To Contract Chart 15Profits Are Collapsing Bottom Line: The profitability of both small and large companies is under pressure, but small companies have fewer resources and are less resilient. Earnings Expectations For Small Have Turned Down, Albeit From High Levels The market expects the S&P 500 and the S&P 600 to grow earnings by 10% and 13% respectively over the next 12 months (Table 3). Small is getting more analyst upgrades than Large (Chart 16). Table 3The Street's Forecasts We concluded in the “Is Earnings Recession Likely?” report that earnings expectations are unreasonably high and don’t reconcile with the underlying economic conditions. Slowing economic growth is bound to weigh on earnings growth (Chart 17). We believe that an earnings recession is likely and estimates just do not reflect the reality on the ground and need to come down. Chart 16But Sell-side Analysts Are Optimistic Chart 17Earnings Have Turned Arguably, small-cap earnings growth will contract more than that of large caps, as Small is a high-octane, high-beta asset class with high exposure to cyclicals and a higher degree of operating leverage. Bottom Line: Earnings growth estimates for both Large and Small are unrealistically high and are misleading. We expect an earnings recession and negative earnings growth is likely for both asset classes. Investment Implications To sum up the analysis, we have put together a Small/Large scorecard (Table 4). Table 4Scorecard We conclude that the macroeconomic backdrop is extremely unfavorable for Small compared to Large. Small caps tend to underperform in the environment of slowing growth as lower levels of profitability make this asset class vulnerable in a downturn. Rising high yield spreads and the increasing probability of defaults don’t bode well for Small as it is a lower-quality asset class. Inflation is also a headwind. And last, earnings expectations for both Small and Large are too high and do not reflect the reality on the ground – earnings growth will decelerate, and earnings of Small will contract further than Large. On the positive side, Small is incredibly cheap both in relative and absolute terms. It is also oversold relative to Large. It is fair to conclude that much of the adversity is already priced in, and Small is unlikely to fall much further. On the first whiff of lower inflation, Small will bounce and will outperform Large and other asset classes. However, sustainable outperformance is unlikely until inflation rolls over and monetary conditions stabilize. We believe that for patient investors with a long investment horizon, buying Small at this level is attractive. However, on a tactical basis, we will underweight Small relative to Large until macroeconomic headwinds clear. Bottom Line Small caps are a more cyclical, lower quality, high-octane asset class than Large caps and face significant macroeconomic headwinds from slowing economic growth. Their profitability is also under pressure from rising costs of raw materials and spiraling labor costs. We recommend underweighting Small relative to Large, despite attractive valuations, until macroeconomic uncertainty dissipates, inflation turns, and earnings deceleration gets priced in. We also want to highlight that Small will be a certain leader in the bear market rallies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum 

Executive Summary Though the BCA House View has downgraded global equities to neutral, US Investment Strategy still recommends overweighting equities in US multi-asset portfolios over the coming twelve months. We believe that financial markets have prematurely discounted a sharp economic downturn. The selloff is an opportunity to get long equities if the recession fails to begin this year and/or turns out to be mild. We were surprised and disappointed by the May CPI report but view it as merely a delay in the flow of evidence confirming our view that inflation is peaking, not a repudiation of it. Inflation expectations will shape the intensity of the Fed’s efforts to lean against the economy, but the University of Michigan consumer survey that placed it on high alert was only preliminary and market-based measures of longer-run inflation expectations remain contained. History, folklore and popular culture all suggest that wage-price spiral fears are overdone. The Bear's Here; Where's The Recession? Bottom Line: Although the odds of an adverse outcome are rising, we maintain a constructive base-case view on the twelve-month prospects for US equities and the US economy, subject to a meaningful decline in inflation over the rest of the year. Feature At our monthly editorial view meeting last Monday, BCA researchers voted to downgrade the 6-to-12-month House View on equities to neutral from overweight. The US Investment Strategy team argued for an overweight recommendation and cast our vote with the minority to maintain it. Though we are on the opposite side of the slight plurality that voted to underweight equities, we acknowledge that the risks to our constructive view have risen. The difference between our view and the BCA consensus is mainly a matter of timing – while we believe the US economy is on its way to a recession, we think the journey will be more winding than expected. The Timing And Severity Of The Gathering Storm Recession was the key economic issue informing our investment strategy decision: When will it begin (if it hasn’t already) and how severe will it be? The domestic economy is clearly slowing, and the Eurozone and China face sizable pressures. As Chief Global Strategist and Director of Research Peter Berezin highlighted, every one-third-percentage-point increase in the three-month moving average of the unemployment rate has been followed by a recession. Mean reversion and the Fed’s campaign to combat inflation by cooling off demand suggest that the unemployment rate will soon be rising, en route to crossing the one-third-of-a-point threshold. Related Report  US Investment StrategyThe Yield Curve As An Indicator Though we noted last week that a return to the pre-pandemic labor force participation rate would allow payrolls to expand despite a rising unemployment rate, the expansion’s days are numbered. A broad range of series, from payroll employment (Chart 1, top panel) to the Leading Economic Index (Chart 1, middle panel) and consumer confidence (Chart 1, bottom panel), echoes the unemployment rate’s message: once the economy begins to move in the wrong direction, a recession eventually follows. Our read is that financial markets have overlooked the eventual aspect in their headlong rush to price in the effects of the Fed’s promised tightening campaign. While no one can pinpoint the equilibrium fed funds rate’s exact position, all agree that it’s nowhere near the current 1.5-1.75% target. Tight monetary policy is a necessary (but not sufficient) precondition for a recession; based on the latest guidance provided by Chair Powell and the dots, it looks like it won’t be met until around the end of the year. Once it is, the start of the recession will be subject to debate (Chart 2, top panel), along with its impact on the economy (Chart 2, middle panel) and equities (Chart 2, bottom panel). Chart 1Recessions Occur Once Key Metrics Roll Over Chart 2Predictions About The Future Are Hard As it dawns on investors that the recession is approaching at a meandering pace, and that it may turn out to be mild, equities will likely retrace some of their losses. The vicious May/June selloff was predicated on forecasts that a Category 4 or 5 hurricane could be arriving soon. If the storm system is downgraded to a Category 2 or 3 event, and the date that it’s due to make landfall is pushed back by two or three quarters, we expect that a playable rally will unfold. 4% Is Easy, 2% Will Be A Bear Our relatively constructive base-case view is predicated on the idea that core inflation has peaked and will soon begin declining toward 4% of its own accord. If inflation shows clear and convincing evidence of trending down over the rest of the year, the Fed will not feel obligated to race to push the fed funds rate to a restrictive level. The longer it takes for monetary policy to become restrictive, the longer it will take for the recession to begin. The further the recession can be pushed out into the future, the harder it will be for restless investors and asset allocators to stay on the sidelines as the dire scenario discounted in equity prices fails to materialize. Conversely, if the Fed has to proceed as rapidly as possible to regain the upper hand over inflation, the recession timetable will be accelerated, and the downturn may be more severe than anticipated. We were therefore relieved to hear our Chief US Bond Strategist, Ryan Swift, reiterate his team’s view that inflation will recede to 4% independent of any policy intervention, provided that pandemic-driven supply constraints unwind. Ryan cites the Atlanta Fed’s decomposition of core inflation into flexible and sticky components to illustrate how pandemic-fueled inflation in flexible categories that tend to experience more pricing variability, like new and used vehicles, hotel room rates and airfares, have pushed up the overall series to double-digit levels. The sticky subset, including rent and medical care, is elevated itself, but if the flexibles undershoot on their way back to the mean, year-over-year core CPI can end the year in the 4% neighborhood (Chart 3, top panel). Chart 3Not As Bad As It Looks An 8% trailing four-quarter increase in unit labor costs – a wage measure that considers compensation per unit of output instead of compensation per unit of time – would suggest on its face that inflation isn’t likely to dip to 4% any time soon. The four-quarter measure has been skewed by wild post-pandemic swings in productivity growth, however. Smoothing out those swings by using the annualized trailing five-year trend in productivity to deflate the 12-month growth rate in average hourly earnings yields a much easier to stomach 3.8% rate of compensation growth (Chart 3, bottom panel). With reference to other more nuanced measures of the underlying inflation trend and a deeper dive into the outlook for automobile prices, which will fall as demand wanes and supply increases, our bond strategists expect core CPI to move toward 4% across the rest of this year while the expansion continues, albeit at a slower pace. Unfortunately, sticky shelter is the largest component of core CPI, and labor market strength will keep residential rents growing at an elevated level consistent with 4% inflation. The Fed will have to lean heavily on the economy to get inflation from 4% back down to its 2% long-run target, and that should induce the recession markets have discounted. Our position is that the recession won’t begin until the second half of 2023 or the first half of 2024. Expectations Are Still Well Anchored Chart 4Still Anchored Chair Powell repeatedly cited increasing household inflation expectations as a driver of this month’s 75-basis-point rate hike following the preliminary June University of Michigan consumer sentiment survey’s sharp move higher (Chart 4, bottom panel). The Michigan survey is not the last word on inflation expectations, however, and 5-year-on-5-year TIPS breakeven rates are in line with the Fed’s 2% target (Chart 4, top panel). 5-year-on-5-year CPI swap rates have also remained well behaved (Chart 4, middle panel) despite the volatility in reported inflation and near-term expectations measures. We have been watching the evolution of inflation expectations carefully and will continue to do so; if they remain well anchored, and measured inflation comes down in line with our expectations, we are likely to remain constructive. A Half Century Of Bear Markets The fact that the S&P 500 has entered a bear market despite rising earnings estimates has stimulated a lot of discussion within BCA. More bearish observers’ general take has been, “If stocks are down almost 25% while earnings are up 8% since the start of the year, they’re in real trouble once the inevitable earnings declines arrive.” We have countered that a 30% valuation haircut on inchoate recession expectations could be considered extreme. A review of the empirical record might advance the discussion. Table 1 lists the ten bear markets of the last 60 years, defined as a peak-to-trough decline in closing prices of at least 20% (1990's 19.9% decline has been rounded up). Half of the bear markets lasted between one-and-a-half and two years, while the remainder, excepting the current unfinished one, have been relatively sudden events, persisting for less than six months. Table 1US Equity Bear Markets, 1968 -2022 Drawdowns have ranged from 20 to 57%, with average and median losses of 36% and 34%, respectively. The mean and median duration of the bear markets have been 12 and 17 months. Bear markets and recessions tend to coincide, as we’ve frequently noted, with only the first leg of the Volcker double dip in 1980 lacking ursine company and the Black Monday bear market of late 1987 occurring outside of a recession (Chart 5). The magnitude of the 1987 bear market was no different from the 50-year average, however, though it did end swiftly. Chart 5The Bear Arrived Ahead Of Its Escort Even though the specter of restrictive monetary settings triggered the current bear, Chart 2 demonstrated that there is not a clear parallel between the intensity or duration of rate hiking cycles and the severity of the economic or market declines. Mild recessions can produce mild drawdowns, as in 1990, or severe ones, as at the turn of the millennium. Bad recessions may occur alongside terrible stock market declines (1973-74 and 2007-09) or comparatively modest ones (1980-82). All we can say now is that equities and many other public assets were priced dearly at the start of the selloff and were therefore more vulnerable while the lack of glaring imbalances suggests the economy is reasonably well insulated. The bear markets only begin to show some resemblance to one another in terms of the relative share of the declines accounted for by earnings and multiple contractions. Valuations absorb the full force of the decline during bear markets, falling 30%, while forward earnings estimates are barely revised lower. The pattern is consistent no matter where starting multiples began, though the dot-com bust produced the biggest valuation haircut of the forward earnings era (Table 2). Table 2Bear Market Earnings And Multiple Changes ​​​​​​​ The multiple/earnings breakout is mostly a function of the fact that analysts do not adjust their forward estimates in real time while prices can change from moment to moment while markets are open. The result is that the numerator of the price-earnings ratio immediately resets, while the earnings denominator adjusts only after an extended lag. Considering the peak-to-trough changes in earnings estimates, which typically play out beyond the bounds of the strictly defined bear phases, the pain is nearly equally shared. The takeaway for today is that the nearly 30% forward multiple decline is partially a placeholder for future earnings revisions and downward revisions should not be viewed as an add-on to the valuation haircut that’s already occurred. John Henry And The Wage-Price Spiral Many of our colleagues and clients are concerned about rising wages. Nominal compensation is already growing at its fastest pace in decades. Though none of the major wage series has managed to keep pace with inflation, the labor market remains undeniably tight. Rising wages threaten to squeeze corporate profits, exacerbate demand-over-supply imbalances, and act as the linchpin of a vicious circle in which rising prices beget rising prices. The wage-price spiral of the seventies and early eighties lurks at the edge of all our inflation discussions, and nearly all investors seem to view the seventies as something of a baseline. A careful read of history highlights that the spiral took hold near the end of organized labor’s 50-year heyday, however, and challenges the received wisdom that the subsequent 40-year Reagan era is an anomaly at risk of being overturned. Those waiting for labor to be delivered from the depredations of the last 40 years might do well to consider the legend of John Henry, a nineteenth-century railroad laborer in West Virginia or Virginia who drove steel drill bits into mountain rockfaces to create openings for tunnel-blasting explosives. Henry competed against the newly invented steam shovel to see if a man could hew his way through the rock faster than a machine. Henry won the race but succumbed to exertion while doing so. Songwriter Jason Isbell’s take on the legend deftly links the pre-New Deal days with today. Labor may have the numbers, but management has the capital and the incentive to automate every process it can. We contend that wages will rise less than expected over the rest of this expansion and in the early stages of the coming recession, as labor faces a steeper climb than is widely recognized. A few years of cyclical labor market tightness will not be enough to overcome the structural advantages that employers have obtained over the last four decades and guarded jealously in John Henry’s time, before New Deal legislation temporarily leveled the playing field.   It didn’t matter if he’d won/ If he’d lived or if he’d run/ They’d changed the way his job was done/ Labor costs were high   That new machine was cheap as hell/ Only John would work as well/ So they left him layin’ where he fell/ The day John Henry died   “The Day John Henry Died” (Isbell)   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com​​​​​​​

Executive Summary Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked​​​​​​ Chart 5Hong Kong Faces More Troubles​​​​​​ Chart 6Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia​​​​​​ Chart 11Russia Squeezes EU's Natural Gas​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration​​​​​​ Chart 16Internal Sources Of Nationalism​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades​​​​​​ Chart 21Favor Semiconductors But Not Taiwan​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks​​​​​ Chart 23Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

In this week’s report “Adaptive Expectations: Revisiting Our Views”, we concluded that the S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize, and US equities will follow a “fat and down” trajectory. We recommended that investors should overweight defensives vs. cyclicals. Accordingly, today we downgrade our overweight in Travel complex (Hotels, Cruises, and Airlines) to underweight. As a reminder, we recently moved retailing and durables categories to below benchmark. The key reason for this call is the effect of persistently high inflation on discretionary spending. In the past, we have written about the bifurcation of the US consumer, and that, while lower-income Americans are struggling with soaring prices of food, gas, and shelter, wealthier Americans are more comfortable and just shift their spending away from goods to services, such as eating out and travel. We expect strong profits for the travel sector this summer on the back of strong consumer demand and return of the business and international travel. We have discussed the drivers of the industry in these reports (here and here). Yet, markets are forward-looking, and the outlook for the industry beyond the summer months is dimming. With inflation entrenched, now even middle- and upper-class Americans as well as retirees are also starting to feel the pain. The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP (Chart 1). These are nest eggs and pensions shrinking by the day, diminishing future spending, and causing anxiety about the future. And while the S&P 500 is still at a level above the pandemic lows, adjusted for inflation, most of the gains are gone. On top of the reduced value of investments, negative real wage growth dampens consumer confidence (Chart 2). To make things worse, fears of recession and impending layoffs are pervasive in media stories, stoking fear of the future, and perhaps, making an economic downturn a self-fulfilling prophecy. Therefore, even wealthier Americans may have to tighten their belts and reduce their discretionary spending, with travel and leisure categories being on top of their list. Chart 1 Chart 2 Therefore, after the summer vacation surge is over, hotels and airlines are likely to experience slower demand which will weigh on their sales and pricing power. At the same time, these are industries most affected by the rising cost of fuel (airlines and cruise lines) and rising wages (hotels). As a result, we expect profitability to diminish and earnings growth recovery to stall. We have a negative outlook on the travel industry on a tactical time horizon. Bottom Line: Entrenched inflation is weighing on discretionary spending, and travel is likely to be the next victim of curtailed spending. We downgrade the S&P Hotels and the S&P Airlines indexes from overweight to underweight.