Emerging Markets

Highlights Chart 1Stick With Steepeners Stick With Steepeners Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Prepare For Liftoff Prepare For Liftoff Table 2Fixed Income Sector Performance Prepare For Liftoff Prepare For Liftoff Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Prepare For Liftoff Prepare For Liftoff Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights For the time being, US core inflation will not drop anywhere close to the Fed’s target range. The Fed will continue tightening until something breaks. US bond yields and the US dollar are heading higher. The S&P500 will need to drop meaningfully for the Fed to stop tightening. The Fed’s tightening and the US dollar’s persistent strength amid the lack of recovery in the Chinese business cycle will eventually produce a drawdown in commodity prices in the coming months. Absolute-return investors should stay defensive on EM risk assets and asset allocators should continue to underweight EM versus DM in global equity and credit portfolios. Feature We are starting the year with a review of a few macro pillars of our view that will shape global financial markets in the coming months. US Core Inflation Will Prove Sticky… Chart 1Average Of All Core US Inflation Measures Average Of All Core US Inflation Measures Average Of All Core US Inflation Measures The average of seven various US core inflation measures – core CPI, core PCE, trimmed-mean CPI, median CPI, sticky core CPI, trimmed-mean PCE and market-based core PCE – has surged to 4% (Chart 1). Although the core inflation rate could decline in 2022 as supply bottlenecks ease and base effects become more favorable, it is unlikely to drop below 3%. Instead, it will remain well above the Fed’s inflation target. If the Fed adheres to its mandate, it will have to hike rates until inflation heads toward 2%. US core inflation will not drop toward 2% unless the economy slows materially. Consumer and business inflation expectations have risen substantially. US consumer inflation expectations for one and three years ahead have risen to 4-6%, and US non-farm businesses have been able to raise prices by 4.5% y/y in Q3 (Chart 2). We can say the genie – inflation and inflation expectations – is out of bottle and it will be hard to put it back in. Importantly, labor market shortages will persist, and employee wage demand will be strong. Employees’ current wage growth expectations are based on their inflation expectations in the next one to three years, not the next decade. Even though longer term inflation expectations remain somewhat muted, they will not prevent high wage growth. Critically, inflation has “eaten” into employee income: real wage growth – adjusted for headline consumer price inflation – has been negative in 2021 (Chart 3). Consistently, employees know their compensation has lagged inflation and will be demanding significant wage hikes in 2022. Chart 3Inflation Is "Eating" Into Wages In The US Inflation Is "Eating" Into Wages In The US Inflation Is "Eating" Into Wages In The US Chart 2US Inflation Expectations Have Risen Sharply US Inflation Expectations Have Risen Sharply US Inflation Expectations Have Risen Sharply   In short, a wage-price spiral of moderate proportions is unfolding. Given tight labor market conditions, businesses will have no choice but raise wages considerably and then try to pass the higher costs on to their consumers. … Prompting Higher US Bond Yields … Despite the surge in core inflation to a 30-plus year high, US bond yields have remained low. The long end of the US yield curve has continued to be suppressed even as the market participants raised their rate hike expectations. Not only has the expected terminal Fed funds target rate not risen much, but also the bond term premium has remained negative. The bond term premium is akin to the equity risk premium. Pronounced uncertainty about the US inflation outlook as well as elevated bond volatility warrant a higher bond term premium (Chart 4). … Which Will Push The US Dollar Higher… Rising US interest rate expectations will lead to a stronger greenback. Our US Dollar Liquidity Indicator points to continued firmness in the broad trade-weighted US dollar ( the latter is shown inverted in this chart) (Chart 5). Chart 5US Dollar Liquidity And The US Dollar US Dollar Liquidity And The US Dollar US Dollar Liquidity And The US Dollar Chart 4Inflation Uncertainty And High Bond Volitility Herald A Higher Term Premium Inflation Uncertainty And High Bond Volitility Herald A Higher Term Premium Inflation Uncertainty And High Bond Volitility Herald A Higher Term Premium   Our framework for the relationship between currencies and their interest rates is as follows: Scenario 1: When inflation is high or rising fast, the central bank is willing to hike rates and the economy can withstand higher borrowing costs, the currency will appreciate. Scenario 2: When inflation is high or rising fast and the central bank is unwilling to hike rates, the currency will depreciate. This is the case when the central bank falls behind the curve. Scenario 3: When the central bank is tightening but the economy cannot handle higher borrowing costs, the currency will depreciate. The US economy is presently able to handle higher interest rates. Hence, the US dollar is currently driven by the dynamics described in Scenario 1, i.e., rising interest rates will support the greenback. Chart 6US Household Finances Are Healthy US Household Finances Are Healthy US Household Finances Are Healthy Our rationale is that US interest rate sensitive sectors like housing and car sales have been restrained by supply shortages – not weak demand. In fact, there is large pent-up demand for both housing and autos and a reasonable rise in borrowing costs will not thwart this demand. Besides, US household debt and debt servicing costs have declined substantially in the past 10 years (Chart 6). US households are no longer highly indebted. This development – along with robust wage gains – will allow households to borrow more and service their debt. Finally, unlike in many other Anglo-Saxon countries, in the US it is long-term rates – rather than short ones – that matter for household debt servicing. Mortgages make up 70% of household debt in the US and the mortgage rate is tied to the 30-year bond yield. In many other advanced and emerging economies, mortgage rates are more influenced by the central bank policy rate than long-term bond yields. As a result, the US economy will be able to endure monetary tightening by the Fed better than other developed and emerging economies can handle rate hikes from their central banks. Specifically, mainstream EM economies (EM ex-China, Korea and Taiwan) will slow markedly as and if their central banks hike rates further (Chart 7). There is, however, a caveat: Even though Main Street America will be able to withstand a reasonable amount of rate hikes, Wall Street might not be able ride out these rate hikes. The difference is the starting point – US equity valuations are very high. … And Will Herald A US Equity Correction And Sector Rotation The spike in US core inflation is likely to engender a negative correlation between US share prices and bond yields, as was the case in 1966. We first made this argument in last year’s Special Report titled A Paradigm Shift In The Stock-Bond Relationship (Chart 8). Chart 7Mainstream EM: Monetary Tightening Will Dampen Growth Mainstream EM: Monetary Tightening Will Dampen Growth Mainstream EM: Monetary Tightening Will Dampen Growth Chart 8S&P500 And Bond Yields Correlation Will Turn Negative S&P500 And Bond Yields Correlation Will Turn Negative S&P500 And Bond Yields Correlation Will Turn Negative   The current episode in the US is akin to the second half of the 1960s when US core inflation and bond yields rose after decades of lingering at very low levels. Starting in 1966, US share prices became negatively correlated with US Treasury yields (Chart 9 – bond yields are shown inverted). Going forward, the S&P 500 will often take its cue from US bond yields: stocks will rally when bond yields decline, and tumble when bond yields rise. Given that we expect US Treasury yields to rise in the coming months (10-year yields will move well above 2%), the S&P 500 is likely to correct. The key risk to this view is the massive amount of cash on the sidelines, and widespread investor willingness to buy any dip in US equities. The absolute level of US retail money market funds currently stands at a formidable $1 trillion (Chart 10, top panel). However, this just represents a mere 2% of the US equity market cap (Chart 10, bottom panel). Hence, if institutional investors begin selling stocks, retail investors might not be able to support the market. Chart 9Early 2020s = Late 1960s? Early 2020s = Late 1960s? Early 2020s = Late 1960s? Chart 10Cash on Sidelines: A Lot Or Not So Much? Cash on Sidelines: A Lot Or Not So Much? Cash on Sidelines: A Lot Or Not So Much? Chart 11EM Relative Equity Performance Is Correlated With The USD, Not Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not Bond Yields Furthermore, rising US bond yields will cause US value stocks to outperform US growth stocks. Will EM stocks outperform US or DM ones as US bond yields rise? The top panel of Chart 11 illustrates that there has been no stable correlation between US bond yields and EM versus DM relative equity performance. Yet, there is a strong relationship between EM relative equity performance and the US dollar (Chart 11, bottom panel). If the broad trade-weighted US dollar rallies, EM stocks will underperform their DM counterparts (the greenback is shown inverted in the bottom panel of Chart 11). A sell-off in US stocks and bonds and the greenback’s rally will tighten US financial conditions considerably. The Fed is putting a lot of weight on financial conditions, especially when they are becoming restrictive. As US financial conditions tighten, the Fed will likely pivot, i.e., soften its hawkish stance. The Fed would likely argue that tight financial conditions will slow growth, which will in turn bring down inflation. Such a Fed pivot will potentially mark the end of a US dollar rally, enable American share prices to rise again, and EM stocks to start outperforming. However, we are not there yet. Bottom Line: For the time being, US core inflation will not drop anywhere close to the Fed’s target range. Hence, the Fed will continue tightening until something breaks. It will take a meaningful drop in the S&P500 (~20%) to make the Fed stop tightening. Commodity Prices Commodity prices have been caught between two opposing forces: US inflation and China’s slowdown. Worries about US inflation have made investors buy inflation hedges, and commodities are traditionally viewed as an inflation hedge. Yet, there is a caveat: Inflation is proliferating in the US but not in China. On the contrary, Chinese imports of key commodities contracted dramatically in H2 2021 (Chart 12). We are surprised that commodity prices have been so resilient despite shrinking Chinese commodity imports. Our sense is that commodity prices have been held up by two forces: strong global manufacturing activity and financial demand from investors. As for the green revolution, we believe it will be a major bullish force for select commodities in a couple of years. At the moment, however, it is not large enough to offset the slowdown in the Chinese economy. It might take investor concerns about US demand and/or a slowdown in global manufacturing to trigger a relapse in commodity prices. Rising US interest rates and a continued dollar rally will eventually result in a meaningful drawdown in commodity prices. Chart 13 demonstrates that the declines in the Swedish manufacturing PMI new orders-to-inventory ratio and the Swedish krona/Swiss franc cross rate point to downside risks in raw materials prices. Chart 12Chinese Imports Of Key Commodities Have Shrunk Chinese Imports Of Key Commodities Have Shrunk Chinese Imports Of Key Commodities Have Shrunk Chart 13A Red Flag For Commodities From Industrial Sweden A Red Flag For Commodities From Industrial Sweden A Red Flag For Commodities From Industrial Sweden   Bottom Line: Commodity prices have so far ignored China’s slowdown. However, the Fed’s tightening and the US dollar’s persistent strength amid the lack of recovery in the Chinese business cycle will eventually produce a drawdown in resource prices in the coming months. Investment Strategy For EM Chart 14EM Equities: No Profit Growth, No Bull Market EM Equities: No Profit Growth, No Bull Market EM Equities: No Profit Growth, No Bull Market EM share prices have been falling in absolute terms despite the strength in the S&P 500. The EM equity index will drop further due to the dismal EM profit outlook and the continued de-rating of Chinese TMT stocks. In absolute terms, the EM equity index is at the same level as it was in 2011 because EM EPS in USD has not expanded at all since 2011 (Chart 14). Investors are reluctant to pay high multiples for EM companies because they have produced zero earnings growth over the past 10 years. Besides, higher US bond yields and continued strength in the US dollar will lead to higher EM sovereign and corporate bond yields. EM non-TMT share prices typically wobble when EM US dollar borrowing costs rise (Chart 15). Chart 15Rising EM USD Borrowing Costs Are Bearish For EM Non-TMT Stocks Rising EM USD Borrowing Costs Are Bearish For EM Non-TMT Stocks Rising EM USD Borrowing Costs Are Bearish For EM Non-TMT Stocks We continue to recommend underweighting EM in a global equity portfolio. EM always underperforms DM when the greenback rallies. We maintain our short positions in a basket of EM currencies versus the US dollar. Rising US bond yields and a firm greenback will continue weighing on EM fixed income markets – both local currency and US dollar ones. Fixed-income investors should favor US corporate credit over EM corporate and sovereign credit, quality adjusted. In local rates, we are betting on yield curve inversion in Russia and Mexico, receiving rates in China and Malaysia and paying rates in the Czech Republic. For the full list of our fixed-income, currency and equity recommendations, please refer to the tables below. These are also available on our website. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights December’s PMI and our market-based China growth indicator improved slightly, but the underlying data send a mixed signal about the country’s business cycle and do not give a green light for cyclically overweighting Chinese stocks. Our research suggests that the odds of an earnings contraction for Chinese investable stocks over the coming year are high. In previous cycles, stocks only bottomed when the earnings adjustment process was well underway. In the next one to three months, investors may bid up Chinese stocks for their relatively cheap valuations and in expectation of further policy easing. A tactical rebound in Chinese stocks (in both the domestic and investable markets) in absolute terms is likely. However, we think it is premature to switch to an outright overweight stance on Chinese versus global stocks over the coming 6-12 months. Feature Chart 1Chinese Stocks Underperformed Global Markets In 2021 Chinese Stocks Underperformed Global Markets In 2021 Chinese Stocks Underperformed Global Markets In 2021 Chinese stocks underperformed global equities last year. In particular, Chinese investable stocks were among the worst performing major equity indices last year, ending 2021 with a 23% loss (Chart 1). Lately China’s macro policies have begun to refocus on supporting the economy, and investors have been asking whether cheaper valuations in Chinese equities warrant an overweight stance versus global stocks. We think a tactical rally in Chinese stocks is likely, as investors may bid up the market in expectation of more stimulus. The Chinese offshore market remains deeply oversold in relative terms, and further easing in policy in the coming few weeks may significantly improve global investor sentiment towards the country’s bourse. However, we maintain our view that a legitimate improvement in domestic fundamentals is needed before we recommend investors to upgrade their cyclical equity allocation to China. Mixed Signals Over the past several weeks, we focused heavily on China’s cyclical economic conditions, and whether any “green shoots” are evident from the key indicators that we track. The official PMIs and our high-frequency, market-based growth indicator both improved slightly in December, but their underlying components point to continued weakness in the old economy sectors. Hence, for now, we regard the marginal improvement in these indicators as a mixed signal rather than a green light for upgrading Chinese stocks on a cyclical basis. The official PMI manufacturing index inched up to 50.3 in December from 50.1 in November. While the proxy for domestic demand – measured by the new orders component subtracting the new export orders – ticked up slightly last month, the overall new orders subindex remains below the 50 threshold (Chart 2). In addition, both new orders and business activity in the construction PMI subindex fell sharply in December, due to sluggish infrastructure activity as well as a significant drag from the housing sector (Chart 3). Chart 2Manufacturing New Orders Remain In Contraction Manufacturing New Orders Remain In Contraction Manufacturing New Orders Remain In Contraction Chart 3Construction PMI Fell Sharply In December Construction PMI Fell Sharply In December Construction PMI Fell Sharply In December Chart 4Largely Driven By Commodity-Related Components Largely Driven By Commodity-Related Components Largely Driven By Commodity-Related Components Our market-based China growth indicator also rose slightly in December, although it remains in contraction. Chart 4 presents this growth indicator, its four asset class subcomponents, and the range between the strongest and weakest components. The chart shows that the recent rise in the indicator is not uniform. While most of the individual components have improved over the past month, a rise in metal prices and commodity-related equity and currency prices have accounted for most of the gains. As highlighted in China’s November and December PMIs, we think the improvement in the commodity component of the growth indicator reflects an easing in production-side constraints, rather than a sustained rebound in demand. Bottom Line: Data released recently point to a mixed picture regarding China’s economic fundamentals. It is premature to conclude that the current policy easing measures will suffice in reviving China’s slowing economy. The Negative Factors Impacting Cyclical Outlook There are two negative factors impacting our outlook for Chinese stocks. One is the effect of a slowing domestic economy on earnings; our model suggests that the odds of an earnings contraction over the coming year are high. The other negative factor is the ongoing regulatory and secular geopolitical risks on Chinese offshore-market stocks. Chart 5 presents the odds of a serious earnings contraction over the coming 12 months (defined as earnings growth falling below -5%). The chart shows that the model successfully warned of the three major earnings contractions over the past decade. Crucially, the odds of a major contraction did not rise above the 50% mark in 2012, when investable earnings growth decelerated significantly and fell briefly into negative territory. The current message from the model is clear: the odds of a significant earnings contraction over the coming 12 months are as high as 70%, implying that the deceleration in 12-month trailing earnings growth shown in the bottom panel of Chart 5 is likely to continue. In addition to the elevated risks of an earnings contraction, regulatory and geopolitical risks remain a major challenge for Chinese companies listed in the offshore equity markets (Chart 6). Big tech names like Alibaba, Tencent, and Meituan still face regulatory pressures from authorities. Last week, Beijing further tightened scrutiny of overseas equity sales by unveiling regulations that bar Chinese companies in sensitive industries from receiving foreign investment.  Chart 5Our Model Implies High Odds Of An Earnings Contraction Our Model Implies High Odds Of An Earnings Contraction Our Model Implies High Odds Of An Earnings Contraction Chart 6Chinese Investable Stocks Continue Facing Regulatory And Geopolitical Risks Chinese Investable Stocks Continue Facing Regulatory And Geopolitical Risks Chinese Investable Stocks Continue Facing Regulatory And Geopolitical Risks Pressures from both Chinese and US regulators will continue to push Chinese firms to depart from US stock exchanges. The disputes between the US and China, which in our US Geopolitical Strategy's view are deep and structural, will likely culminate in the months leading up to the 20th National Party Congress in China and the mid-term election in the US in the fall of 2022. It is true that the delisted Chinese firms will likely migrate to Hong Kong, and in theory should offer global investors the same returns. However, we argue that as the delisted companies fail to comply with transnational disclosure standards and financial audit regulations mandated by the US Securities and Exchange Commission (SEC), global investors will demand higher risk premiums (and hence lower valuations) to own Chinese investable stocks. In the next two to three months, it is possible that investors may bid up Chinese stocks in expectation of further policy loosening. Since data on the real economic activity in the first two months of the year will not be released until March, investors will likely focus on credit, monetary, and trade data. However, we caution against moving to an overweight stance towards Chinese stocks for investors with time horizon of 6 to 12 months. While easier macro policies are certainly welcome, we remain skeptical that: a) the existing policy support is enough to revive China’s economy; and b) Chinese policymakers will provide aggressive stimulus and allow a major acceleration in credit growth for the entire year of 2022.  Bottom Line: While in the near term, investors may find Chinese stocks attractive due to cheap valuations and expectations of further stimulus, Chinese stocks face challenges both from the impact of a slowing economy on earnings growth and ongoing regulatory and geopolitical risks.  Investment Conclusions Chinese stocks in both the onshore and offshore markets have cheapened relative to global equities. However, in absolute terms Chinese stocks are not unduly cheap and their valuations are higher than in both 2015/16 and 2018/19 (Chart 7). In previous cycles, Chinese stock prices bottomed when the earnings adjustment process was well underway or near the end of the process. Chart 8 presents some perspective on when investors are likely to anticipate an eventual bottom in stock prices, if an earnings contraction does indeed occur. The chart shows the level of 12-month forward earnings for investable and domestic stocks, and circles at what point share prices bottomed during the previous cycles. Chart 8The Forward Earnings Adjustment Process Has Just Started The Forward Earnings Adjustment Process Has Just Started The Forward Earnings Adjustment Process Has Just Started Chart 7Chinese Onshore Stocks Are Not Cheap In Absolute Terms Chinese Onshore Stocks Are Not Cheap In Absolute Terms Chinese Onshore Stocks Are Not Cheap In Absolute Terms   The chart shows that onshore equities bottomed roughly halfway through the earnings adjustment process, whereas the investable market bottomed almost at the end of the process. The chart also shows that this adjustment process has barely begun in the current cycle, which argues against a cyclically overweight stance towards Chinese stocks.   Jing Sima China Strategist jings@bcaresearch.com Equity Sector Recommendations Cyclical Investment Stance

Image We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Growth Will Continue To Be Above Trend Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Growth Will Be Boosted By The Wealth Effect... Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production ...And Capex To Increase Production ...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Covid Cases Not Leading to Hospitalizations And Deaths Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Fed Hikes Have Usually Caused Only A Short-Lived Selloff Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots The Futures Market Is In Line With The FOMC Dots The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Tapering Didn't Much Affect Stocks Either Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year Inflation Probably Will Decline This Year Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Year-On-Year Inflation Will Remain High Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? Risk Of A Price-Wage Spiral? Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Where Have All The Corrections Gone? Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow Stock Market Has Got Very Narrow Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chinese Data Looks Very Poor Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Is Credit Growth Now Bottoming? Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Slump In China Property Is Not Over Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up It Will Take A While For Commodity Prices To Pick Up It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? What Can Drive Returns In 2022? What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Margins Likely To Slip From Record High Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Europe Is More Sensitive To China Slowing... Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap ...And Not Particularly Cheap ...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese US Treasurys Are Attractive to Europeans And Japanese US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Long Rates Low Given Fed Signaling Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation Breakevens Already Pricing In A Lot Of Inflation Breakevens Already Pricing In A Lot Of Inflation Chart 24 In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds ...As Are Some EM Dollar Bonds ...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Dollar To Rise On More Hawkish Fed? Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Gold Is Vulnerable To Rising Real Rates Gold Is Vulnerable To Rising Real Rates Chart 27 Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation