Equities

Executive Summary Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases The economic impact of China’s struggle with another wave of COVID outbreaks is showing up in March’s PMI and high-frequency data. The highly contagious nature of the Omicron variant suggests that Shanghai’s battle against the virus spread may last longer than the market has priced in. Chinese authorities will continue playing whack-a-mole in efforts to eliminate the country’s COVID cases. The zero-COVID approach and the virus’ mutating to more contagious variants mean that the country may have to impose more frequent mobility restrictions going forward than in the past two years. Although Chinese policymakers are determined to stabilize the economy, the ongoing combat with COVID will weigh down the effectiveness of the stimulus. In relative terms, we maintain a neutral position on Chinese onshore stocks. However, downshifting corporate profits and the economic shock from lockdowns remain significant risks to the absolute performance of Chinese stocks. Bottom Line: China’s combat against the current COVID-19 outbreaks may last longer than the market has priced in. In the near term, the lockdowns will weigh down the effectiveness of the stimulus. In the second half of the year, the more contagious virus mutations and China’s sticking to zero-COVID strategy may lead to more frequent disruptions to business activity.     Chart 1China Is Bracing For The Worst COVID Outbreak Since Early 2020 China’s efforts to stabilize economic growth are facing new challenges, dampening an already fragile recovery. The current wave of COVID-19 outbreaks — the worst since early 2020 — has infected more than 100,000 (TK) people across the country, and the number of new cases is still rising at an exponential rate (Chart 1). Measures to contain the spread of the virus have led to city lockdowns, halted factory production and have dragged down the tourism and catering industries. In previous reports, we noted that it is challenging for China to reach this year’s 5.5% growth target due to downbeat private-sector sentiment and subdued demand for housing. The outlook for China’s economy is grimmer now. The highly contagious COVID virus mutations, including the emerging Omicron BA.2 variant, will make it more difficult for China to control its domestic outbreaks going forward. We do not expect that China will fundamentally change its zero-COVID policy throughout the rest of this year. Therefore, the country will probably see more frequent regional and city lockdowns this year than in the past two years.  The leadership will calibrate its handling of these lockdowns to minimize damage to the economy, and Beijing will continue stepping up its growth support policies. However, the whack-a-mole strategy to eliminate domestic COVID cases will be disruptive to business activity and dampen the effectiveness of policy easing. A One-Two Punch… Related Report  China Investment StrategyA Choppy Bottom The downside risks to China’s economy stemming from the ongoing domestic COVID outbreaks are adding to the difficulties the country is already facing due to subdued domestic demand. As we have been highlighting in our previous reports, weak private sector sentiment has been weighing down the effectiveness of authorities’ efforts to stimulate the Chinese economy. The sluggish PMI data released last week in part reflects the impact of restrictions imposed to control the latest wave of COVID-19 infections, but also highlights the bleak domestic demand conditions. Notably, the March PMI survey does not capture the full impact of the Shanghai lockdown as the data collection period ended before the restrictions went into effect on March 28. The official composite PMI fell from 51.2 to 48.8 – below the 50 boom-bust threshold and the lowest reading since February 2020. The drop reflects a slump in the manufacturing and – to a greater extent – the non-manufacturing sectors, which both fell into a contractionary territory. The manufacturing PMI slid 0.7 points to 49.5, while the non-manufacturing PMI dropped 3.2 points to 48.4 (Chart 2). The new orders sub-index of the manufacturing PMI lost nearly two percentage points and deteriorated more sharply than the production index (Chart 3). Moreover, the spread between the new orders component and new export orders – a proxy for domestic demand – ticked down in March (Chart 3, bottom panel). This indicates that weak production does not just stem from COVID-related supply-side issues, but also from poor domestic demand conditions. Chart 2Chinese PMIs Slide Into Contractionary Territory Chart 3Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Chart 4Auto Inventory Index Jumped To Highest Since Early 2020 In addition, high-frequency data from the China Automobile Dealers Association shows that the Vehicle Inventory Alert Index (VIAI) – a survey that measures destocking pressures in the automobile industry – jumped to the highest level since the first wave of COVID-19 hit China in early 2020 (Chart 4). A rising VIAI above the 50-percent threshold indicates that auto inventories are cumulating at a faster pace than demand.  Importantly, the cities and regions that have been worst hit by this round of COVID outbreaks are mostly coastal metropolises and business hubs such as Shanghai, Shenzhen and cities in Jiangsu and Zhejiang provinces. These cities and provinces represent more than 20% of China’s aggregate GDP and almost 30% of the country’s total import and export volume. As such, the negative impact on China’s overall economy from the lockdowns will be more substantive than during the previous waves. Measures to contain Shanghai’s worst-ever COVID outbreak are also disrupting operations at the world’s busiest container port, adding strains to the already overstretched global shipping industry (Chart 5). The supplier delivery times subindex of the manufacturing PMI dropped to 46.5 in March, the lowest reading since March 2020 (Chart 6). This suggests that suppliers’ delivery times have lengthened with near-term supply chain pressure, since lower readings reflect longer delivery times. Chart 5Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Chart 6Chinese Suppliers' Delivery Times Have Lengthened Bottom Line: The economic shock from the current COVID outbreaks is compounding an already weak domestic demand in China. Since the cities and regions that are affected by this round of lockdowns are some of China’s most developed metropolitan areas, the negative impact will likely be larger than during the past two years. How Long Will The Battle Last? China’s struggle to contain the current round of domestic COVID outbreaks will likely last longer than the market has priced in. There is also a non-trivial risk that during the rest of the year, the country will need to shutter large parts of its economy more frequently to combat the spread of COVID variants, which appear to become more contagious as the mutation continues. The lockdowns in Shanghai have already been extended beyond the originally announced two-phased, eight-day restriction plan (Chart 7). The first phase of the lockdown, for which restrictions were due to be lifted on the morning of April 1, has now been extended to anywhere between 3 to 10 days. It may take Shanghai, a city of 25 million residents, between four to six weeks to bring the number of new cases down to a level that is acceptable to the authorities. Chart 7Shanghai Is Extending Its Two-Phased, Eight-Day Lockdowns Shenzhen, a dynamic metropolitan city bordering Hong Kong, seems to have successfully contained its COVID outbreaks after only one week of a city-wide lockdown. However, Shenzhen imposed lockdowns at an early stage of the outbreak, when both confirmed and asymptomatic case numbers in the city were in the low double digits. Shanghai, on the other hand, took more stringent measures when the number of asymptomatic cases had already reached nearly a thousand. The Omicron variant is four times more transmissible than the earlier Delta mutation, which means it will generate an explosive rise in cases and make containing the virus spread much more difficult than with Delta. In a fully susceptible (unvaccinated and uninfected) population, one person with Delta would on average infect five other people, while one person with Omicron could transmit the virus to about 20 others. As a result, despite a relatively low number of newly confirmed cases, the surging asymptomatic cases in Shanghai imply that a larger population in the city might have already been infected (Chart 8). China’s struggle with the current wave of COVID outbreaks may be an example of what lies ahead, as continuously mutating variants become more contagious and will pose fresh new challenges to China’s zero-COVID approach. The latest strain of Omicron BA.2 appears to be 40% more contagious than the original Omicron strain and is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 9). It took only two months from when China reported its first local Omicron BA.1 case in early January to the outbreaks of Omicron BA.2 in March. Chart 8Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Chart 9Covid Cases Are On The Rise Again Globally This presents the Chinese authorities with a difficult dilemma: impose severe mobility restrictions when domestic cases pop up, or let the virus run rampant and develop a herd immunity among much of its population. China’s leadership has recently reiterated that the country will stick to its zero-COVID strategy. The success that China has had in suppressing the virus in the past two years has left its population with little natural immunity. Moreover, while China’s overall vaccination rate is high at 85%, less than 50% of people over the age of 80 in the country are fully vaccinated. The authorities have been fine tuning their measures to control the virus spread while sticking to a zero-COVID approach. The recently calibrated measures include allowing residents to take rapid antigen tests at home, quarantining people with asymptomatic COVID cases at dedicated isolation centers rather than hospitals, and monitoring patients for shorter periods than previously required. China has also fast-tracked the approval for the importing and domestic manufacturing of Paxlovid, which is highly effective at preventing hospitalization if taken within five days of the onset of symptoms. In addition, the global production of antiviral drugs is starting to ramp up (Chart 10). Nonetheless, China will probably wait until the antiviral drugs are in sufficient supply before fundamentally relaxing its zero-COVID policy. In the meantime, while the country’s economic growth will rebound when the current wave of COVID cases subsides, disruptive outbreaks and lockdowns may become more frequent as the authorities continue to play whack-a-mole with COVID (Chart 11). As a result, business activity in China will suffer. Chart 10Production Of New COVID Drugs Is Picking Up Chart 11China Has The Most Stringent COVID-Control Measures Among Large Economies Bottom Line: Shanghai’s current battle with COVID outbreaks will likely continue in the coming weeks. Before China can relax its zero-COVID policy, the more contagious COVID virus mutations in the future will see Chinese authorities adopt even harsher quarantine and control measures, which will disrupt economic activity further. Investment Conclusion  Chinese stocks in both onshore and offshore markets have recovered some ground from their deeply oversold conditions in mid-March (Chart 12A). While the risk-reward profile for the A-share market warrants a neutral position in a global portfolio, in absolute terms both on- and offshore Chinese stock prices have probably not reached their bottom (Chart 12B). Chart 12AChinese Stocks Will Likely Fall Further In Q2 Chart 12BIn Relative Terms, Stay Neutral On Chinese Onshore Stocks The private sector’s downbeat sentiment, households’ subdued demand for housing, and the ongoing COVID-19 lockdowns pose significant near-term downside risks to China’s economy and corporate profits. February’s credit impulse shows that corporate and household demand for credit has been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Moreover, the March PMI readings suggest that the lockdowns in China’s business and manufacturing hubs will have substantial negative impacts on the economy. As such, we maintain our neutral stance on Chinese onshore stocks and continue to recommend underweight Chinese offshore stocks in a global portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Strategic Themes Cyclical Recommendations

Executive Summary Tighter Financial Conditions May Affect Growth Inflation Outlook: Inflation is becoming entrenched, spreading beyond a few pandemic-related items to “sticky price” categories. A wage-price spiral and unmoored inflation expectations translate into upside risk to the 2.5% consensus core PCE forecast. Consumer Spending: Americans are being forced to allocate a larger proportion of income towards food and gas, shifting consumption away from discretionary spending. As such, consumer spending alone may not be able to keep the economy afloat. On a 50bps hike: The rate hike increments are less important than the message the Fed is sending out to the market: Talking up 50 bp rate rises, the Fed is signaling that is it laser-focused on inflation, which is reassuring. Tightening and the economy: Aggressive monetary tightening will lead to slower economic growth, but this is not yet reflected in consensus economic growth forecasts. Recession Coming? Economic growth is slowing but off high levels, and recession is not imminent.  Our recession indicator does not flash danger. However, we are watching out for a growth disappointment. Bottom Line: In a commentary to our bi-monthly sector chart pack report, we provide answers to the most frequently asked questions on the state of the US economy.  Feature Performance Markets never cease to surprise. In March, US equities staged an unexpected rally despite the backdrop of a hawkish Fed, raging inflation, surging energy prices, and a war in the heart of Europe. The reversal was broad-based, not leaving a single sector in the red (Chart I-1). The S&P 500 has regained 9% since the market bottom on March 8, 2022 and is only 5.5% off its all-time high. The NASDAQ has rebounded 13%. Is this rally sustainable? In a report a couple of weeks ago, we aimed to answer this question. We recommended patience, although many ingredients, such as attractive valuations and oversold technical conditions, were already in place. Our reasons for patience were that: Economic growth expectations are still elevated and bottom-up earnings growth forecasts need to come down, to reflect slowing growth, a tighter monetary regime, and higher commodities and energy prices. Our view is unchanged. This week was a busy one: A media interview with The Deep Dive, and two virtual conferences in Australia, one run by Insider Network and the other by Equity Forum. In today’s cover report for our sector chartpack, we answer questions we received from the media and conference audience, that we believe will be of interest to clients. Chart I-1Powerful Rebound Questions And Answers The Consumer Price Index (CPI) increased by 7.9% and the PCE price index, the Fed’s preferred measure of inflation, came in at 6.4% in February – readings not seen since 1982. What is your outlook on inflation? Inflation will come down, assisted by the arithmetic of the base effect. However, it is unlikely to revert to levels that the Fed and the US consumer will consider acceptable. Moreover, inflation could surprise further to the upside. The concern is that inflation is becoming entrenched. It has spread beyond a few pandemic-related items to goods for which prices are usually sticky (Chart I-2). There are also clear signs that price increases are feeding through to wage increases. Real wage growth remains negative at -2%, while demand for labor is robust – there are 1.7 open jobs per job seeker, and companies are raising wages to retain talent (Chart I-3). Subsequently, they will raise prices to pass on cost increases to customers. These are fertile conditions for a wage-price spiral, with inflation becoming even more entrenched. Chart I-2Even Sticky Prices Are Now Rising Chart I-3Rising Wages Are In Lockstep With Rising Prices Further, inflation expectations have become unmoored: According to a University of Michigan survey, consumers expect prices to rise by 5.5% over the next year, and by more than 3% a year over five to 10 years (Chart I-4). Concerningly, the upward adjustment in inflation expectations is relentless. The war in Ukraine exacerbates many causes of inflation: Its indirect effects are shortages of raw materials, energy, and shipping disruptions (Chart I-5). Chart I-4Inflation Expectations Are Unmoored Chart I-5Supply Chains Remain Disrupted Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. Bottom Line: Inflation will come down but may not normalize any time soon. What is the effect of food and energy inflation on consumer spending? Negative real wage growth bites into consumer purchasing power, sapping confidence (Chart I-6). It does not help that food and energy prices are up by 8% and 14% respectively year over year (Chart I-7). However, the rising price of necessities has the most pronounced effect on low earners: Food accounts for more than a quarter of the after-tax income of the lowest quintile of earners, falling to just over five percent of income for top earners (Chart I-8). As many Americans are forced to allocate a larger proportion of income towards food and gas, they have to shift consumption away from discretionary spending. Thus, a high price for gasoline does not necessarily suppress demand for gasoline but rather reduces demand for, say, fast-food meals. Chart I-6High Inflation Saps Consumer Confidence Chart I-7Food And Energy Prices Have Surged This change in a spending basket explains a slowdown in consumer spending: PCE increased only 0.2% month-on-month in February, which is underwhelming compared to the 0.7% expected. It also explains rising credit-card balances (Chart I-9). Chart 8Rising Cost Of Food Cuts Into Discretionary Spending... Chart I-9Many Consumers Are Struggling At the same time, we know that US consumers have $2.3 trillion in excess savings – which are clearly not uniformly distributed across income groups. This nice stash of cash provides a solid consumer spending cushion for the US economy, but it may not be up to the challenge of keeping the economy afloat single-handedly. Bottom Line: For now, the US consumer is in good shape but there are cracks in the foundation as lower-income Americans are clearly struggling with rising food and gas prices. Fed Chair Jerome Powell noted last week that the Fed could raise rates from the traditional 25 basis points per meeting to 50 basis points if necessary. Do you think 50 basis points will have much of an impact on inflation or on the real economy? The Fed has gotten way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already over-heated (Chart I-10). At long last, the Fed, despite its dual objective, is laser-focused on inflation. As with most central banks, signaling is presumably more important than action – remember the famous Mario Draghi’s “whatever it takes.” Talking up 50 bp rate rises, the Fed is signaling that “the inflation cop is back in town.”  And while it will be hard for the Fed to put the inflation genie back in the bottle, it is reassuring that it will at least try. As for a potential 50-basis-point rate rise, for now it does not present an immediate threat to the real economy: Real rates remain negative and monetary conditions are fairly loose, while the neutral rate (that elusive r-star) is still quite a ways off from where the rates are now (Chart I-11). Bottom Line: The rate hike increments are less important than the message the Fed is sending out to the market. Chart I-10The Fed Is Behind The Curve Chart I-11The Market Expects The Fed To Move Aggressively To Combat Inflation What will be the effect of monetary tightening on economic growth? Related Report  US Equity StrategyHave US Equities Hit Rock Bottom? While early on, rate hikes can be shrugged off by a strong economy, over time, tighter financial conditions necessary to combat inflation, augur badly for growth. While financial conditions are still loose, they have already tightened on the back of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart I-12).  However, as we have pointed out in our “Have We Hit Rock Bottom Yet?” report, GDP growth forecasts do not reflect tighter monetary conditions and higher commodity prices (Chart I-13). The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1, yet consensus expectations have barely budged. Bottom Line: Aggressive monetary tightening will lead to slower economic growth. Chart I-12Tighter Financial Conditions May Affect Growth Chart I-13The GDP Forecasts Have Not Been Revised Down To Reflect New Challenges Investors are increasingly worried that the US is heading for a recession. What are your views?  As my colleague, US Investment Strategist Doug Peta has put it: “Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation.” Indeed, the Fed has a narrow margin of error for achieving a “soft landing.” The war in Ukraine makes the Fed’s objective even more challenging. Alan Blinder, a former Fed economist and current Princeton University professor who has a forthcoming book on monetary and fiscal policy history over the past 60 years, says the Fed has just once in the last 11 tightening periods nailed a “perfect soft landing” – in the early 1990s. But twice more, in the mid-1960s and early 1980s, the central bank raised interest rates without sparking an official recession—and such “soft-ish” landings, he said in a recent presentation, are not all that rare.1 This is a track record we find disturbing. However, we share Powell’s view that “the probability of a recession within the next year is not particularly elevated… all signs are that this is a strong economy and, indeed, one that will be able to flourish… in the face of less accommodative monetary policy.” We concur. A recession is unlikely in the next 12 months or so. The US economy is in the midst of a classic slowdown stage of the business cycle: Growth is still strong albeit slowing, inflation is elevated, liquidity is (still) abundant, capacity utilization is high, and the unemployment rate is low (Table 1). The American consumer is unhappy but has not tightened purse strings much yet. Importantly, growth is slowing off high levels so this stage can take a long time (Chart I-14). Table I-1Stages Of The Business Cycle Doug Peta’s simple recession indicator, built from components that have reliably provided an advance warning, reinforces this conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting (Chart I-15). Chart I-14The Business Cycle Indicator Signals Slowdown Chart I-1510-Year Treasury Yield Less 3-Months Treasury Bills Segment Is Not Inverted The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart I-16). The ISM Manufacturing PMI is well above 50. The Fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart I-17). Chart I-16The LEI YoY% Is Way Above Zero Chart I-17The Fed Funds Rate Is Far From Neutral Excluding the pandemic, recessions over the last 50-plus years have occurred only when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Bottom Line: We are watching out not for a recession, but for a growth disappointment.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuations And Technicals Chart II-8Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations And Technicals Chart II-16Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Chart II-18Profitability Chart II-19Valuations And Technicals Chart II-20Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Chart II-22Profitability Chart II-23Valuations And Technicals Chart II-24Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Chart II-26Profitability Chart II-27Valuations And Technicals Chart II-28Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Chart II-30Profitability Chart II-31Valuations And Technicals Chart II-32Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Chart II-34Profitability Chart II-35Valuations And Technicals Chart II-36Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Chart II-38Profitability Chart II-39Valuations And Technicals Chart II-40Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Chart II-42Profitability Chart II-43Valuations And Technicals Chart II-44Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Chart II-46Profitability Chart II-47Valuations And Technicals Chart II-48Uses Of Cash Table II-1Performance Table II-2Valuations And Forward Earnings Growth Footnotes 1     "Recession Risks Are Rising. Can the Fed Stick a Soft Landing?" Barron's (barrons.com)   Recommended Allocation Recommended Allocation: Addendum 

Executive Summary Cheap Or Expensive? President Emmanuel Macron will be re-elected.French growth will slow in the coming quarters but will also remain solid beyond that horizon.France’s reform push will continue, particularly pension reforms and efforts to reduce inefficiencies. However, austerity is unlikely to materialize.French stocks will underperform once energy inflation peaks. Consumer discretionary and staples have run ahead of themselves relative to the broad market and to their European peers. French small-cap stocks and aerospace and defense equities are attractive.RecommendationsINCEPTIONDATERETURN (%)COMMENTBuy French Small-Caps Equities / Sell French Large-Caps Equities (*)04/04/2022 CyclicalSell French Consumer Equities Relative to French Benchmark (*)04/04/2022 CyclicalOverweight French Aerospace & Defense**04/04/2022 Structural  Bottom Line: A second Macron presidency will not boost the appeal of French large-cap equities, even if it helps French long-term growth. Investors should underweight the French market in Europe via a large underweight in French consumer discretionary and consumer staple stocks. However, investors should overweight French defense names as well as small-cap equities.FeatureThe French presidential election is upon us. President Emmanuel Macron ambitious pro-growth and pro-business reform agenda in 2017 tackled the roots of the French malaise of the past decades. Our conviction that Macron would win a second mandate has survived challenges such as the “Yellow Vest Movement” in 2019 and then COVID-19.  Now, with the shock of the Ukraine war, the evidence still suggests he will win the upcoming election.  Chart 1Five More Years Of Macron Macron is the favorite with 53% of voting intentions against Marine Le Pen in the second round of the election (Chart 1). Even a potential Russian interference in the French election wouldn’t change the outcome of such a duel, which we discussed at length last summer.  Since then, Macron’s advantages over Le Pen have only strengthened, boosted by his handling of Omicron and the Ukraine/Russia crisis while the center-right and the far-right battle each other (Chart 1, bottom panel).Macron also took the unofficial leadership of Europe after Angela Merkel exited the stage. He managed to breathe new life into the European Union (EU), bringing forth greater unity. As a result, the current war in Ukraine and elevated energy prices have made this political rendez-vous more relevant. Chart 2Less Euroscepticism Helps Macron The main axis of Macron’s next term is to make France a more independent nation within a stronger Europe. This is a paradox, but what it means is that he is capitalizing on the current geopolitical climate of great power struggle and hypo-globalization. France is breaking with its tradition of Euroscepticism to secure its national interests within a closer European bloc (Chart 2).True, the French economy will not be spared from the current stagflation episode and growth will slow in the near term. However, France is in a better position to withstand the energy shock than most of its European peers.After Macron is re-elected, his political capital will be replenished and his structural reform effort will continue, albeit with modifications to deal with the post-pandemic and post-Ukraine environment. Fiscal and monetary policies remain very accommodative. As a result, Macron has a favorable chance of reforming France further. Pension reform as well as the green and digital transitions will improve France’s economic competitiveness over the long run.2017 vs. 2022: One Pandemic, One Recession, And One War Later Chart 3The French Economy Will Surprise To The Upside France was badly hit by COVID-19. However, appropriate fiscal policy and strong domestic demand are driving the recovery (Chart 3). While most sectors are expected to recover fully by 2023, a few sectors, such as automotive, aeronautics, and tourism, still lag behind pre-pandemic levels (Chart 3, panel 2). On the upside, France appears to be doing better than the other major European economies (Chart 3, bottom panel). Moreover, about 1.5% of GDP worth of leftover funds from emergency measures and the recovery plan are to be deployed in 2022.The Ukrainian conflict challenges this positive backdrop. Growth forecasts for 2022 were revised to 2.8% from 4%. The impact from elevated energy prices is projected to reduce annual GDP growth by 0.7% and to trim an additional 0.2% once international spillovers are factored in (Table 1). Nonetheless, France is not as vulnerable to Russian energy as Germany and Italy (Chart 4). For now, Russia-EU energy flow continues, although the threats are rising. Germany once again rejected an energy boycott when Biden visited Europe two weeks ago, but it is also preparing for the eventuality that gas flows may dry up, which highlights the fluidity of the situation. Table 1Impact Of High Energy Prices  Chart 4Low Vulnerability To Russian Energy… The direct consequences of the conflict on French exports are limited. Russia, Ukraine, and Belarus represent 1.2% of French exports, or EUR12 billion, most of which comes from transport equipment and other manufactured goods (Table 2). Table 2… And Low Trade Exposure  The evolution of the Chinese economy is another major external influence on French growth. France is exposed to the deceleration of the Chinese manufacturing PMI induced by the slowdown in Chinese credit growth. The recent closing of cities like Shanghai or Shenzhen because of the spread of the Omicron variant will accentuate near-term risks. However, Chinese policymakers want to stabilize growth by the time the Communist Party reshuffles this fall and the credit impulse is trying to bottom, which will help French exports to China improve later this year or next (Chart 5).Higher inflation is another consequence of supply disruptions and elevated energy prices caused by the Ukrainian war. For now, this is not a pressing concern in France. Headline inflation came in at 5.1%, well below the European average (Table 3). The government intervened to shield consumers from rising energy prices by handing out energy vouchers, freezing gas prices until the end of the year, and cutting electricity taxes. Chart 5France Is Sensitive To The Chinese Economy  Table 3Lower Inflation In France  Chart 6French Households Accumulated Plenty Of Excess Savings This is good news for French households, as it preserves some of their purchasing power, especially when compared to Spanish households that suffer an inflation rate of 9.8%. However, it is not enough to prevent consumer confidence from crumbling. From Table 1, consumer spending is projected to fall by 1%. Yet, French consumers benefit from their large savings, accumulated during the pandemic (Chart 6). Unlike the US, where the household savings rate has already gone back to pre-pandemic levels, the savings rate in France is still high. Households can use those excess savings to mitigate elevated energy prices.With respect to employment, the generous French furlough scheme contributed to this accumulation of savings by limiting the rise in unemployment (Chart 7). Therefore, the French labor market was resilient throughout the crisis and has recovered quickly. Labor force participation exceeds its pre-crisis level by about 0.5%. Youth unemployment reached its lowest level since the 1980s, at 14.8 %, in part because of the 2017 labor and vocational reforms. Moreover, labor market conditions are now tighter than they were pre-pandemic and firms are increasingly complaining about labor shortages (Chart 8). The business sector still expects employment growth to remain as robust as it was in 2018. As a result, French wage growth will firm up before the year-end. Chart 7The French Labor Market Has Recovered...  Chart 8...And Is Showing Signs Of Tightening   The corporate sector has several reasons to be optimistic (Chart 9). The emergency measures prevented widespread corporate defaults and bank lending remained supportive through the crisis. Profit margins are high. Additionally, conducting business in France is becoming easier. Business creation has continued to rise (Chart 9, bottom panel) and FDI projects were up 32% in 2021, making France the largest investment destination in Europe. Nonetheless, the rise in non-financial gross corporate debt is concerning, even though the increase in net debt was limited by the jump in bank deposits during the crisis (Chart 10). Chart 9France Is Becoming More Business Friendly  Chart 10Corporate Debt Is A Concern Bottom Line: French growth will decelerate in the coming quarter in response to the Ukrainian crisis, but it will remain stronger than that of its European peers. In the second half of the year, stronger demand recovery in hard-hit sectors, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover markedly.Reforms: Take 2(022)The series of recent crises highlight several weaknesses in the French economy. The pandemic revealed how vulnerable and underfunded the French health sector is. It also underscored that digitalization is inadequate in French firms. The Ukraine/Russia conflict is mixed: it underscores the energy dependence of European countries and highlights the need for greater defense spending, even if France is already less dependent than others and manufactures state of the art military equipment.Related ReportEuropean Investment StrategyFrance: More Than Just A Déjà-VuIn both crises, the French social welfare state played a crucial role as an automatic stabilizer. The IMF estimates that stabilizers absorbed about 80% of the household income shock during the pandemic, while government spending to contain high energy prices amounted to €15.5 billion since last fall.The fiscal response to these crises caused a large addition to the public debt, which already stands at 115% of GDP. Furthermore, at 55% of GDP before COVID, France’s public expenditure ratio was already one of the highest in the Eurozone (Chart 11). For now, the debt burden is manageable because low interest rates make France’s debt arithmetic benign. However, such an elevated share of output controlled by the government increases resource misallocation and hurts productivity, meaning it weighs on potential GDP growth.Low interest rates are not guaranteed in the future. Putting France’s debt on a sustainable path requires structural reforms (Chart 12). Already, the OECD estimates that the 2017-2018 labor-market and tax reforms have generated positive economic spillovers across all income levels (Chart 12, bottom panel). Chart 11Public Debt Just Got Bigger  Chart 12Structural Reforms & Pubic Debt Going forward, reducing debt and cutting spending will be hard considering France’s energy and defense structural goals. Macron’s political party, En Marche!, may perform well in this year’s legislative election, but it is unlikely to achieve the sweeping victory that it saw in 2017. Macron will therefore be forced to compromise to build a coalition in favor of structural reform. His strength in the Assembly will be the chief uncertainty and critical determinant of his ability to achieve his key reform goals in the coming five years. As a result, Macron will focus on lifting French trend growth further by encouraging digital and green transitions. Beyond pension reforms, fiscal austerity will be limited to ensure the social acceptability of structural reforms.In the rest of this section, we focus on the two most important reforms proposed by Macron for his second mandate: pensions and economic competitiveness plans. Reducing public spending is needed to alleviate the burden on resources created by the massive size of the French government, but France’s strategic needs outstrip Macron’s ability to slash spending.French Pension System: Too Generous Table 4Public Spending Comparison Pension represents 14% of GDP compared with 10% in Germany (Table 4). Expenditures on pension explains 35% of the difference on total public spending between France and the Euro Area.Reforming the pension system is a sensitive topic in France. It arguably cost Nicolas Sarkozy his re-election bid in 2012. Yet, pension reforms are essential. The current system is complex and fragmented, with 42 different types of coexisting pensions, each with its own calculation rules. Chart 13Pension Reform Is Long Overdue Additionally, it does not reflect the ageing of the population (Chart 13). Employment among the 55-64 age cohort is only 56% in France, compared to 62% in the OECD average. Also, the effective retirement age in France is 60.8, compared with an average of 65 in Europe. Furthermore, replacement rates (pension / last salaries) are high, which puts an unsustainable burden on the state’s finances.According to the French think tank Institut Montaigne, progressively pushing the retirement age to 65 would save €7.7 billion per year by 2027 and €18 billion per year by 2032. Overall, the government would save around €50 billion per year through such pension adjustments and simplification reforms as well as by operating cost reductions. This would largely finance Macron’s investment to improve competitiveness, digitalization, the green transition, and national defense.Transitioning To Reduce InefficienciesTo boost long-term growth, an important prong of Macron’s project is the €100 billion “France Relance” recovery plan. It is part of the NGEU pandemic relief funds and includes €30 billion for green transition (including measures to improve energy performance of buildings, to increase rail freight, and to support businesses to make the transition). It also includes €34 billion for competitiveness and innovation (tax cuts and support for digitalization). Chart 14French Handicap: Productivity This plan is a band-aid if the many inefficiencies undermining France’s productivity are not tackled (Chart 14). The uptake of digital technologies is uneven and lags far behind other developed nations with respect to cloud computing and the internet of things. Small businesses perform particularly poorly (Chart 15). As a result, the French tech sector has become a priority of Macron’s government. The “France 2030” investment plan unveiled in October 2021, worth €30 billion over five years, aims to foster industrial and tech “champions of the future.” It intends to lift business creation in the tech sector. Nonetheless, this is easier said than done; picking low-hanging fruits will help productivity but matching the prowess of the US is highly unlikely.Another problem is the inefficiency of French R&D. Government support for business R&D is elevated but does not translate into high R&D intensity (Chart 16). This problem is not unique to France: R&D returns across the EU do not match those of the US. Addressing France’s bureaucratic and extremely centralized management structure could tackle some of this hindrance (Chart 16, bottom panel). Chart 15France Is Digitally Lagging …  Chart 16… And Full Of Inefficiencies When it comes to the green transition, Macron focuses on three axes: renewable energies, energy efficiency, and electric vehicles.Macron wants a “massive deployment” of renewable energies. A new plan for the construction of additional nuclear reactors will be implemented, since it is the only solution that allows France to reduce its carbon emissions quickly. Alongside this plan for electricity generation, a strategy will be put in place to increase energy efficiency. This is where the support to electric vehicle production and adoption comes in (Chart 17).Reforming energy taxes is another avenue to generate greater revenues, such as from higher carbon pricing, and this would help finance more green investments. Eliminating fossil fuel subsidies, for which France spends significantly more than its peers, and streamlining tax collectioncould yield 1% in annual savings by 2027 (Chart 18). Moreover, increasing carbon prices to EUR65 per ton by 2030 would contribute to France’s environmental goals and provide additional revenue. Chart 17French EV-olution  Chart 18More Green Taxes Bottom Line: The re-election of President Macron portends another reform push in France. The large public debt load threatens national long-term economic prospects. Hence, increasing potential GDP growth is paramount. True, Macron’s majority in the Assemblée Nationale will decrease, which will limit the scope of the next reform round. Nonetheless, France will implement pension reforms that can both increase the size of the labor force and finance further initiatives. Moreover, France will push forward with efforts to streamline tech investment, increase spending in the nuclear electricity production, and boost energy efficiency.Investment ImplicationsThe investment implications of a second Macron mandate are manifold. First, investors should remain overweight the French tech sector compared to that of the rest of the Eurozone because of the boost to earnings from greater public investment. Chart 19Small-Caps, Big Upside French small-cap stocks will also benefit from reforms. French small-cap equities have become oversold relative to their large-cap counterparts, falling 30% in relative terms since their late 2017 peak (Chart 19). Part of that underperformance anticipated the drag on French households from spiking energy prices. However, French households are more insulated from the impact of high inflation than their US or European counterparts. Moreover, the previous set of reforms boosted lower- and middle-class income (Chart 12 on page 9). Consequently, French consumer confidence will grow compared to that in the US and China, which helps the relative performance of French small-cap shares (Chart 19, panel 2). Rising German yields and an eventual stabilization in the euro will also buoy these stocks (Chart 19, bottom two panels).French industrials equities will be another sector to enjoy a dividend from Macron’s policy initiatives. The “France 2030” plan involves an increase in capex. The build-up in nuclear power under the green transition plan is also positive for industrial earnings. These policies will favor domestic spending, which bolsters French industrial stocks.Last week, we described the tailwinds for European aerospace and defense equities.  The same logic holds true for French aerospace and defense names, which are our favorite plays within the French industrial complex. Chart 3 on page 3 highlighted that the aerospace sector is among the major areas of the economy for which gross value added has yet to recoup its pandemic losses. The gradual re-opening of the global economy will create an important tailwind for the sector. Moreover, France is the fourth-largest global defense exporter. Thus, the French defense industry will profit from the upside in global military spending.Related ReportGeopolitical StrategyFrance: Macron (And Structural Reforms) Still Favored In 2022In this context, French aerospace and defense stocks should outperform not only the overall French market, but also their industrial peers (Chart 20). Since we already favor aerospace and defense equities within the Euro Area, the overweight of French aerospace and defense shares does not translate into an overweight compared to their European competitors. The position of French large-cap stocks within a European portfolio is more complex. They are unlikely to exhibit any significant net impact from Macron’s reform push. French equities have outperformed the rest of Europe already. Most of this outperformance reflected sectoral biases; the French market overweights industrial and consumer stocks. However, the country effect explains the recent outperformance of French equities (Chart 21). The country effect can be approximated by comparing French stocks to the rest of the European market on a sector-neutral basis. Chart 20Favor French Aerospace & Defense  Chart 21Country Effect Explains The Recent Outperformance Of French Equities  The lower vulnerability of the French economy to higher energy prices compared to the rest of Europe explains this outcome (see Chart 4 on page 4). The outperformance of French consumer stocks (which account for nearly a third of the index) relative to their European competitors added to the country effect as well.An end to the energy spike is likely to arrest the outperformance of French equities. Over the past six years, Brent crude oil prices expressed in euros as well as oil and gas inflation have supported the performance of French equities relative to German ones much better than core inflation or bond yields (Chart 22). The forward earnings of French equities compared to those of the Eurozone market closely track energy markets (Chart 23). Essentially, the French market biases and the country’s low reliance on imported energy are valuable hedges when stagflation fears are rampant (Chart 24). Chart 22The End Of The French Reign Draws Near  Chart 23Supply Shock Lifted French Earnings  The best vehicle to underweight French large-cap stocks is to underweight French consumer stocks compared to the Euro Area MSCI benchmark. French equities outperformed the rest of Europe by a greater extent than relative earnings would have implied, which resulted in a small P/E expansion (Chart 25). However, when consumer stocks are excluded, French stocks have performed in line with the rest of the Euro Area and have underperformed relative earnings, which has caused a derating of the French market excluding consumer stocks (Chart 25, bottom two panels). Chart 24French Equities Thrive When Stagflation Fears Are High  Chart 25Cheap Or Expensive?  French consumer equities have become very expensive. Their relative performance has completely decoupled from earnings compared to their Eurozone competitors and their relative valuation has expanded to two sigma above its past 20 years average (Chart 26). Measured against the French broad equity market, the same dynamics can be observed (Chart 26, bottom two panels). These divergences are unsustainable and the most likely catalyst for their correction is the rapid decline in global consumer confidence (Chart 27). Chart 26French Consumer Equities Are Expensive  Chart 27Crumbling Consumer Confidence Does Not Bode Well For French Consumer Stocks   Bottom Line: The best direct bets on President Macron’s re-election are to overweight French small-cap stocks compared to large-cap ones and to favor aerospace and defense stocks within the French market. Investors should also underweight French stocks in Europe. However, to do so, investors should underweight French consumer stocks and maintain a benchmark weight for the other French sectors compared to their allocation in the Eurozone benchmark. Traders should buy Euro Area consumer staples and consumer discretionary stocks and sell French ones. Jeremie Peloso,Associate EditorJeremieP@bcaresearch.comMathieu Savary,Chief European StrategistMathieu@bcaresearch.comFootnotes

Executive Summary US inflation is running at its highest level in over four decades. Although we expect it will soon peak, it appears certain to remain above the Fed’s 2% target level for an extended period. The war in Ukraine and COVID’s assault on China could give rise to a new round of supply disruptions that keep inflation at very high levels even after the initial wave of bottlenecks is cleared. Long-term price stability may best position an economy to achieve its potential, but real S&P 500 earnings have grown twice as fast when CPI inflation is above its mean than they have when it is below its mean. Historically, inflation has only begun to squeeze nominal earnings growth at two-standard-deviation extremes. Meaningful equity de-rating has been a feature when inflation exceeds its mean, however, and investors will have to be alert for any signs that TINA might be losing its grip on financial markets. We do not think that low-to-no-yield Treasuries or cash yet offer an appealing alternative, but animal spirits are always subject to change. Bumping Up Against Tactical Limits Bottom Line: The question of how to navigate an inflationary environment is likely to be with investors across 2022 and beyond. We continue to recommend overweighting equities over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature With consumer prices rising at a clip not seen in over 40 years, inflation is a hot-button topic for anyone with even a passing interest in the US economy. The relentless series of upside inflation surprises have investors preoccupied with finding havens. To help get a handle on where to invest against varying inflation backdrops, we divided inflation into five regimes since the consumer price index (CPI) was launched in 1947: extreme inflation (an annualized quarter-over-quarter rate more than two standard deviations above its mean), high inflation (more than one but less than or equal to two standard deviations above the mean), moderate inflation (up to one standard deviation above the mean), moderately low inflation (one standard deviation below the mean up to the mean) and deflation (two standard deviations below the mean up to one standard deviation below the mean). Related Report  US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) We reviewed the performance of S&P 500 operating earnings, earnings multiples and returns in each CPI regime to see how equities have responded to inflation over the last 75 years. We then reviewed the available total return data for Treasuries, investment-grade corporate bonds and high-yield corporate bonds and analyzed them alongside equity total returns. The empirical record enhances our confidence in earnings growth, but the S&P 500 currently trades at nearly 20 times forward four-quarter earnings, and it is especially vulnerable to de-rating, given that contracting valuations have been the driver of underperformance when inflation exceeds its mean. We find it hard to contemplate overweighting fixed income over the next year when nominal yields are so far below the rate of inflation. It may require a modest leap of faith to believe that equity multiples can maintain their cruising altitude, but the odds are very long that a 10-year Treasury note yielding 2.4% will protect its owner’s purchasing power when prices might rise by 3.5% to 4.5% over the next year. The positive real returns that Treasuries have delivered in high-inflation environments since 1984 were achieved over a lengthy stretch in which inflation compensation at the date of purchase repeatedly topped actual inflation to maturity. Today it appears as if ex-ante inflation compensation is likely to prove woefully inadequate and we are skeptical that bonds can live up to their historical return patterns. 75 Years Of Inflation Data Chart 1 shows 299 quarters of annualized inflation data in standard deviation increments since the CPI was constructed in 1947. The shape of the distribution bears out the notion that prices are sticky to the downside; the population mean is well above the median as the high-inflation right tail is longer and fatter than the deflationary left tail. Across the CPI’s entire history, inflation has averaged 3.52% on an annualized quarter-over-quarter basis with a standard deviation (“sigma”) of 3.55%. Based on those parameters, we define extremely high inflation as CPI increases above 10.62% (17 instances), high inflation as 7.08% to 10.62% (22 instances), moderately high inflation as 3.53% to 7.07% (82 instances), moderately low inflation as -0.02% to 3.52% (155 instances), disinflation as -3.57% to -0.03% (21 instances) and deflation as less than -3.57% (2 instances). Chart 1The Complete Annualized CPI Distribution Inflation And Equities We examined movements in operating earnings, trailing multiples and closing prices for the S&P 500 in each of the six inflation regimes, though we discarded the outlier deflation bucket for insufficient data. In the extreme (greater-than-two-sigma) inflation scenario, S&P 500 earnings initially surged amidst the early postwar period’s pent-up demand explosion before going backwards in the Korean War inflation, the sharp 1973-75 recession and the Volcker double dip (Chart 2, dark solid line). An expanding P/E multiple (dashed line) helped to mitigate the blow from shrinking earnings, but equity investors endured sharp real declines (bottom panel, light solid line). Chart 2Extreme Inflation Squashes Earnings The one-to-two-sigma high-inflation scenario is a mirror image of the extreme inflation scenario. Nominal earnings growth surged (Chart 3, top panel) and managed to hold up well in real terms (Chart 3, bottom panel), but the index’s multiple de-rated at a vicious 15.5% annualized rate, sticking investors with double-digit real losses. 70% of this regime played out from 1973 to 1982 and it also spanned some of 1990-91 and great recessions. The last two data points occurred in 2021, when flat multiples allowed equities to benefit from robust earnings growth, but previously melting multiples illustrate the peril for equities if monetary tightening induces a hard landing. Chart 3High Inflation: Surging Nominal Earnings, Fierce De-Rating The zero-to-one-sigma moderate-inflation scenario has fostered such robust earnings growth that even a steady de-rating headwind cannot hold back equity returns (Chart 4). Despite spanning the entire 1973-74 recession and the early stages of the global financial crisis, the moderate-inflation regime has been solidly conducive to growth. Chart 4Moderate Inflation Is Great For Growth Just over half of the quarters have met our minus-one-to-zero-sigma moderately low inflation standard. They have featured subpar nominal earnings growth, but a benign inflation backdrop has helped them close the gap with mean real growth and a re-rating tailwind has pushed real annualized S&P 500 price returns above 7% (Chart 5). Most of the post-crisis period has unfolded against a moderately low inflation backdrop, which has been good for equity investors even as concerns about tepid growth lingered. Chart 5Moderately Low Inflation Is The Enduring Equity Sweet Spot The minus-two-to-minus-one-sigma deflationary backdrop in which the price level contracts has featured even weaker aggregate growth, but a 10% annualized re-rating boost has allowed equities to deliver double-digit returns (Chart 6). One would expect growth to wither when the price level is deflating but ex-1Q20, when the pandemic halted activity in its tracks, growth in this phase has topped growth in every other phase. That counterintuitive result illustrates that inflation is a lagging indicator that exerts a heavy influence on monetary policy, which impacts the economy with a lag, while markets are forward looking. The ends of the inflation distribution are likely to mark inflection points where momentum reverses. Chart 6Once Prices Deflate, The Danger Has Already Passed Our survey of equity performance across inflation regimes has shown that inflation is much better for earnings growth than disinflation/deflation until it reaches extreme levels. Nominal earnings have grown three times as fast and real earnings have grown twice as fast when inflation is above its 3.52% mean than when it’s below it (Table 1). The fundamental tailwind that comes with perky inflation is almost entirely offset by multiple contraction, however, just as the growth drag from low inflation is offset by multiple expansion. We don’t think investors should be unduly worried that inflation will squash growth this year, but they do need to be alert to anything that might presage de-rating. Table 1Inflation And Earnings, Multiples, And Returns Inflation And Bonds To fill out the asset allocation picture, we also reviewed the performance of the Bloomberg US Treasury, US Corporate and US High Yield Total Return Indices. Table 2 tracks annual nominal and real total returns for all three indices, along with the S&P 500, since the second half of 1983, when the high-yield index was launched. The distribution of CPI changes from 1983 forward is more concentrated about the mean than the entire population distribution beginning in 1947 and nearly 80% of observations fall within one standard deviation of the mean, so the tail distributions have comparatively few observations. Table 2Inflation, Treasuries And Spread Product Nonetheless, the extant tail observations suggest that high yield’s positive carry failed to generate positive excess returns over Treasuries in high-inflation environments while spread widening and increased defaults caused them to lag Treasuries amidst extreme deflation. Investment grade also lagged Treasuries in the tails, albeit by a smaller margin than high yield. High yield comfortably outperformed within the core minus-one-to-plus-one-sigma range, when equities also shined. The bottom line is that Treasuries have provided welcome ballast to multi-asset portfolios in both high-inflation and deflationary episodes over the last 40 years. They were even bigger winners from late 1972, when the Treasury and corporate indexes began, through late 1983, sporting annualized real returns that beat those of high-grade corporates and the S&P 500 by five and eight percentage points, respectively, when inflation exceeded its mean. We question the applicability of the empirical record in the current environment, however, as ex-ante inflation compensation routinely outstripped ex-post inflation over the four-plus decades that it was compiled. Even as the 10-year yield has recently flirted with 2.5%, we expect that the inflation compensation embedded in long-duration bonds will prove inadequate to preserve bondholders’ purchasing power over the bonds’ remaining life. Portfolio Construction The findings from our inflation review do not spur us to make any changes to the ETF portfolio. We continue to believe that the near-term foundations of the US economy are strong and will support above-trend growth over our six- to twelve-month investment timeframe. US growth is at risk from the war in Ukraine and the ongoing COVID-19 revival and aggressive Fed tightening could stifle the effects of past fiscal and monetary stimulus measures that have not yet been felt. We are actively monitoring global geopolitical and public health developments, along with the Fed, though we think it will be difficult for Chair Powell and company to surprise hawkishly over the rest of this year. We believe the moves we made four weeks ago, when we temporarily closed out our equity overweight, reduced our cyclicals-over-defensives positioning, dialed back our value and small-cap overweights, initiated direct exposure to the metals and mining space via the XME ETF and trimmed our Treasury underweight, will protect the portfolio adequately against ongoing inflationary surges and sporadic growth headwinds. The direct homebuilder exposure we took on via the ITB ETF at that time has weighed on performance, but we are sticking with it as we believe the widespread pessimism about the industry’s prospects has gotten way overdone. The labor market remains robust, as the March employment report and the February JOLTS release reiterated last week, less pecunious households are flush with excess pandemic savings and the wealthy are reveling in an unprecedented surge in household net worth. The global situation merits tactical caution, and it looks as if the S&P 500 has hit the top of its near-term range (Chart 7, top panel) while the VIX may have reached a near-term bottom (Chart 7, bottom panel), but our sanguine cyclical view remains intact. Chart 7Equities May Have Reached Another Short-Term Turning Point ETF Portfolio Review - March The cyclical ETF portfolio returned 1.26% in March (Appendix Table), outperforming its benchmark by a modest 8 basis points (“bps”). Our bond underweight was auspicious as yields rose across all maturities last month. Overweighting the riskier segments of the fixed-income market – junk bonds and preferred stocks via the VRP ETF – generated 14 bps of relative performance. However, our equity positioning chipped away at those gains. We underweighted Utilities, March’s top performing sector, and overweighted value, which lagged. Our large Energy overweight mitigated those drags, leaving us with positive net alpha. Since inception two months ago, the portfolio’s value-added stands at 18 bps.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Cyclical ETF Portfolio

Executive Summary Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia Chart 4Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth Chart 7Futures Curves For Most Commodities Are Backwardated     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US...​​​​​​ Chart 12... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Chart 33An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued Chart 50Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well Chart 63Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix Special Trade Recommendations   Current MacroQuant Model Scores

Listen to a short summary of this report.       Executive Summary Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively.  Tighter financial conditions augur badly for growth (see Chart).  We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes   Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Chart 6Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13).   Chart 11China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much.  Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Risks To Our View Chart 17Fed Feedback Loop Back In Action? Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months.     How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components.  Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3).   Chart 23AOPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries...Chart 23CTo Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price.   Chart 24Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound?  Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1).  Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3).  Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth.  As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US.   Global Economy Chart 25Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months.   Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system.  Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1).  In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2).  Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched.    Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation.   Corporate Bonds Chart 30Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis.   Commodities Chart 31Risks To Oil Price Are To The Upside Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4).   Currencies Chart 32Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months.   Alternatives Chart 33Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4).   Footnotes 1   Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this.   Recommended Asset Allocation Model Portfolio (USD Terms)