Developed Countries

Executive Summary Biden Can Take Risks With Russia President Biden will make a last-ditch effort to mitigate Democratic losses in the midterm elections and the effect will be still-high policy uncertainty and erratic US behavior. Biden can take several executive actions against inflation but we do not expect them to resolve the global supply shock or to save the Democrats from a Republican takeover of Congress this fall. There is substantial risk of a direct US-Russia crisis ahead of the election that would sustain bearish sentiment. US policy remains a headwind for equities in 2022 but possibly a tailwind in 2023. A rally after the midterm is fairly likely.   Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 8.8% 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 President Biden and the Democratic Party will make a last-ditch effort in the third quarter to mitigate their large expected losses in the midterm elections. The president will concentrate on fighting inflation, which is weighing on wages, incomes, and consumer and business sentiment (Chart 1). Related Report  US Political StrategyBiden Opens The Border Biden’s frantic efforts will induce additional market volatility. The president has a few limited tools to address global energy and supply shocks that probably will not work. Inflation will remain problematic even if it slows down over the next three months as our bond strategists expect. The odds of recession have risen sharply. Our Chief Global Strategist Peter Berezin suggests that the odds are 40% – a point underscored by inversion of some parts of the yield curve and a falling leading economic indicator (Chart 2). President Biden recently met with outside economic adviser Larry Summers and concluded that a recession is “not inevitable.” Not very comforting. Chart 1Inflation's Toll Chart 2Odds Of Recession Rising Summers, who warned Biden and the Democrats not to add $1.9 trillion in spending at the beginning of 2021, has put forward research showing recession odds at 60%-70% over the next 12-24 months.1 However, BCA’s own recession checklist is still ambivalent (Table 1). BCA’s House View is now neutral on equities. Table 1BCA Recession Checklist What could change the US policy outlook? Not much. Avoiding recession, reducing inflation, mobilizing women voters, and clashing directly with Russia could mitigate some of the Democrats’ expected losses this fall, but the outcome would probably be the same. Betting markets give a 72%probability to Democrats losing control of both the House of Representatives and the Senate. Our own election models show Democrats losing 22 seats in the House and two seats in the Senate (see Appendix), reinforcing our February forecast. The implication is congressional gridlock in 2023-24. Gridlock is marginally positive for the broad US equity market beginning in Q4 2022 … but marginally negative before then. Checking Up On Our Three Key Views For 2022 Our three key views for 2022 remain intact at the halfway point of the year. : 1.   From Single-Party Rule To Gridlock: The Democrats are highly likely to lose control of the House of Representatives this fall, meaning that unified government will end with the lame duck legislative session in November and December. The Democrats’ fiscal 2022 budget reconciliation bill is less likely to pass now that midterm campaigning has begun. A fiscally expansive bill would add to inflation. A deficit-reducing bill – i.e. one with substantial tax hikes – would increase the odds of recession. Biden no longer has an interest in pushing the bill until he is reasonably sure a recession can be avoided. It is very hard to garner 218 votes in the House and 51 votes in the Senate now that Biden’s and Democrats’ popular support is melting down. Democrats are polling comparably to Republicans who lost 41 House seats in the 2018 midterms (Chart 3). Thus while it is still possible for Democrats to pass an energy security and climate change bill under Biden’s presidency, we have no conviction that they can do it before the midterm. More likely it would have to pass during the lame-duck session in the fourth quarter – or as a compromise law with a Republican Congress in 2023-24. Until 2025, at earliest, US government will be divided, which means that the post-election drop in policy uncertainty will be short-lived, as fears will emerge of breaching the debt ceiling in early 2023. Chart 3Democratic Party Troubles 2.   From Legislative To Executive Power: With the legislature stymied, Biden will resort to executive power to keep his presidency afloat. So what will he do? Fight inflation. Biden’s anti-inflation plan consists of three prongs. The first is “letting” the Fed raise interest rates, which is well under way. The Fed hiked rates by 75 basis points on June 15 and plans to raise the Fed funds rate to 3.25% or 3.5% by end of year. The second prong is passing his Build Back Better plan and the third is consolidating the fiscal deficit. But these two options are bogged down in Congress – no new belt-tightening will occur until 2023 at earliest. So Biden’s remaining options consist of administrative maneuvers and executive orders. Biden could stop collecting the federal gas tax, although the tax has not risen since 1993 and its removal will have a marginal impact (Chart 4). He has already tapped the strategic petroleum reserve, to an unprecedented degree, without preventing the surge in prices at the pump (Chart 5). Chart 4Biden To Defer Federal Gas Tax Chart 5Strategic Petroleum Reserve Already Tapped   3.   From Domestic To Foreign Policy: Part of Biden’s turn toward executive power will be a turn toward foreign policy orientation. However, before the midterm, Biden’s foreign policy will be defensive or reactive. That is, with the exception of Russia, he will attempt to placate foreign threats and mitigate the energy shock. On China, Biden is considering pulling back on some of President Trump’s extraordinary tariffs, though probably not the Section 301 tariffs related to technology theft. He has the authority to do so unilaterally just as Trump had the authority to put them on. The problem is that easing the China tariffs will have little effect on inflation, and only after the midterm, while it would weaken Biden’s political standing in the Rust Belt and undermine the US’s strategic competition with China. Tariff relief would only temporarily benefit the renminbi, if at all, given China’s need for a weak currency amid its economic slowdown (Chart 6). Hence Biden may reduce some tariffs but it will be underwhelming. Not a reliable way to bring down inflation. Chart 6Biden Can Ease China Tariffs (But Don't Bet On It) Second, Biden has proposed to ease sanctions on Iran if it will freeze its nuclear program and come back into compliance with the 2015 nuclear deal that the Trump administration rejected. But the Iranians can export oil anyway at today’s prices, they have customers in China and India, and they have immense military leverage over Iraqi production, which means they are not forced to capitulate (Chart 7). Not a reliable way to bring down inflation. Third, Biden is courting the Gulf Arab states and tinkering with easing sanctions on Venezuela and others. OPEC support is a better option than Iran/Venezuela. However, OPEC will decide when and how much support to give. The Arab states will act to prolong the global business cycle but will not base their strategy on helping Democrats win an election. Hence they may not come to the rescue as early as the third quarter (Chart 8). Chart 7Biden Can Ease Iran Sanctions (But Don't Bet On It) Chart 8Biden Casting About For Oil Providers Moreover if the Biden administration makes amends with Saudi Arabia, then Iran’s nuclear progress will steam ahead and ignite tensions in the Middle East within the year. That would vitiate the impact of increased OPEC production. Not a reliable way to bring down inflation. Biden has even sought to exempt Russia from some sanctions for the sake of reducing inflation, such as with grain exports. However, these arrangements may not last. Given Biden’s weak domestic support and given the way that the Cuban Missile Crisis helped President Kennedy to mitigate his party’s losses in 1962, Biden can afford to be confrontational and even provocative toward Russia (Chart 9). After all, Russia is already pulling levers to add to inflation. The problem is that a direct US-Russia showdown would increase inflation while heightening global risk aversion. Bottom Line: Gridlock is coming, which is marginally negative for US equities in Q3 2022 but marginally positive as early as Q4 2022 and in 2023. It is not good for equities in 2022 because of elevated uncertainty – uncertainty not so much about the election results as about the volatile and unpredictable impacts of the president’s last-ditch efforts to fight inflation. Chart 9Biden Can Take Risks With Russia Checking Up On Our Strategic Themes For The 2020s Looking beyond the short term, this year’s inflation outbreak and geopolitical events will largely reinforce our three long-term US political themes, in the following ways: 1.   Millennials/GenZ Rising: In the coming 12 months, a fall in job openings due to the economic slowdown, combined with a recovering labor participation rate, could reduce wage pressures and inflation, in accordance with the Federal Reserve’s plan for a “soft landing” (Chart 10). Of course, that is not happening yet. And conversely labor participation will fall again if recession risks materialize. So there will be a lot of noise in the short run. Over the long run, a rising dependency ratio, in the context of a growing population, has inflationary implications. It decreases the pool of savings, increases the need for public investment, and increases the cost of each prime-age worker. Today the headline labor participation rate has mostly recovered but workers over the age of 55 are failing to return to pre-pandemic levels of participation, as are young people, which will keep wage pressures up (Chart 11). Chart 10The Fed's Idea Of A Soft Landing Chart 11Generational Shift In Labor Market Thus generational change will be marginally inflationary and will have powerful political effects. An increasingly multi-ethnic and educated population will hold different opinions from previous generations. Political parties will evolve to capture these voters. Underlying the shift will be the fact that government support will be necessary for the rising share of dependents, yet fiscal discipline will be necessary to restrict inflation. The current quarrel between older and younger generations will intensify before it subsides. The Silent Generation, along with the conservative Baby Boomers, will remain the decisive voting bloc in the 2022 midterm and will seek to freeze fiscal policy. That brings us to our next theme … 2.   Peak Polarization: Political polarization has declined since the 2020 election, as we predicted. All voters dislike high inflation (Chart 12). However, polarization will remain at historically high levels at least over the short and medium term. Chart 12Everyone Loathes Inflation Chart 13Women’s Turnout Will MatterPolarization will remain high in part because of the generational divide, which is still very wide and underpins stark ideological divides. For example, a short-term driver of polarization will be abortion. The Supreme Court is likely, though not certain, to overturn the 1972 Roe v. Wade decision that guarantees nationwide access to abortion. If it does, protests and civil unrest will occur. Women turned out in droves against President Trump’s Republicans in the 2018 midterms and will do so again in 2022 (Chart 13), helping Democrats to mitigate some of their losses. Polarization will also remain high due to the electoral system and intra-party dynamics. While Democrats ensconce themselves in formal institutions, Republicans continue to transform into a populist party. So far in the Republican primary elections, candidates endorsed by former President Trump are winning the nomination at a 94% rate. Table 2 shows the outcomes in the GOP primary elections for the House of Representatives so far. A GOP House majority is likely to impeach President Biden for one or another reason, even though they will not be able to remove him from office. Table 2Polarization Will Stay Near Historic Peaks Over 2022-24 Cycle Today’s extreme polarization entails that congressional gridlock will return and that the US remains at high risk of social unrest, political violence, and domestic terrorism (Chart 14). A terrorist attack that affects critical infrastructure, high-level personnel, or the electoral system would lead to greater sociopolitical instability. Especially if violence tips the narrow political balance of one of the branches of government and has a concrete impact on national policy.2 Social unrest alone will hardly move markets but unrest that fundamentally damages US political stability is possible and would engender risk-aversion. Over the long run, however, the US will avoid a second civil war since Washington possesses the world’s most powerful military and intelligence apparatus, which is highly unlikely to be coopted or defeated by an extremist movement. The military swears allegiance to the constitution. For example, neither the military nor the political institutions (as opposed to individuals) showed any serious sign of breaking down during the January 6, 2021 insurrection. The vast majority of voters will recoil from any major incidents of terrorism or militancy. While opinion polls show non-negligible support for political violence, such polls need to be interpreted carefully (Chart 15). A recent study shows that these polls overstate public support for violence.3 Chart 14Major Risk Of Domestic Terrorism, Political Violence Chart 15Opinion Growing More Militant … Until Militancy Happens The emerging Russo-Chinese strategic challenge, combined with generational change, will force political elites to cooperate to prevent domestic insurrections, regime fracture, and foreign humiliation. Polarization will give way to a new American consensus which is largely directed at domestic stabilization and fighting the Second Cold War. 3.   Limited Big Government: The inflation outbreak has dealt a blow to arguments in favor of unlimited government, including Modern Monetary Theory. While the US rediscovered the need for “Big Government” during the deflationary 2010s, it is already starting to rediscover the need for limited government via the inflationary 2020s (Chart 16). The next Congress will reimpose some fiscal discipline – and future governments will face some checks and balances on spending due to their fear of an inflationary surge and negative consequences at the voting booth. Unless Democrats somehow retain control of Congress this fall, they will reinforce the precedent set by the Carter administration that high inflation is politically undesirable. Chart 16Inflation Outbreak Will Limit Big Government Fiscal policy will be more expansive in the coming decade than in recent decades due to structural factors. But it will still face limitations from democratic politics, i.e. gridlock. As long as polarization does not spiral out of control, the US government will not become authoritarian or autocratic and fiscal policy will not result in Big Government Socialism or No Government Anarchism. A new compromise will be found which will be Limited Big Government. Bottom Line: Generational tensions will rise and then fall – and so will political polarization. The US faces a high risk of sociopolitical instability in the short term. The 2022 midterm will become a source of uncertainty, volatility, and a still-elevated equity risk premium. After the midterm, uncertainty and risk premiums will dissipate temporarily. But avoiding a recession will become the critical factor in maintaining policy continuity and national stability through the 2024 election cycle. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds, as noted. US Political Strategy remains defensively positioned, as midterm elections typically provide a tailwind to defensive sectors for the first three quarters of the election year. This is also true when unified governments shift to divided governments – and in that case bond yields tend to be higher than usual (Chart 17). While the inflation outbreak makes this year different from many recent midterm years, these trends have persisted. For this reason, and our Geopolitical Strategy views, we will maintain our defensive bias in the third quarter. Chart 17Stocks Flat, Bond Yields High, Until After Midterm Elections We remain overweigh health care relative to the broad market and overweight nominal Treasuries relative to inflation-protected securities. Having said that, we are putting our long US dollar (DXY) trade on downgrade watch. We do not doubt that the dollar can go higher this year but our bearish views have come to fruition both within the US and in the geopolitical space and they are now largely priced. It may soon be time to step back and reassess, especially because interest rate differentials are turning against the dollar (Chart 18). In addition China’s government will take a pro-growth turn to try to secure the economic recovery over the next 12 months. In the energy space, we expect volatility. The Biden administration is focused on fighting inflation and could pull various levers to affect the oil market, outlined above. If Biden succeeds against expectations, then the oil price would suffer a substantial setback. Moreover OPEC has an independent interest in prolonging the business cycle now that global prices have become punitive. Hence we are neutral on oil prices and booked gains on our long energy trades for the time (Chart 19). Chart 18Put US Dollar On Downgrade Watch If inflation subsides and bond yields moderate, then growth stocks should rebound against value stocks. However, we implemented this idea prematurely earlier this year and suffered for it. Therefore we remain neutral on the question of portfolio styles for now. Our cyclical plays remain the same: long cyber security stocks, defense stocks, and infrastructure stocks. We also remain long renewable energy, although for now we only recommend it as a tactical trade (Chart 20). Chart 19Energy Prices Will Be Volatile Chart 20Stick With Cyber Security, Defense, And Renewables     Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu. 2     Consider the January 6 insurrection, the recent plot against Supreme Court Justice Brett Kavanaugh’s life, the gun attack on Republican Senators in 2017, and the risk of assassinations or other extremist incidents. 3    See Sean J. Westwood et al, “Current research overstates American support for political violence,” Proceedings of the National Academy of Sciences, 119:12 (2022), pnas.org. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets  

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

Executive Summary Calculating Trend Inflation Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition should occur later this year. Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession will eventually be required to push inflation from 4% down to the Fed’s 2% target. Economic growth will slow going forward, but we won’t see enough weakness for the Fed to abandon its tightening cycle within the next 6-12 months.       Bottom Line: US bond investors should keep portfolio duration close to benchmark, underweight TIPS versus nominal Treasuries and maintain a defensive posture on corporate bond spreads (underweight IG and neutral HY). The Fed Goes Big Chart 1Inflation Expectations The US Federal Reserve continued to prove its inflation-fighting mettle last week with a 75 basis point rate hike, the largest single-meeting increase since 1994. Chair Powell had initially telegraphed 50 basis point rate increases for both the June and July FOMC meetings, but he made it clear during last week’s press conference that the committee was spooked by May’s surprisingly high CPI number and by the recent jump in 5-10 year household inflation expectations (Chart 1). Alongside the 75 basis point rate hike, committee members revised up their fed funds rate forecasts. The median FOMC member now expects the funds rate to reach a range of 3.25% to 3.5% by the end of 2022. That is consistent with three more 50 basis point rate hikes and one more 25 basis point hike at this year’s four remaining FOMC meetings. Looking further out, the median committee member anticipates 25-50 bps additional upside in the fed funds rate in 2023 but is then forecasting a modest reduction in 2024. Critically, the fed funds rate is still expected to be above estimates of long-run neutral by the end of 2024. Chart 2 shows how current market expectations compare to the Fed’s forecasts. We see that, even after the Fed’s upward forecast revisions, the market still anticipates a somewhat faster pace of tightening this year. The market is also priced for rate cuts in 2023, likely due to the increasingly widespread expectation that a recession is coming within the next 12 months. Chart 2Rate Expectations: Market Versus Fed The Fed’s Near-Term Plan As for what we can expect going forward, we found two comments from Chair Powell’s press conference particularly enlightening. First, he called last week’s 75 basis point rate increase “unusually large” and said that he “doesn’t expect moves of that size to be common.” Second, Powell said that the Committee will need to see “convincing” and “compelling” evidence of falling inflation before it starts to moderate its tightening pace.1 From these statements we deduce the following near-term plan: 1. The Fed’s baseline expectation is to lift rates by 50 bps at each meeting. 2.  A significant upside surprise in either the monthly core CPI data or long-dated inflation expectations would cause the Fed to lift by 75 bps instead of 50 bps. 3.  The Fed will not reduce the pace of tightening to 25 bps per meeting until there is clear and convincing evidence that inflation is trending down. Bottom Line: Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition from 50 bps per meeting to 25 bps per meeting should occur later this year, meaning that the Fed will tighten no more quickly than what is already priced into the yield curve for the remainder of 2022. Inflation: All Clear To 4%, 2% Will Be More Challenging It’s evident from the above discussion that inflation remains the critical input for both monetary policy and US bond yields. In particular, the key questions are: 1. Will inflation trend down, and if so, how quickly? 2. Is an economic recession required to curtail inflation? Our answer to these questions is that core US inflation should fall naturally to a trend rate of roughly 4-5%, even in the absence of recession. However, an economic recession and its associated labor market weakness are likely required to move inflation from 4% back to the Fed’s 2% target. Chart 3Calculating Trend Inflation To arrive at these conclusions, we seek out different ways of estimating inflation’s underlying trend (Chart 3). The first method we consider is the Atlanta Fed’s decomposition of core inflation into “flexible” and “sticky” components. As defined by the Atlanta Fed, “flexible” items tend to change price more frequently compared to “sticky” items. Items like hotels and new & used vehicles fall into the flexible index, while rent and medical care fall into the sticky index.2 As of May, 12-month core flexible inflation is running at a rate of 12.3%. Meanwhile, core sticky inflation is running at 5.0% (Chart 3, top panel). Second, we consider the New York Fed’s Underlying Inflation Gauge (UIG). The UIG uses a dynamic factor model to derive a measure of trend inflation from a broad set of data.3 In total, the measure uses 346 data series encompassing price measures and other nominal, real and financial variables. The New York Fed has demonstrated that the UIG provides better forecasts of CPI inflation than other measures of core and trimmed mean inflation. At present, the UIG is running at 4.9% (Chart 3, panel 2). A second “prices only” UIG measure that includes only price data and no other economic or financial variables is running hotter at 6.0%. Finally, we can assess inflation’s underlying trend by looking at wage growth. Specifically, we can look at unit labor costs, a measure of wages relative to productivity. Unit labor costs are volatile, but they tend to track core inflation over long periods of time. Unit labor costs grew at an extremely high rate of 8.2% in the four quarters ending in Q1, but this is partly due to huge post-pandemic swings in productivity growth. If we create a more stable measure of underlying wage pressure by subtracting annualized 5-year productivity growth from the 12-month growth rate in average hourly earnings, we see that this trend inflation measure is running at only 3.8% (Chart 3, bottom panel). Chart 4Auto Inflation Will Slow We conclude from our analysis that 12-month core CPI inflation will fall from its current 6.0% back down to its trend level of roughly 4-5% without the Fed needing to slam the brakes on economic growth. This will occur because we will finally see the normalization of some prices that were pushed dramatically higher during the pandemic. Auto price inflation, for example, shot up above 20% last year because the pandemic and the fiscal response to the pandemic conspired to cause a surge in auto sales at the same time as a slump in production (Chart 4). Now, for reasons that have nothing to do with monetary policy but everything to do with the waning impact of the pandemic, we see auto sales rolling over as production ramps up. This will push prices lower in the second half of this year. All that said, once core inflation reaches its 4-5% trend level, more economic pain will be required to push it lower. Shelter, for example, carries a huge weight in the Atlanta Fed’s core sticky CPI and it is highly correlated with the economic cycle. A rising unemployment rate, and an economic recession, will eventually be required to push shelter inflation down. Bottom Line: Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession and a rising unemployment rate will eventually be required to push inflation from 4% down to the Fed’s 2% target. The Risk Of Recession Just because US inflation can fall to 4% in the absence of recession doesn’t mean that the Fed won’t get impatient and cause one anyways. In fact, the Fed made it clear last week that it isn’t interested in nuanced inflation forecasts. The Fed will tighten aggressively until it is apparent that inflation is rolling over, even if it causes economic pain. In this section, we run through several economic and financial market indicators that often send signals near the peak of Fed tightening cycles and in advance of recessions. We conclude that economic growth is slowing, but we do not yet see any evidence of an imminent recession or of any growth slowdown that would be large enough for the Fed to pause or reverse its tightening cycle. First, we look at financial conditions (Chart 5). The Goldman Sachs Financial Conditions Index has tightened rapidly during the past few months and that tightening is broad-based across all five of the index’s components. That said, the index has still not quite moved into “restrictive” territory. Typically, Fed tightening cycles only end once financial conditions are already restrictive, and in this cycle, high inflation means that the Fed will likely tolerate even more tightening of financial conditions than usual. Second, we observe that the end of a Fed tightening cycle is often marked by a dip in the ISM Manufacturing PMI to below 50. Presently, the PMI is a solid 56.1 but it is falling, and regional Fed surveys suggest that it may soon dip into contractionary territory (Chart 6). Chart 5Financial Conditions Chart 6PMIs Are Slowing Third, residential construction activity is a strong predictor of both recession and the end of Fed tightening cycles. Specifically, we have observed that Fed tightening cycles tend to terminate once the 12-month moving average of housing starts falls below the 24-month moving average.4  At present, there is strong evidence that higher mortgage rates are starting to bite the housing market. Housing starts dipped sharply in May and homebuilder confidence is trending down (Chart 7). That said, our housing starts indicator still has a long way to go before it signals the end of the Fed’s tightening cycle (Chart 7, bottom panel). Finally, we turn to the labor market where we do not yet see any evidence of an economic slowdown. Nonfarm payroll growth usually turns negative prior to recession, but right now it is running at a rate of 4.5% during the past 12 months and 3.3% during the past three months (Chart 8). The unemployment rate, for its part, is extremely low, but this only reinforces the idea that the Fed won’t be inclined to abandon its tightening cycle anytime soon. Chart 7US Housing Chart 8The US Labor Market Consider that the Congressional Budget Office estimates that the natural unemployment rate is 4.4% and the median FOMC member estimates that it is 4.0%. In other words, the Fed would still consider the labor market tight even if the unemployment rate rose from its current 3.6% level to around 4%. Even though such an increase in the unemployment rate might technically be consistent with a recession, the Fed would not be inclined to ease monetary policy into such a labor market if inflation is still above its 2% target. Additionally, we must also consider that the labor force participation rate is trending up and it still has breathing room before it reaches its pre-pandemic level. Further increases in labor force participation – which seem likely – could support employment growth going forward even if the unemployment rate stops falling. Bottom Line: The Fed’s rate hikes, and tighter financial conditions more generally, will slow economic growth going forward. However, we don’t see any evidence that growth will be weak enough for the Fed to abandon its tightening cycle within the next 6-12 months. This is especially true because above-target inflation increases the amount of financial conditions tightening and labor market pain that the Fed will tolerate. Investment Implications Portfolio Duration & US Treasury Curve May’s surprisingly elevated CPI number caused US Treasury yields to move above their 2018 peaks across the entire yield curve (Chart 9). But we wouldn’t be surprised to see that uptrend take a breather during the next few months as inflation descends toward its 4-5% underlying trend. As noted above, falling inflation will likely cause the Fed to tighten by no more than what is already discounted between now and the end of the year, this should keep US Treasury yields rangebound. As a result, we advise investors to keep duration close to benchmark in US bond portfolios, with an eye toward re-evaluating this positioning once core inflation moves closer to its underlying trend. Chart 9US Treasury Yields On the Treasury curve, the 5-year note continues to trade cheap relative to the 2-year/10-year slope (Chart 9, bottom panel). We recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS Chart 10Underweight TIPS Versus Nominals Investors should position for inflation falling back to trend by underweighting TIPS versus duration-matched nominal US Treasuries. Not only will falling inflation weigh on TIPS breakeven inflation rates during the next few months but a resolutely hawkish Fed will also apply downward pressure (Chart 10). We are particularly bearish on short-maturity TIPS, and we advise investors to initiate outright short positions in 2-year TIPS (Chart 10, bottom panel). In last week’s press conference, Chair Powell pointed to negative short-maturity real yields as evidence that financial conditions have room to tighten further. To us, this suggests that the Fed will not quit until real yields move into positive territory across the entire yield curve. In an environment of falling inflation, this is likely to occur because of falling TIPS breakeven inflation rates. However, the Fed has now demonstrated that even if inflation doesn’t fall it will push real yields higher with its policy rate actions and forward guidance. Corporate Credit The combination of slowing economic growth and increasingly restrictive Fed policy compels us toward a defensive positioning on corporate bond spreads. Specifically, we advise investors to carry an underweight (2 out of 5) allocation to investment grade US corporate bonds and a neutral (3 out of 5) allocation to high-yield US corporate bonds. Our slight preference for high-yield comes from the view that spread widening is likely to take a breather this year as inflation turns down and the Fed tightens by no more than what is already discounted in the yield curve. Though the long-run prospects for corporate bond returns remain bleak, if inflation moderates this year as we expect, then spreads could easily re-tighten to the average levels seen during the last tightening cycle (2017-19). That would equate to 31 bps of spread tightening for investment grade US corporate bonds (Chart 11), or roughly 300 bps of excess return versus duration-matched US Treasuries.5 For high-yield, a return to average 2017-19 spread levels would equate to 133 bps of spread tightening (Chart 12), or roughly 875 bps of excess return versus duration-matched US Treasuries.6 Chart 11IG Spreads Chart 12HY Spreads In our view, this warrants a slightly higher allocation to high-yield for the time being, though we will likely turn increasingly bearish should spreads tighten to average 2017-19 levels or once inflation converges with its 4-5% trend.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220615.pdf 2 For more info on the Atlanta Fed’s sticky and flexible CPIs please see: https://www.atlantafed.org/research/inflationproject/stickyprice 3 For more info on the Underlying Inflation Gauge please see https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 4 For more details on this indicator please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 This excess return estimate is roughly 31 bps of spread tightening multiplied by average index duration of 7.5. We then add half of the index OAS as an estimate of the carry earned during the next six months. 6 This excess return estimate is roughly 133 bps of spread tightening multiplied by average index duration of 4.3. We then add half of the index OAS, less estimated default losses of 200 bps, as an estimate of the carry earned during the next six months. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns