Economy

Highlights Federal Reserve: Market turbulence will not dissuade the Fed from starting to hike rates in March, with longer-term consumer inflation expectations climbing steadily higher. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Canada: Canadian growth is set to recover as the intense Omicron wave has peaked, further intensifying inflationary pressures. The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with inflation expectations above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates. Feature Chart of the WeekA Less Friendly Policy Backdrop For Risk Assets Risk assets have taken a beating over the past week, with major equity indices in the US and Europe suffering the sharpest selloffs seen since the early days of the pandemic. There are many sources of investor angst fueling the risk aversion wave - a potential Russian invasion of Ukraine, some mixed results on Q4/2021 corporate earnings reports, the lingering Omicron wave and most importantly, fears of tighter global monetary policy. The latter is most evident in the US, with a few prominent Wall Street investment banks now calling for the Fed to deliver much more than the 3-4 rate hikes currently discounted for 2022. The Fed is now in a difficult spot. Realized US inflation remains very high, supply chain disruptions are not going away, and wage growth is accelerating amid tight US labor market conditions. Survey-based consumer inflation expectations show little sign of peaking, with longer-term expectations now climbing steadily higher. As a result, the Fed has been forced to rapidly shift its policy guidance in a more hawkish direction. These trends are not unique to the US, however, as similar inflation dynamics are playing out in places like the UK and Canada where central banks are also expected to deliver a lot of monetary tightening this year (Chart of the Week). For inflation targeting central banks, a surge in inflation that becomes increasingly embedded in longer-term inflation expectations is a direct challenge to their credibility. The policy prescription must involve monetary tightening to raise real interest rates in a bid to stabilize inflation expectations. At the same time, given the starting point of near-0% nominal policy rates and high inflation, deeply negative real interest rates have a lot of room to rise before becoming a serious restraint on economic growth. This limits how far bond yields can decline in response to a generalized risk-off move like the one seen over the past week. For financial markets hooked on easy monetary policies, an inflation-induced monetary tightening cycle will lead to even higher bond yields – especially real yields - and more frequent bouts of market volatility this year. The events of the past week will likely not be a one-off. The Fed Cares About Inflation, Not Your Equity Portfolio US equity markets have had a rough start to 2022. The S&P 500 is down -9% so far in January, with the tech-heavy NASDAQ index down a whopping -13% (Chart 2). The VIX index now sits at 31, nearly double the level seen at the end of 2021. The selloff in risk assets has occurred alongside an increase in real US bond yields. TIPS yields for the 2yr, 5yr and 10yr maturities are up +20bps, +36bps and +43bps, respectively since the start of the year - a reflection of increasing Fed rate hike expectations. Yet other financial markets have seen more limited swings so far in 2022. Non-US equities are sharply outperforming the US; the EuroStoxx index of European equities is down -6%, while the MSCI emerging market (EM) equity index is down just -2%. US investment grade and high-yield spreads, using the Bloomberg benchmark indices, are up a relatively modest +9bps and +36bps, respectively, while the DXY US dollar index is up only +0.4%. The risk asset selloff seen year-to-date has been sharp, but has likely not been enough for the Fed to postpone the expected March liftoff of the fed funds rate. US financial conditions have tightened, but not nearly by enough to make the Fed to more concerned about the US economic growth outlook (Chart 3). Also, financial markets appear to be functioning normally, suggesting what is happening is a repricing of risk assets rather than a selloff driven by poor market liquidity conditions. Chart 2A 'Real' Equity Market Correction​​​​​​ Chart 3High Inflation, Not High Asset Values, is The Fed's Biggest Concern​​​​​​ The bigger risk to US growth may actually come from high inflation, rather than falling asset values. Real US household income growth, derived from responses in the New York Fed’s Survey of Consumer Expectations to individual questions on incomes and inflation, is expected to contract -3% over the next year (bottom panel). Given that decline in perceived spending power, with inflation far exceeding wage growth, it is no surprise that the University of Michigan consumer confidence index is near an 8-year low. US business confidence has also been hit by high inflation. The NFIB survey of small business sentiment and the Conference Board survey of corporate CEO confidence declined in the latter half of 2021, largely in response to inflationary supply chain disruptions and labor shortages. Nearly one-quarter of NFIB survey respondents cite “inflation” as the single most important problem in operating their businesses. Economic sentiment has clearly taken a hit because of elevated US inflation, even with the US unemployment rate at 3.9% and overall real GDP growth remaining solidly above trend. This suggests that slowing inflation could actually provide a more sustainable boost to the US growth through improved confidence – if the Fed can first successfully engineer a “soft landing” for the economy once it begins hiking rates. The problem the Fed now faces is that the high inflation of the past year is starting to leak into longer-term survey-based measures of inflation expectations. 5-10 year ahead consumer inflation expectations from the University of Michigan survey are now at a 10-year high of 3.1%, while the 10-year-ahead inflation forecast from the Philadelphia Fed’s Survey of Professional Forecasters is at a 23-year high of 2.6% (Chart 4). Market-based inflation expectations like TIPS breakevens have stopped rising, as a more hawkish Fed has boosted real TIPS yields, but remain elevated at levels consistent with the Fed achieving, but not exceeding, it's 2% medium-term inflation target (bottom panel). The combination of a tight US labor market and consumers expecting more inflation raises the risk that the US could enter a wage-price spiral, where workers demand wage increases in response to higher inflation and companies are therefore forced to raise prices to maintain profitability. The conditions for a wage-price spiral seem to now be in place in the US (Chart 5): unemployment is low, wages are accelerating and a growing number of US workers are quitting jobs to find better work. Perhaps most importantly, US consumers are more uncertain about where inflation will be in the future. Chart 4US Inflation Expectations Becoming More Entrenched​​​​​ Chart 5The Start Of A US Wage/Price Spiral?​​​​​​ The New York Fed Survey of Consumer Expectations asks respondents to place probabilities on certain ranges for future US inflation rates one and three years ahead. The probability-weighted average of those inflation rates is dubbed “inflation uncertainty”, and those have doubled over the past year from 2% to 4% (bottom panel). This means that the survey respondents now see higher inflation outcomes as more probable, which will likely result in increased wage demands to “keep up” with the cost of living. With the US labor market looking tight as a drum, amid extensive shortages of quality workers as reported in business confidence surveys, the odds of wage increases because of higher inflation instead of higher productivity – a.k.a. a wage-price spiral – have shot up significantly. Already, the 5-year-annualized growth rate of US unit labor costs has doubled since the start of the pandemic (Chart 6), evidence that wage increases are not being matched by faster productivity. Given the strong historical correlation between unit labor cost growth and core inflation in the US, the rise in the latter will be more persistent if US workers ask for bigger cost-of-living driven wage increases. Chart 6Rising US Labor Costs Provide A Lasting Boost To US Inflation​​​​​​ ​​​​​ Former Fed Chair Alan Greenspan famously described “price stability” – the Fed’s stated medium-term goal - as a situation where “… households and businesses need not factor expectations of changes in the average level of prices into their decisions.” This is clearly not the situation in the US today, which is why the Fed has no choice but to move ahead with interest rate increases to begin the road back to price stability. Financial market selloffs may actually assist the Fed in achieving that goal through tighter financial conditions, thereby limiting how much interest rates must increase to cool off above-trend US economic growth. Interest rates must still go up first, though – especially in real terms. Already, investors have adjusted to that reality by lifting their medium-term “real rate expectations”. We proxy the latter by taking the difference between the forward path for nominal US interest rates discounted in the US overnight index swap (OIS) curve and the forward path of US inflation discounted in the US CPI swap curve. Over just the past month, that market-implied forward path for the real fed funds rate has shifted from discounting an average level of around -1% over the next decade to something closer to -0.25% (Chart 7). We anticipate that those real rate expectations will move even higher as the Fed begins to hike rates in March and continues its tightening cycle over the next 1-2 years. This will underpin the move higher in US bond yields that we expect this year, for both government and corporate debt, with the benchmark 10-year Treasury yield reaching a high of 2.25% by year-end. Bottom Line: Market turbulence will not dissuade the Fed from starting to hike rates in March. Longer-term consumer inflation expectations are climbing steadily higher, which is starting to feed into higher wage demands in a very tight labor market. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Stay below-benchmark on US interest rate exposure, both in terms of duration and country allocation, in global bond portfolios. Canada Update: The BoC Has A Lot Of Work To Do The Bank of Canada (BoC) meets this week and we anticipate that the first rate hike of this tightening cycle will be announced. This will just be the beginning of what will likely be an extended cycle. Canadian monetary conditions are far too accommodative given above-trend growth and accelerating inflation. The BoC places a lot of analytical weight on its Business Outlook Survey when assessing the state of the Canadian economy. The Q4/2021 survey signaled very strong business confidence and robust demand (both domestic and foreign), with a growing majority of firms surveyed planning to increase investment and hiring over the next year (Chart 8). Survey respondents also reported significant capacity constraints, especially in industries that have experienced strong demand during the pandemic, like retail, manufacturing and housing. This is related to global supply chain disruptions, but also to intensifying labor shortages. Chart 8A Bright Outlook For The Canadian Economy The survey was conducted before the Omicron variant began to spread through Canada, which lead to the reimposition of severe economic restrictions. The number of Canadian COVID cases has peaked, however, and some restrictions have already begun to be lifted in Ontario, Canada’s largest province by population. The economic impact of Omicron will therefore be concentrated in the first couple of months of 2022 and should not derail the hiring and investment plans indicated in the Business Outlook Survey. A reacceleration of Canadian economic growth post-Omicron would magnify high Canadian inflation at a time of intense capacity constraints and tight labor markets. The Canadian unemployment rate fell to 5.9% in December, just 0.2 percentage points above the pre-COVID low seen in February 2020. Headline CPI inflation reached a 31-year high of 4.8% in December 2021, with trimmed CPI inflation (which omits the most volatile components) reaching an 30-year high of 3.7% (Chart 9). The rise in inflation has been broad-based, with large increases seen for both goods inflation (6.8%) and services inflation (3.7%). Like the US, high inflation is becoming more embedded in survey-based inflation expectations. Canadian businesses expect inflation to be 3.2% over the next two years, according to the Business Outlook Survey.1 Canadian consumers expect inflation to be 4.9% over the next year and 3.5% over the next five years, according to the BoC’s Canadian Survey Of Consumer Expectations (Chart 10). The latter had been very stable around 3% since the survey began back in 2014, thus the 0.5 percentage point jump seen in the latest quarterly survey is a highly significant move that suggests the 2021 inflation surge is become more embedded in Canadian consumer psychology. Chart 9The BoC Has An Inflation Problem On Its Hands​​​​​​ Chart 10Canadian Consumer Inflation Expectations Are Rising​​​​​​ The Canadian inflation backdrop has similarities to the US situation described earlier in this report. Like the US, one-year-ahead Canadian consumer inflation expectations are far above wage expectations (only +2%), which suggests that Canadian consumers expect real wages to contract -2.9%. Also like the US, falling real wage expectations are acting as a drag on Canadian consumer confidence (bottom panel). And also like the US, we expect Canadian workers to increase their wage demands to restore real purchasing power, potentially starting a wage-price spiral. Given widespread Canadian labor market shortages, this process has likely already started. According to the BoC Business Outlook Survey, 43% of firms had to boost wages in Q4/2021 because of “cost of living adjustments”, compared to 29% in Q3/2021 (Chart 11). An even larger share of respondents in the Q4 survey (54%) reported having to raise wages to attract and retain workers, up significantly from Q3 and an indication of how Canadian firms are seeing their wage bill go up trying to find quality labor in a tight job market. Given the messages on growth and inflation from its surveys, the BoC has all the evidence it needs to begin the rate hiking process as soon as possible. The bigger question is how high will rates have to go to cool off Canadian economic growth and bring inflation back into the BoC’s 1-3% target range. The BoC’s own internal models estimate that the neutral level of the policy interest rate is between 1.75% and 2.75%. Those estimates were last produced back in April 2021, however, and the range may need to be revised higher to reflect the changes seen in the Canadian economy since then – most notably the greater supply constraints and higher inflation. At a minimum, the BoC will likely have to raise the policy rate to the higher end of its last estimated range for the neutral rate. Current market pricing in the Canadian OIS curve discounts the BoC hiking the policy rate from 0.25% today to 1.6% by the end of 2022 (Chart 12). With eight scheduled BoC policy meetings this year, including this week, the 2022 pricing is realistically achievable. However, only another 50bps of hikes are priced for 2023 and no additional hikes after that. Chart 12Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Chart 13Stay Underweight Canadian Government Bonds A peak policy rate around 2% would only be in the lower half of the BoC’s range of neutral rate estimates. It would also represent a very low peak real rate of 0% assuming inflation returns to the midpoint of the BoC target range. It is possible that markets are underestimating how high the BoC will have to lift rates, both in nominal and real terms, because of a fear that rate increases will hurt highly indebted Canadian homeowners and trigger a sharp pullback in house prices. This is a legitimate concern given the stretched housing valuations across most major Canadian cities. However, the BoC is facing the same credibility issue that the Fed and other inflation-targeting central banks are facing in the pandemic era. Canadian inflation is too high and becoming more embedded in inflation expectations. Also like the Fed, the BoC will have to fight the inflation battle now and deal with the collateral damage on financial conditions (and the housing market) later. Importantly, with the Fed also likely to deliver several rate hike in 2022. Thus, the BoC has less need to fear a surge in the Canadian dollar, driven by widening interest rate differentials, that could aggressively tighten financial conditions beyond the impact on asset markets and house prices from higher interest rates (Chart 13). Summing it all up, we maintain our negative strategic outlook on Canadian government bonds as markets are underestimating the tightening that will be required from the BoC over the next 1-2 years. Bottom Line: The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with medium-term consumer inflation expectations now above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Business inflation expectations calculated as the share of respondents reporting expected inflation within a certain range multiplied by the midpoint of the range. We assume a value of 0.5 for “less than 1” and a value of 3.5 for “greater than 3”. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights 2022 has had a rough start for equity investors: the S&P 500 is now down 8% from its peak, and NASDAQ is officially in correction territory.  The question on everyone’s mind is how long this correction will last, and whether it is the right time to start buying beaten-up Tech stocks. Looking “under the hood” of the NASDAQ, we observe that with the technology space being top-heavy and dominated by the likes of Microsoft and Apple, index returns mask the heavy losses of some of the smaller, and less profitable, constituents, with many down 40-50% from their peaks.  Analysis of the market breadth shows that three-quarters of NASDAQ names are trading below their one-week highs, which, according to our analysis, indicates that Tech is (almost) ripe for a bounce back. However, the sector is currently under duress from rising rates and imminent monetary tightening.  Historically, Tech’s worst performance was two to three months prior to the first rate hike – the current pullback is a “textbook” behavior.  It will take another couple of months after the rate hike for a sustainable rebound. In addition to headwinds from rising rates, there is also an ongoing slowdown in demand for tech products and services, which translates into a deceleration of earnings and sales growth. On the valuations front, Technology is trading with a significant premium to the market, while its expected earnings growth is on par with that of the S&P 500. We recommend investors to be patient: While Tech appears oversold, and recent volatility is a function of market panic, the stars have not yet aligned for the sector.  We are tactically bearish but structurally bullish. Feature 2022 has had a rough start for equity investors: Since the beginning of January, the S&P 500 has pulled back 8%.  Market consensus is that this violent rotation is a repricing of risk, triggered by the Fed’s new hawkish stance aimed at taming the runaway inflation that has surged to a nearly 40-year high. The market expects the first rate hike as soon as March, followed by three more into the year-end. It is also grappling with the timing and degree of quantitative tightening (QT), which will follow on the heels of tapering. Energy and Financials are the only sectors in the green so far this year, with Real Estate, Healthcare, and Tech being hit the hardest (Chart 1). Internet Retail is down almost 20% from its local peak in mid-2021 and Interactive Media, home of Facebook, is down 11%. NASDAQ is officially in correction territory (Chart 2). Rising rates have hit growth and interest-rate-sensitive areas of the market the hardest. While these negative returns indicate a sharp pullback, they don’t do justice to how painful this correction has been, as much of it was happening under the radar. The S&P 500 and many of its tech-related sectors and industries are top-heavy, being home to FAANG+M, which has proven to be more immune to rising rates.  It is the smaller growth companies that have fallen much more than the top-line number indicates, with many down 40-50% from their peaks. However, now with more than 58% of stocks in the NASDAQ trading below their 30-week moving average, the natural question is: “Are we there yet?” or how much longer will this sell-off last? There are early signs of bottom-fishing among the stocks and industries hit hardest. Yet most days, both the S&P 500 and the NASDAQ start in the green, only to finish splattering to a new low (Chart 3). Chart 3Mega-cap Tech Has Fallen But Less Than Small-cap Brethren In this report, we will aim to gauge when the sell-off in tech names will have run its course by focusing on the S&P 500 Technology sector.    Also in today’s publication, we will reverse our usual course of analysis: We will start from the technicals as they are most helpful for timing entry points, and we will follow with macro and fundamentals.   Tech Sector Is Top Heavy The S&P 500 Technology sector is top-heavy, with each industry group dominated by one of the tech giants, such as Microsoft in Software and Services, Apple in Hardware and Equipment, and Nvidia in Semiconductors. We call this trio “MAN.” The MAN accounts for 50% of the S&P 500 Technology sector market capitalization (Chart 4). As a result, both sector performance and valuation are heavily affected by index composition.  To unpack what is going on within the Tech sector, we plotted the dispersion of last month’s performance within the sector through a market cap bucket, with the first bucket containing the MANs. The last couple of buckets, 10 and 11, contain some of the smallest stocks in the index. Unsurprisingly, the largest stocks in the sector have not fallen that much. The correction has most affected stocks in buckets 7 through 11, with a market cap of between $8 to $33 billion, and these are the names that may be most tempting for “bottom-fishing.” Technicals It Is A Blood Bath Out There A useful indicator of market breadth, allowing us a look under the hood”, is the percentage of stocks making new lows – which currently stands at nearly 75% (Chart 5). This is a high reading which has happened only 11% of the months since 2000.  However, once this metric rises above 85%, it indicates that the market is oversold.  When that happens, the Tech sector outperforms the S&P 500 by around 7% over the next six months, and returns are positive every month (Chart 6).  Based on this indicator, the NASDAQ in general, and Tech in particular, are close to the oversold conditions and are ready for a bounce.  Chart 5Pullback In Tech Stocks Is Broad-based However, the BCA Technical Indicator for the sector (Chart 7) is still in neutral territory. It is driven primarily by momentum components: It gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology.  This indicator is highly affected by the performance of the largest index constituents. All in all, we conclude that from a technical standpoint, the Tech sector is getting closer to a rebound. Chart 7The Technical Indicator Is In The Neutral Territory Macroeconomic Backdrop New Rate Hiking Cycle Will Take Time Getting Used To Ok, Tech is oversold. Yet there is still the not-so-small matter of a new, tighter monetary regime. How does Tech fare in the environment of rising rates? Clearly, not so good so far. However, the question is, how long will it take for the higher rates to be priced in, and for Tech to rebound. To answer this question, we have run another empirical study, anchoring the performance of the Tech sector to the beginning of each hiking cycle since 1996 (Charts 8 and 9).   According to our analysis, Tech’s worst performance is two to three months prior to the first rate hike – the current pullback in Tech is a perfect illustration. While we may expect a rebound rally “when the second shoe drops” and the Fed announces the first hike, it appears that a sustainable rally may still be a couple of months away. Based on this analysis, we conclude that it will pay off to be patient and wait until the summer. It Is The Economy, Stupid! Apart from the headwind from rising rates, there is also an ongoing slowdown in demand for Tech Business Investment (Chart 10). Moreover, the Tech New Orders Index peaked at a high level at the end of 2021 and has recently turned (Chart 11). So has Private Tech Investment (Chart 12).  This indicates that demand is waning following the surge that accompanied the most recent push to digital transformation—which was accelerated by the onset of the pandemic.   Chart 10Slowdown In Tech Business Investment Chart 11Tech New Orders Have Peaked Chart 12Private Tech Investment Is Also Slowing The macroeconomic backdrop is unfavorable for the Tech Sector Fundamentals Sales And Earnings Growth Are Slowing While the Tech sector enjoyed a fantastic sales recovery in 2021, with sales growth exceeding pre-pandemic levels, this year may be different. Waning demand for tech products and services translates into a sales growth slowdown (Chart 13).   Chart 13The Tech Sector Sales Growth Is Slowing... Chart 14... So Is Earnings Growth With sales growth slowing, earnings growth is bound to follow (Chart 14), which is no different from the broad market. Technology sector earnings growth for the next 12 months is converging with that of the S&P 500: 10% vs. 9% respectively (Chart 15). Margins are expected to compress in 2022, albeit from the high levels (Chart 16). Chart 15Tech And The S&P 500 Expected Earnings Growth Has Converged Chart 16Margins Are Expected To Compress Of course, the Q4-2021 earnings results could bring a respite.  So far blended the year-on-year earnings growth rate is 15.8%: However, only 5 companies out of 71 have reported, beating expectations by 4.6%.  Will these results save the day? Possibly – expectations are a low bar to clear.  Time will tell.  But to prop up the sector, results from the MAN have got to be stellar. Valuations: Better But Not Good Enough While Tech earnings are expected to grow in line with the S&P 500, the sector is trading with a 28% premium to the market at 27x vs. 21x forward PE (Table 1). Relative PE NTM currently stands at 1.7 standard deviations above the five-year average. Although this may seem high, the froth has come off as, only two months ago, Tech was trading at 2.4 standard deviations. This is a significant change, but the sector is not yet cheap enough for bargain hunting. Adjusting for the growth rate differential between Tech and the S&P 500, we divide PE NTM over EPS Growth NTM, to arrive at PEG: Even so, Tech is still more expensive trading at 2.7 for a percentage of future growth, compared to 2.3 for the S&P 500. However, Tech is a growth sector, and perhaps by looking at only one-year-ahead earnings growth, we are being myopic. Let’s take a look at longer-term growth expectations. Curiously, over the next five years, Tech earnings are expected to grow at about an 18% annualized rate, while the S&P 500 is expected to grow at 21% (Chart 17). As a result, the PE/Long-Term Earnings Growth Rate for Tech is 1.5 vs. 1.0 for the S&P 500. Table 1Tech Valuation Premium Is Still Too High Chart 17Long-term Earnings Growth Does Not Justify Valuation Premium Either Of course, we need to keep in mind that since this sector is so top-heavy, the forward PE of the MAN affects overall sector valuations. As you can see in the table below (Table 2), MAN is trading with a premium to the sector. However, within the sector, companies with sky-high valuations are easier to find among smaller constituents (Chart 18). Valuations are elevated, while fundamentals are deteriorating  Table 2The Largest Tech Companies Are Trading With A Premium To The Sector Investment Implications While it is tempting to add to Technology on the back of this pullback, we recommend caution. Tech is oversold and recent volatility is a function of market panic, yet the stars have not yet aligned for the sector. Historically, Tech has delivered negative returns several months prior to rate hikes and underperformed the broad market. Economic normalization also brings a slowdown in demand for tech goods and services, which translates into less exciting sales and earnings growth, and margin compression. Although some froth has come off, valuations for the sector remain elevated, and the premium over the S&P 500 is not justified. The scorecard summarizes each of these points, and it is clear that, on balance, the sector has quite a few challenges ahead (Table 3). Table 3Technology Sector Scorecard On a more optimistic note, this sell-off has been fast and furious, and the worst is most likely behind. We are underweight the Technology sector. Within the sector, we are underweight Semiconductors, and Hardware and Equipment. We are still overweight Software and Services for portfolio diversification purposes. The Software sector will be one of our next “deep dives.” Stay tuned. Are we there yet?  No, we still have a few months to go. Structural Positioning While we reiterate our tactical underweighting of the Tech sector, we are bullish on it over the longer investment horizon. This sector is at the heart of US technological innovation, such as cloud computing, artificial intelligence, cybersecurity, chip design that powers EV and AV, and many others.  The sector is home to some of the best American companies, which have powered US equities throughout the past decade, and will continue to do so for decades ahead. Bottom Line Despite a sell-off of NASDAQ and the Technology sector, we are not yet recommending increasing cyclical allocation to Tech: While technicals appear attractive, tighter monetary policy, the slowdown in demand for tech goods and services, pressures on profitability, and elevated valuations remain headwinds. We reiterate our underweight to the Technology sector on a tactical basis.  We are structurally bullish.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights Banks, households, and businesses are still swimming in cash: Asset purchases and zero rates are ending, but banks, households and businesses have more cash than they know what to do with. It will not be easy for the Fed to mop up enough accommodation to slow the economy in a material way this year. The flood of liquidity may be a headwind for interest rates in 2022, … : The biggest banks have positioned themselves to benefit from rising rates and may limit the backup in yields as they deploy their unused capital hoard into it.  … and protect equities from suffering meaningful de-rating: All the money has to go somewhere, and equities may be the default winner if bonds and cash are poised to deliver negative real returns. The rosy near-term outlook implied by the biggest banks’ observations suggests that the bull market in risk assets isn’t over yet: Households have ramped up spending but have barely begun to tap into their excess savings and businesses are confident and well-heeled. Above-trend economic growth should bolster corporate earnings, credit performance and financial asset prices, keeping the bull market going through the end of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing the Martin Luther King long weekend. Their performance wasn’t bad – the SIFIs squarely beat analysts’ consensus estimates and USB came up about 3% short – but investors apparently wanted more from a group that had burst out of the gate to start 2022. Banks were market darlings in the year’s first nine sessions as investors sought out stocks that could outperform in a rising rate environment, and the SIFIs and USB beat the S&P 500 by 12 percentage points (Chart 1). Over the three sessions that they reported earnings, they gave back more than a third of their relative outperformance, though they still have a 7-point year-to-date advantage. Chart 1Rate Play Our focus, however, is not on the banks themselves or their stocks’ relative performance. We’re after what the principal financial intermediaries are seeing from their privileged vantage point into activity across the economy. We examine the banks’ earnings releases and listen to their earnings calls for insight into the broad macro backdrop as revealed by borrower performance, lender willingness, the state of the financial system and the actions and intentions of households and businesses. Considering the banks’ calls from that perspective, several growth-friendly themes emerged. Households remain flush with cash, even at the lower end of the wealth distribution, heralding robust 2022 consumption. Deposits from households and businesses continue to pile up, supporting credit performance and likely pushing out the date when net charge-off rates will rise to more normalized levels. The deposit flows are increasing the banks’ capacity to lend, and they are champing at the bit to deploy their cash into new loans. Investment banking pipelines are full and rampant liquidity should see to it that new debt and equity offerings meet with a warm reception once they come to market, as long as the current bout of market turbulence doesn’t lead to a lasting rollback in animal spirits. All in all, the banks’ observations affirmed our constructive take on the economy through at least the end of the year. Households are already spending in a way that validates our time-release view of fiscal transfers and their incomes have apparently risen enough that they have not yet begun to deplete the savings they built up from Congress’ pandemic largess. Businesses remain flush and are looking to replenish depleted inventories to reduce their vulnerability to supply chain disruptions. M&A activity is still hot and underwriting calendars are full. Yields are poised to rise as the Fed dials down monetary accommodation, but it’s possible the banks’ eagerness to put their idle cash to work will help limit how high they can go. Households Have Been Spending (Chart 2), But They Still Have Loads Of Dry Powder (Chart 3) … [F]or the holiday period of November and December, [debit and credit] spending was up 26% over 2019. … And so far this year that strength continues. [S]pending of all types through January 17 … [was] up over 11% versus the start of ’21, which is well up over ’20 and ’19, and that bodes well for the rest of the year and quarter. (Moynihan, BAC CEO) Chart 2You Can't Keep An Avid Consumer Down Chart 32 Trillion Of Excess Savings ... [C]ombined credit and debit [card] spend was up 27% versus the fourth quarter of 2019, with each quarter in 2021 showing sequential growth compared to 2019. Within that, travel and entertainment spend was up 13% versus 4Q19, though we have seen some softening in recent weeks contemporaneously with the Omicron wave. (Barnum, JPM CFO) Consumer credit card spend also continued to be strong, up 28% from the fourth quarter of 2020 and up 27% from the fourth quarter of 2019. All spending categories were up in the fourth quarter compared to a year ago, with the largest increases in travel, fuel, entertainment and dining. (Scharf, WFC CEO) [W]hile there is some softening [from Omicron] in restaurant, travel and entertainment in recent weeks, overall spending remained strong in the first week of January with credit card up 26% and debit card up 29% versus the same week in 2020. (Scharf, WFC) [W]e are seeing increases in [card] spend volume … across the board, [with] branded card spend volumes up 24% and retail services spend volumes up 16%[.] People are using our cards, which is a good thing. (Mason, C CFO) [C]onsumer[s] [are] in really good shape, … spending … 25% more than they spent pre-COVID, 25% more. And that number drives all the order books for everybody else. (Dimon, JPM CEO) We believe there’s lots of potential spending capacity left as average deposit balances (Chart 4) continue to move up … despite … heavy spending[.] We had [only] one cohort of deposits that dipped [in any] month [in] the last part of the year: … customers who had balances of $2,000 or less pre-pandemic [saw their balances] dip by 1% [in November]. Other than that, every cohort from June [through] December [had their balances] grow every month. And what’s striking is that the balances for people who had less than $2,000 average balances before the pandemic [now have] five times [their pre-pandemic] balances. [C]ustomers who had $10,000 in their accounts before the pandemic are now sitting with two times [that] in their accounts. (Moynihan, BAC) Chart 4... Are Sitting In Checking Accounts, Waiting To Be Spent  … Helping Credit Performance (Chart 5) And Keeping A Lid On Card Balances (Chart 6) Chart 6Cash-Rich Consumers Don't Need To Carry Credit Card Balances The asset quality of our customers remains very healthy and net charge-offs this quarter fell to a historical low of … 15 basis points of average loans. … Our credit card loss rate was 1.42%, … less than half of the pre-pandemic rate, [and] it improved in every quarter during the year. (Borthwick, BAC CFO) [O]ur 30, … 60 or 90 days past [due consumer loans] are staying at … low levels. … [C]ustomer [checking account] balances, elevated in some cases five times [above] … pre-pandemic levels … probably account for a lot of the consumer credit quality improvement. We’re anticipating at some point it will go back towards more normal historical levels. We just think it’s going to bump around here for a little while. (Borthwick, BAC) [W]e’re exiting the fourth quarter with a card net charge-off rate of … something like 1.2% -- -- Which you’ll never see again (Barnum and Dimon, JPM) [C]redit card [charge-offs] has been a number that we’ve never seen in our lives. Middle market has been lower than ever. … Mortgages have been lower than ever. They’re all low. Eventually, they’re going to normalize. (Dimon, JPM) In terms of [card] losses, … [we are seeing] very low loss levels. [W]hen I look at the delinquency trend, there’s really nothing to focus on there. [Delinquencies] remain quite low and we don’t see any signs or areas of concern. (Mason, C) Payment rates do remain stubbornly high, [negatively] impacting our loan growth … in [our] cards businesses. (Mason, C) Consumer credit performance remains strong with higher collateral values for homes and autos and consumer cash reserves remain[ing] above pre-pandemic levels. (Santomassimo, WFC CFO) Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio to remain lower than historical levels, but normalize over time as the effects of the pandemic continue to subside. (Dolan, USB CFO) Business Borrowing May Be Turning A Corner (Chart 7) Chart 7Are Middle-Market Corporate Borrowers Really Back? [Sequential] growth was broad-based across all commercial lending segments. We saw improvement in new loans as well as improvement in utilization from existing clients. … In the all-important small business segment, lending activity is running consistently above pre-pandemic levels. (Moynihan, BAC) We are seeing an uptick in revolver utilization rates, … and it remains sort of skewed to the smaller clients. But we are starting to see an uptick … even in the bigger clients. … [O]ne driver of that is CEOs and management teams have been burned by low inventory levels as a result of the supply chain problems, wanting to run higher inventories and that is maybe driving higher utilization. … At the same time, we’re hearing quite a bit of confidence in the C suites, and all else equal that should be positive for C[ommercial]&I[ndustrial] loan growth. The levels there are modest still in a world where capital markets have been exceptionally receptive to … [bond] issuance … and so people [have been] well-funded [by the] capital markets. (Barnum, JPM) Commercial loan balances started to increase late in the third quarter and have now grown for four consecutive months with growth accelerating in December. … Increases in middle-market banking were driven by growth from our larger clients, a modest uptick in revolver utilization and strong seasonal borrowing. Growth in asset-based lending and leasing was driven by new client wins as well as increased levels from higher prices and some increase in inventory levels. (Santomassimo, WFC) We are encouraged by the loan growth momentum and we have a positive outlook for 2022, given improving client sentiment and business conditions, and continued strength in certain focused commercial portfolios, such as asset-backed securitization lending and supply chain financing. (Cecere, USB CEO) [W]e’re now starting to see a nice shift with respect to the commercial and the C&I portfolios. … At the end of the fourth quarter, we saw nice expansion of utilization rates, … like 60 basis points on average from the third quarter, but in December it was up almost 2.5%. … [P]eople are rebuilding their inventories on the commercial side. I think … they still have some [supply chain] concerns, so I think they’re being cautious about making sure they have inventory to be able to run their business. And I think they’re starting to make business investment ahead of the consumer spend and the economic growth they see in 2022. (Dolan, USB) [The] number one fourth-quarter trend that looks positive going into 2022 is the increase in utilization rates, which we haven’t seen for a number of quarters. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 8) And Want To Put It To Work (Chart 9) When The Time Is Right Chart 8Water, Water Everywhere And Not A Drop To Drink Chart 9Banks Are Eager To Lend Given continued deposit growth and low rates, our asset sensitivity to rising rates remains significant. (Borthwick, BAC) [W]e still have significant dry powder to put to work with either client demand [loans] or in an increasing rate environment [securities], which we expect. (Mason, C) [W]e have huge firepower to grow, to expand, to make loans, to extend duration. I’ve never seen a bank with [our level of] liquidity: $1.7 trillion in cash and marketable securities and $1 trillion in loans. There’s $500 or 600 billion of those cash and marketable securities that could be deployed in higher-yielding assets or loans when and if the time comes. (Dimon, JPM) [Our] expectation is that when long-term rates rise, which we’re starting to see now, we’re going to be able to take advantage of the rising rate environment. … We [deployed some cash into securities] in the fourth quarter but employed hedging strategies to keep the duration of those purchases relatively short … to maintain as much asset sensitivity going into 2022 as we possibly could. (Dolan, USB) [W]e want maximum flexibility as long-term rates start to rise. (Dolan, USB) Investment Implications​​​​​​​ Chart 10Comeback Or Head Fake? The biggest banks told a consistent story about the US economy on their earnings calls. Activity is rising, as evidenced by avid consumption that gathered momentum across 2021, a pickup in business and consumer appetite for borrowing that quickened toward the end of the year (Chart 10), and expressions of confidence from businesses that are directing capital to replenishing inventories and buying equipment. Credit performance is tremendously strong with record-low net charge-off rates and low delinquency rates underpinned by bloated business and consumer deposit balances. Abundant cash reserves provide further fuel for consumption and should keep GDP growth well above its trend level. The growth and credit tailwinds suggest that a recession is not lurking around the corner and therefore offer a green light for investors to overweight equities within multi-asset portfolios. As detailed in the last two reports on rate hikes’ impact, we do not view the recent equity turbulence, triggered by a surge in Treasury yields, as the start of an inflection point for financial markets. We are inclined to see the decline as more of a buying opportunity than a herald of a new shift in the business cycle. The Fed has the means to slow the economy if it sets its mind to it but given the amount of cash that is overwhelming banks, businesses, households and investors, draining enough accommodation to do so by the end of 2022 is an awfully tall order.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com