Developed Countries

Executive Summary The recent pullback was all about a multiples contraction while strong earnings growth helped absorb the blow. With the multiple contraction phase complete, the S&P 500 performance is now all about earnings. Consensus still expects earnings to grow at 10% over the next 12 months, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability. We need to see downgrades or earnings will disappoint. Our brand-new model predicts that earnings growth will trend towards zero over the next three months. Earnings growth is a tug of war between rising input costs and corporate pricing power. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months. Because growth is slowing not only in the US but also abroad. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power Bottom Line: We forecast that earnings growth will undershoot consensus expectations and an earnings recession is likely.  Since the multiples contraction phase of the bear market is likely over, equities performance will be dictated by earnings growth.  In the short run, we expect equities to be range-bound, with rallies and pullbacks alternating.  In case of an earnings recession, equities may fall another 5-8%. Feature Related Report  US Equity StrategyMarginally Worse Ever since the Fed started hiking interest rates back in March, investors started worrying about the recession. The BCA house view is that a recession is unlikely over the next 12 months.  However, to us, of even greater concern is the likelihood of an earnings disappointment or even an outright earnings recession. We believe that earnings growth will slow dramatically. We wrote back in October 2021 report, “Marginally Worse”, that margins will contract at the beginning of the year – indeed, this prediction materialized during the Q1-2022 earnings season (Chart 1). Shrinking profit margins are likely to translate into flat to negative real earnings growth over the next 12 months. However, economic and earnings growth expectations remain elevated. As our readers may recall from the “Have We Hit Rock Bottom?” and “Fat and Flat” reports, we believe that for the markets to begin to heal, growth expectations need to come down and a negative outlook needs to get priced in. Chart 1Margins Are Contracting In this week’s report, we take a close look at the S&P 500 earnings growth expectations and provide our own estimate based on a simple regression model. We will also discuss implications for the US equity market. Sneak Preview: We estimate that earnings growth will trend towards zero over the next three to six months, consistent with current trends in US economic growth, inflation, corporate pricing power, monetary conditions, and the strength of the USD. Sell-off Driven By Multiples Contraction, Not Earnings Growth This year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, decomposition of the total return demonstrates that the pullback was all about multiples contraction, while strong earnings growth helped absorb the blow (Chart 2). A pertinent question is what happens to the market when earnings growth softens? One may wonder whether the bad news has already been priced in, as multiples tend to front-run growth. A case in point is strong market performance in 2020 on the back of multiples expansion in anticipation of a post-pandemic rebound in earnings growth (Chart 3).  Chart 2Sell-off Was Driven By A Multiples Contraction Chart 3Multiples Lead Earnings With multiples down from 23x to 17x over the past two years, and the S&P 500 down by 19% from its January 2022 peak, arguably much of the upcoming earnings growth slowdown/contraction is priced in. Much but not all. The next chapter of the bear market will be driven by earnings growth. Earnings Growth Headwinds As we have pointed out on multiple occasions, it is confounding that, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability, earnings estimates for 2022 have been revised up (Chart 4) and stand at about 10% (Chart 5). However, at long last, upgrades are starting to moderate (Chart 6). We need to see downgrades. Chart 42022 Earnings Estimates Are Still Trending Up Chart 5Earnings Are Expected To Grow At 10% Chart 6Analysts Are No Longer Upgrading Chart 7Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Since the beginning of 2022, there have been quite a few developments that will weigh on earnings growth: Slowing growth in the US and globally means sales growth is decelerating. This week, the World Bank downgraded global GDP growth from 4.1% to 2.9%. Global manufacturing PMI is also trending towards 50 (Chart 7). Consumer demand is weakening: Negative real wage growth saps consumers’ confidence and cuts into their purchasing power. Moreover, demand for goods is returning to the pre-pandemic trend, and retail sales, especially in real terms, are flagging (Chart 8). Demand for services remains strong, but the S&P 500 index is dominated by goods producers. Corporate pricing power is still strong but is showing signs of waning as many US consumers, distraught by the negative wage growth, are strapped for cash (Chart 9). Chart 8Retail Sales Are Contracting In Real Terms Chart 9Corporate Pricing Power Is Waning Prices of raw materials have soared and supply disruptions are exacerbated by lockdowns in China and the war in Ukraine. Companies’ COGS (Cost of Goods Sold) bills are skyrocketing. Nominal wage growth is 6% and is on the rise, affecting companies’ bottom lines. The dollar is strong: it has gained 15% since January 2021. This makes US goods more expensive and reduces companies’ earnings via the currency translation effect. These are the reasons why it is increasingly hard for companies to preserve margins and grow earnings – a commentary that we have heard repeatedly during earnings calls. According to Refinitiv, for Q2-2022, there have been 73 negative EPS preannouncements issued by S&P 500 corporations, compared to 42 positive EPS preannouncements (N/P=73/42=1.7). A year ago, in Q2-2021, the N/P ratio was 0.8, with more companies offering positive guidance. All of this points to weakening profitability. Refinitiv also estimates the earnings growth rate for the S&P 500 for Q2-2022 at 5.3%. If the energy sector is excluded, the growth rate declines to -1.9%. We believe growth will come to a halt or contract into the end of the year. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Earnings Recessions Often Happen When The Economy Is Still Growing One may wonder if an earnings recession is even possible without an economic recession. In fact, that happened quite a lot in the past. Out of 27 earnings recessions since 1927, 11 did not coincide with economic recessions (Chart 10). Chart 10Earnings Recessions And Economic Recession Often Don't Coincide The S&P 500 does not mirror the US economy, with the former dominated by larger companies, many of which are multinationals and more exposed to global demand and the USD than the broad economy. Also, services and consumer spending constitute roughly 70% of the US economy, while the index overrepresents manufacturing, technology, and goods-producing companies. With the S&P 500 being global in nature, quite a few earnings recessions were triggered by events abroad: The 2016 earnings recession was caused by the devaluation of the Chinese yuan; in 2012, one was triggered by a post-GFC double-dip recession in Europe; and the 1998 one was triggered by an Asian financial crisis. It is also often the case that a profit recession is a harbinger of economic recession. Both the 2000 dot-com crash and GFC economic recessions were preceded by earnings recessions, one starting in December 2000, and the other in August 2007. The 2019 earnings recession was brief and came hand in hand with widespread fears of the end of the business cycle. Hence, we believe that a confluence of factors both at home and abroad, as discussed above, makes an earning recession a high probability event. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months, because of slowing growth not only in the US but also abroad. Modeling Earnings Growth Since we are distrustful of the consensus of 10% expected eps growth, we have built our own simple earnings growth forecast model to gauge what earnings growth rate we may expect over the next quarter. The model has five factors, each of which has fundamental relevance to earnings growth (Table 1): Table 1EPS Growth Forecast Model ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in input costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. Roughly 35% of S&P 500 sales are outside the US. Each factor is calculated on a year-on-year percentage change basis, with a three-month lag to allow the effects of macroeconomic developments to get priced in. Adjusted R2 is 65%, which is a strong fit. All factors are statistically significant at the 1% level. The model forecasts that earnings growth will come down from 6% MoM as of April 2021 to 1.3% as of August 2022 (Chart 11). While this does not map directly to the “next 12 months” of eps growth, it does indicate that earnings growth is trending towards zero in nominal terms and will be outright negative in real terms. Further, while we are unable to predict earnings growth more than three months ahead, we do expect that it will reach zero and then shift into contraction territory into the balance of the year. Chart 11Model Predicts That Earnings Growth Will Be Flat   Looking closer at the key drivers of growth (Chart 12), we observe that there is a tug of war between pricing power and rising costs (PPI), with earnings growth falling as pricing power starts to give away ground. The other factors that have an adverse effect on earnings growth are slowing growth (ISM PMI), an appreciating dollar, and rising borrowing costs (HY spreads). Chart 12Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power The model indicates that earnings growth is trending towards zero over the next three months. Price Target What does all of this mean for US equities?  If the multiple contraction phase is complete, the S&P 500 performance is now all about earnings.  If we expect earnings to grow only 0-3% in nominal terms, with the forward earnings multiple unchanged at roughly 18x, then the S&P 500 is likely to come down another couple of percentage points. If earnings contract 5%, the index may be down as much as 8%. If multiples contract another point to 17x and earnings contract by 5%, the market may be down as much as 15% (Table 2). Table 2The S&P 500 Target Scenario Analysis For now, we are sticking with our “fat and flat” thesis expecting the S&P 500 performance to continue to trend down as rallies and pullbacks alternate. Earnings growth slowdown/shallow contraction is likely to result in another leg down of roughly 5-8%. Investment Implications Street forward earnings growth expectations are too high at 10% and need to be downgraded. There are multiple reasons why earnings growth will be underwhelming, ranging from slowing growth abroad to weaker demand for goods and rising wages at home. We anticipate that earnings growth will be flat to negative into the balance of the year. The multiple contraction phase of the bear market is over, and now equities performance will be dictated by earnings growth. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Bottom Line We forecast that earnings growth will undershoot consensus expectations and that an earnings recession is likely. Since the multiple contraction phase of the bear market is likely over, equity performance will be dictated by earnings growth. In the short run, we expect equities to trend down, with rallies and pullbacks alternating. In the case of an earnings recession, equities may fall another 5-8%.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum

Executive Summary ECB & Inflation: Whatever It Takes? Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials.     Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox Chart 11The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade Chart 15An Unusual Disconnect Chart 16German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Chart 22The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Hiring is slowing and layoffs have begun to rise, but today's robust net increases in non-farm payrolls are inconsistent with an approaching recession. The demise of the American consumer has been greatly exaggerated. Households have lots of savings to spend and the capacity to borrow against them if they choose. The extensive forward guidance that the Fed has been at pains to provide to markets may have fueled a sharp preemptive tightening in financial conditions that might prove premature if it reduces the Fed's need to cool the economy itself. None of the three components of our simple recession indicator (the slope of the yield curve, the year-over-year change in the Leading Economic Index and our assessment of monetary policy settings) is sounding the alarm, or even flashing yellow. No Recession Warning In This Series Bottom Line: Although gloom is increasingly pervasive among investors, we remain constructive on risk assets and the economy over the next twelve months, and reiterate our recommendation to overweight equities in a balanced portfolio. Feature Per the mosaic theory of security analysis, analysts, portfolio managers and independent investors piece together fragments of publicly available information to form a thesis about a company’s prospects. After appraising the company’s securities based on that thesis, the analyst/PM/investor determines whether they’re overvalued, undervalued or fairly valued and takes the appropriate action in his/her portfolio. All market participants are in a race to be among the first to see the outline of the complete picture as the opportunities to exploit mispricings are inversely related to the available share of relevant data. Security fair values become more apparent as more bits of colored glass begin to circulate and alpha-seeking investors have to move on to the next mostly incomplete puzzle to find an edge. Related Report  US Investment StrategyAll The Way To Ticker Symbols The same framework applies to macroeconomic analysis. It’s especially apt now, given the lack of a close precedent for the monetary and fiscal support policy makers lavished on the economy to protect it from COVID-19’s potential ravages and the way that data flows have refused to conform to a well-defined trend supported by a stable narrative theme. Macro data and news from individual companies are stuck in a one-step-forward, one-step-back pattern as embodied by stagnant stock indexes. The S&P 500 paced the same 100-point path between 4,075 and 4,175 for two full weeks before tumbling through the bottom of the range last Thursday and losing contact with it on Friday after the May CPI report showed that inflation remains stubbornly high (Chart 1). Chart 1Stocks See The Glass As Half-Empty The details of the May CPI report weren’t as bad as the headlines, though we were surprised and disappointed by its failure to confirm our view that inflation is peaking. From the full range of puzzle pieces we already have, however, we continue to think the picture for risk assets and the economy one year from now will be encouraging. We spent last week speaking and mingling at a conference and meeting with clients one-on-one last week, confirming that our sanguine view is decidedly in the minority as investors have become increasingly resigned to the idea that inflation cannot be brought down to a tolerable level without squeezing the economy. We think there is a middle way, at least over the next twelve months, as we highlight below by reviewing some of the largest and most important factors. Employment If a recession were imminent, we would expect to see hiring begin to sputter. Year-over-year payrolls growth has slowed, but it remains more than a standard deviation above the mean (Chart 2, top panel), at its highest level in 38 years. Annualized month-over-month growth is strong as well, if not as much of an outlier as year-over-year growth (Chart 2, bottom panel). Going forward, payrolls growth is poised to remain strong (Chart 3, top panel), as small businesses’ hiring intentions are very high (Chart 3, second panel), temporary employment is still elevated (Chart 3, third panel) and initial unemployment claims, while rising, are extremely low (Chart 3, bottom panel). Chart 2Payrolls Are Growing At A Nice Clip ...​​​​​​ Chart 3... And Will Continue To Do So​​​​​​ Consumption Chart 4Solid Footing We have stressed that households’ massive pandemic savings have provided them with ample ability to consume. They have worked down the debt they took on ahead of the financial crisis, restoring the household debt-to-GDP ratio to its 2002 level (Chart 4, second panel), which is much more lightly borne today than it was then, thanks to interest rates that remain extremely low despite their recent backup (Chart 4, bottom panel). It is an open question, subject to occasionally fierce debate within BCA, if households have the willingness to consume the mountain of savings they have amassed since COVID-19 reached the US. Our answer has been an unequivocal yes, and we have been working under the purposely conservative assumption that households will spend just half of their $2 trillion-plus stash. So far, the data are on our side: consumers have not lost their appetite for dining out, returning to restaurants at their pre-pandemic pace once the Omicron coast was clear (Chart 5, top panel). Travelers are returning to the skies, as well, undeterred by soaring airfares (Chart 5, bottom panel). Although passenger levels have not made it all the way back to their 2019 levels, nearly 60% more passengers have passed through TSA checkpoints so far this year than they did at this point in 2021, and credit card usage indicates that reduced business travel is responsible for the shortfall, as individuals have eagerly sought to cure their cabin fever (Chart 6). Chart 5Back To Restaurants, Bars ...​​​​​​ Chart 6... And The Friendly Skies​​​​​​ Private Investment/Credit Spreads Although consumption accounts for two-thirds of overall US output, or three-and-a-half times more than investment, the latter is slightly more likely to bring about a contraction in GDP because it is considerably more volatile.1 Nonresidential investment accounts for the lion’s share of private investment and BCA’s capex model projects that it will remain robust over the next two quarters (Chart 7). Residential investment will have to grapple with the housing slowdown imposed by the sudden and significant increase in mortgage rates, but we agree with our Bank Credit Analyst colleagues’ assessment that housing is unlikely to tank the economy.2 Homes remain undersupplied after several years of insufficient construction and the spread between the baseline 30-year fixed mortgage rate and the 10-year Treasury yield has become so stretched that it appears that the mortgage rate may have already reached its 2022 peak (Chart 8). Chart 7Capex Prospects Are Good ... Wider corporate bond spreads and intimations that banks are becoming less eager to lend could signal a further tightening of financial conditions. There have been three major spread-widening episodes in the high yield era (Chart 9, top panel) and none began until three preconditions had been met. Chart 8... And Mortgage Borrowers Are Due For A Break​​​​​ The Fed had to have completed its rate hiking cycle (Chart 9, second panel), our proprietary Corporate Health Monitor (CHM) had to have crossed into deterioration (Chart 9, third panel) and the Fed’s quarterly Senior Loan Officer survey had to indicate that a majority of banks was imposing tighter credit standards on business borrowers (Chart 9, bottom panel). None of those conditions is in place yet, though banks' lending appetites may be shrinking and the first quarter was not great for corporate health. Chart 9Perhaps Forward Guidance Was TMI Broad Recession Probability Pulling back to 30,000 feet, none of the key recession prerequisites we constantly monitor is yet signaling any distress. The 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping (Chart 10). The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis (Chart 11), and the target fed funds rate is far below our estimate of the equilibrium fed funds rate (Chart 12). Each series has issued its own false signal – an above-equilibrium fed funds rate has been a necessary, but hardly sufficient, recession condition – but they have a perfect track record when considered together. Chart 10When The Yield Curve Inverts, ... Chart 11... Year-Over-Year LEI Contracts ... Chart 12... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows Investment Implications The May CPI report only strengthened the conviction of those holding bearish views and will at least temporarily fuel a barrage of gloomy headlines that might sway the uncommitted. It has reduced the marginal probability that the Fed will be able to thread the needle and meet its price stability mandate without taking direct aim at its full employment goals. We still expect that the Fed will be able to maintain its balancing act for another twelve months because we think inflation will begin to come down on its own once the fevers in new and used auto prices and airfares finally break. The more remote that prospect seems to investors, the more stock prices will fall and bond yields will rise if the bullish view, or something slightly less bearish than discounted, comes to pass. The University of Michigan’s consumer sentiment survey made an all-time low in the preliminary June data released Friday morning. We are less concerned about the headline number – Open Table reservations and busy TSA security lines suggest investors are better served by focusing on what consumers do than how they feel, and the Michigan gloom is contradicted by the Conference Board survey's modest optimism – than we are about the upward turn in consumers’ long-run inflation expectations. Respondents to the Michigan survey increased their median estimate for inflation in five to ten years to 3.3% from 3% over the previous four months (the estimate had been between 2.9 and 3.1% for ten months beginning last August). If workers’, businesses’, investors’ and consumers’ long-run inflation expectations become unmoored, an inflation mindset in which high prices beget still higher prices could threaten to take hold, forcing the Fed to channel its inner Paul Volcker, shattering our temporary thread-the-needle thesis. For now, the term structure of inflation expectations remains sharply inverted. That’s to say that TIPS breakevens, CPI swaps and survey respondents continue to expect that intermediate- and long-term inflation will slow considerably from its currently elevated levels. If they begin to lose faith that very high inflation readings are a temporary phenomenon, we will have to revisit our glass-half-full perspective. We are not irresolute, but like Lord Keynes, when the data change, we change our minds.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      The probability that investment could decline enough in any given quarter to zero out 2% growth in consumption and government spending is 23%, based on its historical distribution. The probability that consumption could wipe out 2% growth in investment and government spending is 17.6%. Government spending, which is one-fourth the size of consumption and considerably more stable than comparably sized investment, has just a 2.3% probability of negating trend growth in the other components. (All calculations disregard net exports.) 2     "Is The US Housing Market Signaling An Imminent Recession?" Bank Credit Analyst Special Report, June 2022.