Financial Markets

Executive Summary A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 Global Bond Yields Take A Breather Global Bond Yields Take A Breather In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking Rising Real Yields Where Central Banks Have Been Hiking ​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish More Stable Real Yields Where CBs Are More Dovish ​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US Global Bond Yields Take A Breather Global Bond Yields Take A Breather The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ZEW Survey Shows Weaker Growth & Inflation Expectations ​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out Medium-Term US Inflation Expectations Have Not Broken Out ​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation? A Peak In US Core Inflation? A Peak In US Core Inflation? ​​​​​ Chart 9Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures Global Bond Yields Take A Breather Global Bond Yields Take A Breather The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking The Goods-Driven Canadian Inflation Surge May Be Peaking ​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing BoC Rate Hikes Will Cool Off Canadian Housing ​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Global Bond Yields Take A Breather Global Bond Yields Take A Breather Chart 17Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Global Bond Yields Take A Breather Global Bond Yields Take A Breather The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Global Bond Yields Take A Breather Global Bond Yields Take A Breather Tactical Overlay Trades

Executive Summary Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Global semiconductor stock prices are vulnerable to the downside over the next three to six months. The global semiconductor industry has entered a cyclical slump. Demand for semis faces headwinds this year. The pandemic boom in goods (ex-auto) consumption in developed economies is likely over. Plus, households’ disposable income in these economies is contracting in real terms. In China, ongoing lockdowns are depressing household income, which will limit their discretionary spending. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point.      Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will be looking to recommend buying semiconductor stocks when a more material deceleration in semi companies’ revenue and profits are priced in. Feature Chart 1Semi Stocks Have Been Selling off Despite Strong Revenues Semi Stocks Have Been Selling off Despite Strong Revenues Semi Stocks Have Been Selling off Despite Strong Revenues A small divergence between global semiconductor sales and semi stock prices has opened up (Chart 1). Although global semiconductor sales have been super strong, global semiconductor stock prices peaked in late December and have since declined by 23%. We believe the global semiconductor industry is entering into a cyclical slump. The demand for PCs/tablets/game consoles/electronic gadgets as well as commercial computers and servers – and with them semiconductor sales/shipments – had surged in the last two years.  Behind this boom was the significant increase in online activities stemming from pandemic-related lockdowns. However, these one-off factors have largely run their course. Global semiconductor demand growth currently faces headwinds and is set to slow meaningfully in H2 this year. We expect more downside in global semiconductor stock prices over the next three to six months. The five previous cyclical downturns in the global semiconductor sector resulted in share price declines that were greater than the current 23% drawdown (Table 1). Also, in four of these five cycles, the duration of the peak-to-trough period exceeded the current 3.5 months of decline from the December peak. Nevertheless, the structural outlook for global semiconductor demand remains constructive due to the increasing adoption of the 5G network, electric vehicles, data centers and IoTs. We are waiting for a better entry point later this year. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market Global Semi Stocks: More Downside Global Semi Stocks: More Downside Near-Term Demand Headwinds Chart 2Global Semis Sales Have Diverged From Global Manufacturing Cycle Global Semis Sales Have Diverged From Global Manufacturing Cycle Global Semis Sales Have Diverged From Global Manufacturing Cycle There has been a remarkable divergence between world semi sales and the global business cycle (Chart 2). The US ISM manufacturing new order-to-inventory ratio, a barometer of the global business cycle, dropped below 1, signaling a slowdown in US manufacturing in the coming months (Chart 2, top panel). Critically, the volume of China’s semiconductor imports started to contract recently and the growth of Chinese imports from Taiwan also plunged (Chart 3). China is the world’s largest semiconductor consumer, accounting for 35% of global semiconductor demand. The slowdown in the country’s chip demand does not bode well for the global semiconductor market. We expect the growth of semiconductor sales in all regions to decelerate considerably this year (Chart 4). Chart 3China's Semis Import Volumes Are Contracting China's Semis Import Volumes Are Contracting China's Semis Import Volumes Are Contracting Chart 4Semiconductor Sales Value Growth Across Regions Semiconductor Sales Value Growth Across Regions Semiconductor Sales Value Growth Across Regions   First, the one-off boost to demand for goods in general, and electronic devices in particular, due to global pandemic lockdowns has largely run its course. Chart 5The Pandemic Boom In PC Sales Is Largely Over The Pandemic Boom In PC Sales Is Largely Over The Pandemic Boom In PC Sales Is Largely Over Traditional PCs and tablets: Demand for traditional PCs1 and tablets surged in the past two years. This was due to the significant increase in online activities, such as working from home, business, education, e-commerce, gaming and entertainment. According to the International Data Corporation (IDC), after two consecutive years of strong growth, global traditional PC and tablet shipments experienced a 5% contraction in volume terms in 1Q2022. In addition, computer production in China – the world’s largest computer producer and exporter – also showed a significant growth deceleration (Chart 5). These data indicate that the pandemic boom in PC sales is largely over. Server demand: Another major contributor to the boom in semi demand was from the server sector. The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers to run on. However, demand growth for the server sector is also set to decelerate slightly. According to TrendForce Research, global server shipment growth will slow from over 5% year-on-year in 2021 to 4-5% this year. The global server sector and the traditional PC/tablet sectors together account for about 22% of global chip demand, based on the data from the IDC. Second, automobiles and consumer electronic goods (e.g., smartphones and home appliances), – which together account for about 42% of global semiconductor demand – will weaken this year. Both ongoing lockdowns in China and the surge in commodity prices due to the Russia-Ukraine war will exacerbate inflationary pressures and create major headwinds to household disposable income in real terms and discretionary spending around the world. Hence, global consumers will remain cautious in their spending on discretionary goods. For example, China’s household marginal propensity to consume proxy dropped to a 15-year low (Chart 6, top panel). This will translate to constrained household spending this year, leading to weaker sales in consumer electronic goods and automobiles (Chart 6, middle and bottom panel). Similarly, US real household consumption of goods ex-autos is likely to experience a mean reversion this year (Chart 7, top panel). After having bought the sheer number of goods (ex-autos) in the last two years, US consumers are likely to shift their spending towards services. Chart 6China: Consumer Spending Will Continue Disappointing China: Consumer Spending Will Continue Disappointing China: Consumer Spending Will Continue Disappointing ​​​​​​ Chart 7Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos   Plus, very high headline inflation is eroding US consumers' purchasing power (Chart 7, bottom panel). The relapse in DM goods demand will hinder the global semiconductor industry. There are already some signs of a slowdown in consumer demand. Apple was reported to have reduced its orders for its recently released iPhone SE by 20% and cut orders for AirPods by about 10 million units due to weaker-than-expected demand.2 Notably, global smartphone sales have been – and will remain – stagnant due to their longer replacement cycle.3 Chart 8Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Third, inventory stockpiling also contributed to last year’s strong semiconductor sales. The length and intensity of the chip shortage which started in H2 2020 caused a broad range of customers – including the manufacturers of smartphones and other consumer electronics – to order more than they need. This inventory stockpiling caused forward inventory days for customers of semi producers to increase by 28% from last quarter to 50 days, which is near peak inventory levels experienced in the last cycle. Businesses will likely start drawing down their stockpiles, rather than increasing their semiconductors orders this year. This will also reduce semiconductor demand on the margin. The semiconductor shipments-to-inventory ratios from Korea and Taiwan have been falling, corroborating the cyclical downturn in the Asian semi industry (Chart 8). Bottom Line: We believe the global semiconductor sector has entered a cyclical slump. The sector’s sales are facing plenty of headwinds, and its growth will decelerate considerably this year. What About The Supply Shortage? The semiconductor industry has been known for its cyclicality. Periods of shortage have been followed by periods of oversupply. The latter led to declining prices, revenues, and profits for semi producers. Hence, massive expansion plans announced by the major players have indeed raised fears that the supply shortage will turn into a supply glut down the road. The global semiconductor shortage in place since late 2020 has been eased to some extent and is set to diminish considerably later this year and next year. Both a moderation in demand growth and an increase in new capacity will likely mitigate the supply tightness meaningfully. It takes about 18-24 months on average to build a new semiconductor fabrication plan. According to estimates from the Semiconductor Industry Association (SIA), the global semiconductor industry added 4 million wafers per month of manufacturing capacity between January 2020 and January 2022. 75% of this new manufacturing capacity had already come on-line as of October 2021. IC Insights also reported global installed wafer capacity increased 6.7% in 2020 and 8.6% in 2021. It also projected the capacity expansion to be 8.7% in 2022. In comparison, the annual growth rate in global installed wafer capacity was only 3.2% in 2019. Last June, industry organization SEMI estimated that construction on close to 30 new fabs will start by the end of 2022.4 Mainland China and Taiwan added the greatest number of new fabrication plants, followed by the Americas. In addition the world’s top three chip makers (TSMC, Intel and Samsung) all raised their capex plans significantly for this year (Box 1). On the whole, according to IC Insights, worldwide semiconductor capex will likely jump by 24% in 2022 to a new all-time high of $190.4 billion, up 86% from just three years earlier in 2019. BOX 1 Top 3 Chip Makers: Massive Capex Expansion Ahead TSMC doubled capex from nearly US$15bn in 2019 to US$30bn in 2021 and set aside US$40-44bn for 2022, a 33%-47% boost year-on-year. In mid-2021, Samsung’s chip manufacturing unit increased its capex plans until 2030 from US$115bn (about US$12.8 bn annually) to US$151bn (about US$16.8 bn annually), a 31% increase year-on-year. Intel increased its capex from US$14.5 billion in 2020 to $18-19 billion in 2021. This number jumped to US$25-28 billion for 2022, a 39-47% lift year-on-year. In general, massive capex at a collective level will be negative for share prices of semi producers. Announcements of capex expansion, which increase an individual company’s production capacity, could be perceived as a positive for that company. Yet, rapid capacity expansion is typically negative for the overall sector as it often leads to lower prices and profitability down the road. Chart 9Aggressive Collective Capex Ultimately Hurts Semis Stocks Aggressive Collective Capex Ultimately Hurts Semis Stocks Aggressive Collective Capex Ultimately Hurts Semis Stocks Given that the collective capex for the global semiconductor sector has expanded substantially, the odds of an oversupplied semiconductor market have increased. This shift will likely weigh on semiconductor stock prices (Chart 9). Bottom Line: The global semiconductor supply-demand balance is likely improving (demand is slowing and supply is rising). Massive capital spending plans will inevitably raise concerns about an eventual supply glut in the global semiconductor industry. This will weigh on global semiconductor share prices in the coming months. Taiwanese And Korean Semi Stocks Odds are that Taiwanese and Korean semi stock prices will continue falling in absolute terms. Interestingly, since early 2021 TSMC and Samsung share prices have exhibited different price patterns vis-a-vis the global semiconductor stock indexes (Chart 10). TSMC had double tops in the past 15 months and has dropped 30% in USD terms from its January peak despite posting substantial revenue growth (Chart 11, top panel). Chart 10TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife Chart 11Semi Stocks in Asia: Share Prices Lead Corporate Revenues Semi Stocks in Asia: Share Prices Lead Corporate Revenues Semi Stocks in Asia: Share Prices Lead Corporate Revenues Share prices of Korean DRAM producers (Samsung and Hynix) are down over 30% in USD terms from their early 2021 peak, frontrunning the decline in our DRAM revenue proxy (Chart 11, bottom panel). In addition, even though Samsung released better-than-expected business performance for the first quarter last Thursday, it still failed to attract buyers. Both cases –TSMC and Samsung –signal that robust revenue/earnings are no longer enough to trigger a rally in semiconductor share prices. This suggests that the market is forward-looking and foresees a poor outlook. Chart 12Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over A slowdown in demand will lead to a deceleration in both companies’ revenue growth and profits. For TSMC, the smartphone sector still accounts for 44% of the company’s revenue. Hence, a risk is that global smartphone sales contract this year due to longer replacement cycles5 and constrained household spending as inflation curbs their purchasing power. In such a case, TSMC’s sales growth will disappoint, and the stock will likely drop toward $80 (Chart 10 on page 9). Taiwan’s new orders-to-client inventories ratio for semiconductors points to lower semi stocks in this bourse (Chart 12). For Samsung, signs of a slowdown in demand are already emerging in memory chips, reflecting slower sales, primarily of PCs. Moreover, TrendForce expects average overall DRAM pricing to drop by approximately 0-5% in 2Q22 due to marginally higher inventories and weakening demand. Equity Valuations And Investment Conclusions Chart 13Multiples Of Global Semis Stocks Are Still Elevated Multiples Of Global Semis Stocks Are Still Elevated Multiples Of Global Semis Stocks Are Still Elevated The global semiconductor stock index in USD terms has declined by 23% from its recent peak. The still-elevated multiples of semiconductor stocks suggest that there is more downside ahead in absolute terms (Chart 13).  One of the reasons that semi stocks have fallen could be their de-rating amid rising US bond yields. Having rallied tremendously in the past 10 years, global semis had become one of the most expensive industry groups worldwide. As a result, higher US bond yields are causing multiple compression for global semis (Chart 14). The closest comparison for the current episode is probably the 2016-2018 boom-bust cycle (Chart 15). During this period, the massive stimulus in China and the adoption of 4G smartphones/tablets had pushed up semiconductor share prices. In 2018, after the one-off adoption/replacement cycle ran out of steam, semi stocks dropped by nearly 30% amid slowing demand and rising global bond yields. By comparison, the one-off surge in global semi demand in 2020-2021 was much larger than the one in 2016-2018. Also, global semi stocks have rallied by much more and have become more expensive now compared with the 2016-18 episode. We expect a mean reversion in demand to lead to a slightly larger decline in global semi stocks than in 2018. This means that there is still about 15-20% more downside from the current level. As to allocation to semi stocks within an EM equity portfolio, we recommend maintaining a neutral allocation to Taiwan and reiterate an overweight stance on the KOSPI. These are relative calls, i.e., against the EM benchmark. We remain negative on their absolute performance. Chart 14Higher US Bond Yields = Multiple Compression For Global Semis Stocks Higher US Bond Yields = Multiple Compression For Global Semis Stocks Higher US Bond Yields = Multiple Compression For Global Semis Stocks Chart 15A Comparison With The 2016-2018 Semi Rally And Selloff A Comparison With The 2016-2018 Semi Rally And Selloff A Comparison With The 2016-2018 Semi Rally And Selloff Given that Korean stocks in general, and Samsung in particular, have already underperformed, further downside in their relative performance will be limited. As to the Taiwanese overall equity index and TSMC, share prices remain elevated relative to the EM benchmark. Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We will be looking to recommend buying semiconductor stocks after a more material deceleration in semi companies’ revenue and profits gets priced in. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Traditional PCs are comprised of desktops, notebooks and workstations. 2     https://asia.nikkei.com/Spotlight/Supply-Chain/TSMC-says-demand-for-sma… 3     https://www.wsj.com/articles/good-chip-results-wont-be-good-enough-1164… 4     https://asia.nikkei.com/Spotlight/Supply-Chain/Chipmakers-nightmare-Wil… 5     https://www.cnet.com/tech/mobile/getting-a-new-iphone-every-2-years-is-…

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Spreads Near 2017-19 Average Spreads Near 2017-19 Average Spreads Near 2017-19 Average The main indicators that determine corporate bond performance are valuation, the cyclical/monetary environment and corporate balance sheet health. US corporate bond valuation is quite expensive. Spreads are off their post-COVID lows, but consistent with the 2017-19 average. The flat 2-year/10-year Treasury curve indicates that the cyclical/monetary backdrop is relatively poor. What’s more, the yield curve could easily invert within the next few months as the Fed tightens. This would send an even more negative signal for corporate bond returns.  Corporate balance sheets are currently in excellent shape, but their health will deteriorate within the next 12 months as profit growth slows and interest rates rise. Relative valuation favors high-yield over investment grade corporates, and high-yield has a track record of outperformance during periods of restrictive monetary conditions and strong corporate balance sheets. Bottom Line: Investors should cyclically reduce exposure to US corporate bonds while retaining a preference for high-yield over investment grade. We recommend downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5). Feature Chart 1A Rapid Recovery A Rapid Recovery A Rapid Recovery US corporate bonds have had a very good run since the March 2020 peak in spreads. Investment grade corporates outperformed a duration-matched position in US Treasuries by 23% during the first 12 months of the recovery, the best 12-month excess return since 2010 (Chart 1). That same period also saw an extremely rapid re-normalization of credit spreads. It took just 11 months for the investment grade corporate index option-adjusted spread (OAS) to reach 90 bps following its March 2020 peak, and the index delivered an annualized excess return of 26% during that period. In contrast, it took 109 months for the index OAS to reach 90 bps following the 2008 recession and corporates only beat duration-matched Treasuries by an annualized 4% during that time (Table 1). Table 1US Investment Grade Corporate Bond Returns From Spread Peak Until 90 BPs Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds The outlook for US corporate bond returns looks much different today. Spreads are tighter and the Fed is rapidly removing policy accommodation. Against this backdrop, we decided last week to cyclically reduce our corporate bond exposure.1  Specifically, we recommended downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5) within US bond portfolios. This Special Report discusses the rationale for our recent decision. First, we examine trends in the main indicators that determine corporate bond performance. These indicators fall into three categories: (i) valuation, (ii) cyclical/monetary indicators and (iii) balance sheet health. We then discuss the outlook for the relative performance of high-yield versus investment grade corporates. Valuation Starting with a simple examination of the average investment grade index OAS, we see that the spread has widened somewhat off its pre- and post-pandemic lows, but remains close to the average level seen between 2017 and 2019 (Chart 2). The index OAS is a reasonable gauge of value relative to recent history, but for a longer historical perspective we should adjust the index to account for its changing average credit rating and duration. To do this, we first re-weight the index to maintain a constant distribution between the different credit rating buckets. Next, we control for the index’s changing duration by calculating a 12-month breakeven spread. The 12-month breakeven spread is the spread widening that must occur during the next 12 months for the corporate index to perform in line with a duration-matched position in Treasuries. It can be approximated by dividing the index OAS by average index duration. Finally, Chart 3 presents the 12-month breakeven spread as a percentile rank since 1995. It shows that, after controlling for credit rating and duration, the investment grade corporate index has only been more expensive than current levels 24% of the time since 1995. Notice that the spread bounced off the 0% line in late-2021, indicating that it had reached all-time expensive levels. Chart 2Spreads Near 2017-19 Average Spreads Near 2017-19 Average Spreads Near 2017-19 Average Chart 3Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation All in all, we can conclude that investment grade corporate bonds are quite expensive. Spreads aren’t so low that they would justify an underweight allocation in a supportive cyclical/monetary environment. But they are tight enough that it makes sense to proceed cautiously in a neutral or negative cyclical/monetary environment, like the one we are in today.   Cyclical/Monetary Indicators The slope of the yield curve is the key variable we use to assess the current state of the cyclical/monetary environment. A very flat or inverted yield curve signals a relatively restrictive monetary policy backdrop, and we have shown that such a backdrop tends to coincide with poor excess corporate bond returns. Conversely, we have found that corporate bonds perform best early in the economic recovery when the yield curve is very steep. This steep yield curve signals that monetary conditions are highly accommodative, and thus supportive of credit spread tightening. Today, the yield curve is sending a somewhat confusing message. The 2-year/10-year Treasury slope briefly inverted last week, and it remains flat at 22 bps. Meanwhile, the 3-month/10-year Treasury slope is very steep, up above 200 bps (Chart 4)! Chart 4Conflicting Signals From The Yield Curve Conflicting Signals From The Yield Curve Conflicting Signals From The Yield Curve We discussed how to interpret the signals from different yield curve segments in a recent Special Report.2 We found that the 2-year/10-year Treasury slope sends the most useful signal for corporate bond excess returns, and we therefore view current cyclical/monetary conditions as negative for corporate bonds. In Table 2 we split each of the past six economic cycles into phases based on the 2-year/10-year Treasury slope. We define Phase 1 of the cycle as the period from the end of the prior recession until the 2-year/10-year slope breaks below 50 bps. Phase 2 of the cycle encompasses the time when the slope is between 0 bps and 50 bps. Phase 3 of the cycle spans from when the yield curve inverts until the start of the next recession. Table 2US Corporate Bond Performance In Different Phases Of The Cycle Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds The table shows annualized excess returns for both investment grade and high-yield corporate bonds in each of the three phases, and those returns exhibit a clear pattern. Returns are best in Phase 1 when the yield curve is steep. They take a step down in Phase 2 when the slope is between 0 bps and 50 bps, though they usually stay positive. Negative returns are most likely in Phase 3, after the yield curve inverts. Chart 5Limited Room For Curve Steepening Limited Room For Curve Steepening Limited Room For Curve Steepening With the 2-year/10-year Treasury slope at 22 bps, we are firmly in Phase 2 of the cycle. However, we could easily see the 2-year/10-year slope invert within the next few months while a breakout above 50 bps seems less likely. In fact, there are only two ways in which the 2-year/10-year Treasury slope can steepen further from current levels. First, the market could bid up its expectation of the long-run neutral fed funds rate, pushing long-dated bond yields higher. Second, expectations for the pace of near-term Fed tightening could diminish, pulling short-dated yields down. At the long-end, the 5-year/5-year forward Treasury yield is already above survey estimates of the long-run neutral rate (Chart 5). At the front-end, the market is discounting a rapid pace of 272 bps of tightening during the next 12 months (Chart 5, bottom panel), but that pace has limited room to fall given current extremely high inflation readings. Turning back to a comparison of the signals from the 2-year/10-year slope and 3-month/10-year slope, it is worth pointing out that the 3-month/10-year slope is influenced by yield movements at the very front-end of the curve. Meanwhile, the 2-year/10-year slope is purely a function of rate expectations beyond the next two years. As a result, we can view the 3-month/10-year slope as sending a timelier signal about Fed rate hikes and cuts, while the 2-year/10-year slope gives a better reading of how the market views the ultimate economic impact of Fed actions. For example, the 3-month/10-year Treasury slope inverted in 2019 just before the Fed started cutting rates (Chart 6A). The 2-year/10-year slope, however, only briefly dipped below zero. The message from the market was that the Fed would cut rates, but those cuts would be sufficient to sustain the economic recovery. As a result, corporate bonds performed well during this period, consistent with the message from the 2-year/10-year slope. Another interesting example occurred in early 2000 (Chart 6B). This time, the 2-year/10-year Treasury slope inverted while the 3-month/10-year slope remained steep. In this case, the 3-month/10-year slope was telling us that Fed rate hikes would continue, while the 2-year/10-year slope was telling us that those hikes would eventually kill the economic recovery. Once again, corporate bonds took their cues from the 2-year/10-year Treasury slope and performed poorly during this period. Chart 6AStrong Performance In 2019 Strong Performance In 2019 Strong Performance In 2019 Chart 6BPoor Performance In 2000 Poor Performance In 2000 Poor Performance In 2000 Obviously, the current situation looks more like 2000 than 2019, but with the 2-year/10-year slope still positive there remains scope for positive excess corporate bond returns in the near-term. That said, with high odds of 2-year/10-year curve inversion within the next few months and spreads at relatively tight levels, it makes sense to scale back exposure today in advance of the worst phase of the cycle. Balance Sheet Health The final factor we consider is the health of nonfinancial corporate sector balance sheets, and in fact, this is currently the lone bright spot for corporate bond investors. Our Corporate Health Monitor (CHM), a composite indicator of six key balance sheet ratios, is deep in “improving health” territory (Chart 7). This positive signal is driven by exceptionally high Interest Coverage (Chart 7, panel 2) and Free Cash Flow-To-Debt that is just off its highs (Chart 7, panel 3). Return On Capital is up sharply since 2020 but has not recovered its previous peak (Chart 7, bottom panel). Chart 7Balance Sheets Are In Great Shape Balance Sheets Are In Great Shape Balance Sheets Are In Great Shape While corporate balance sheets are in excellent shape right now, their health will certainly deteriorate going forward as profit growth comes down off its highs and interest rates rise. The only question is whether this deterioration will happen slowly or quickly. Turning to history, two relevant periods stand out (Chart 8). First is the mid-1990s when investment grade corporate bond excess returns peaked in July 1997, 16 months before our CHM moved into “deteriorating health” territory. Conversely, the CHM sent a negative signal before the excess return peak in 2007. But even then, investment grade corporates only outperformed Treasuries by an annualized 0.8% between when the 2-year/10-year slope fell below 50 bps in 2005 and when the CHM moved above zero in 2006. In other words, investors didn’t sacrifice much return by heeding the yield curve’s signal even when the CHM was deep in “improving health” territory. Chart 8Cyclical Corporate Bond Performance Cyclical Corporate Bond Performance Cyclical Corporate Bond Performance Investment Conclusions In summary, we view corporate bond valuations as expensive, and the flat 2-year/10-year Treasury slope suggests that the economic recovery is in its mid-to-late stages. Corporate balance sheets are currently in excellent shape, but they will deteriorate going forward as profit growth slows and interest rates rise. The above three factors suggest that corporate bonds could continue to outperform duration-matched Treasuries in the near-term. However, with spreads already at tight levels, we likely aren’t sacrificing much in the way of excess returns by turning cyclically defensive today. This move also ensures that we will not be invested when the credit cycle eventually turns and corporate bond spreads move significantly wider. Retain A Preference For High-Yield Versus Investment Grade While we recommend downgrading allocations for both investment grade (from neutral to underweight) and high-yield (from overweight to neutral), we think investors should still retain a preference for high-yield corporates over investment grade. To see why, let’s return to the 2005-06 period we looked at in the previous section. The yield curve dipped below 50 bps in 2005 when the CHM was still deep in “improving health” territory, and while investment grade corporate bond returns were low during the time between the signal from the yield curve and the signal from the CHM, junk excess returns were very strong (Chart 9). This makes some sense intuitively. Higher-rated investment grade corporates responded negatively to the Federal Reserve’s removal of monetary policy accommodation, but lower-rated junk spreads stayed well bid because actual default risk was benign. It wasn’t until after the CHM rose above zero that junk bonds started to underperform. In terms of present-day valuations, much like for investment grade, junk spreads are up off their 2021 lows. However, they remain close to their pre-pandemic trough (Chart 10). We also note that the differential between high-yield and investment grade spreads was much tighter in 2006-07. Given the similarities between that period and today, we wouldn’t be surprised to see junk spreads compress further relative to investment grade. Chart 9The Bullish Case For Junk The Bullish Case For Junk The Bullish Case For Junk Chart 10High-Yield Valuation High-Yield Valuation High-Yield Valuation Another way to approach high-yield bond valuation is through the lens of our Default-Adjusted Spread. The Default-Adjusted Spread is the difference between the junk index OAS and 12-month default losses, and we have shown that it has a strong correlation with excess returns (Table 3). Specifically, a Default-Adjusted Spread above 100 bps usually coincides with positive excess junk returns versus Treasuries, and higher spreads tend to coincide with higher returns. Table 3The Default-Adjusted Spread & High-Yield Excess Returns Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds To estimate the Default-Adjusted Spread for the next 12 months we need assumptions for the default and recovery rates (Chart 11). To do this, we model the 12-month speculative grade default rate as a function of gross nonfinancial corporate leverage – total debt over pre-tax profits – and lagged C&I lending standards. We then model the 12-month recovery rate based on the default rate itself. Chart 11Default And Recovery Rate Models Default And Recovery Rate Models Default And Recovery Rate Models Corporate pre-tax profit growth was exceptionally strong during the past 12 months, and we expect it to slow significantly going forward. Profit growth can be modeled as a function of nominal GDP growth and unit labor costs (Chart 12). If we assume that nominal GDP growth comes in at 7.3% this year (the Fed’s median 2.8% real GDP estimate plus 4.5% inflation) and that unit labor cost growth rises to 6%, then profit growth will fall to 0.5% during the next 12 months. If we assume that corporate debt growth remains close to its current level (Chart 12, bottom panel), then we calculate that gross leverage will rise to 6.5 during the next 12 months. Chart 12Profit Growth Will Slow Significantly Profit Growth Will Slow Significantly Profit Growth Will Slow Significantly Table 4 shows the output from our default and recovery rate models under the base case assumption described above. It also shows results for an optimistic case where leverage is 6.0 and a pessimistic case where it is 7.0. The Default-Adjusted Spread is fairly low in the base and pessimistic cases, but it is comfortably above the key 100 bps threshold in all three scenarios. This suggests that junk bonds should deliver positive excess returns versus duration-matched Treasuries during the next 12 months. Table 4Default-Adjusted Spread Scenarios Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Portfolio Allocation Summary, “The Beginning Of The End”, dated April 5, 2022. 2 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds Other Recommendations Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds

Executive Summary The Ukraine war reinforces our key view that commodity producers will use their geopolitical leverage this year. The market is growing complacent again about Russian risks. Iran is part of the same dynamic. If US-Iran talks fail, as we expect, the Middle East will destabilize and add another energy supply risk on top of the Russian risk. The Ukraine war also interacts with our other two key views for 2022: China’s reversion to autocracy and the US’s policy insularity. Both add policy uncertainty and weigh on risk sentiment. The war also reinforces our strategic themes for the 2020s: Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. Stagflation Cometh Stagflation Cometh Stagflation Cometh Trade Recommendation Inception Date Return Cyclically Long Global Defensives Versus Cyclicals 2022-01-20 10.8% Bottom Line: Tactically stay long global defensives and large caps. Cyclically stay long gold, US equities, aerospace/defense, and cyber security. Feature In our annual outlook, “The Gathering Storm,” we argued that the post-pandemic world economy would destabilize due to intensifying rivalry among the leading nations. We argued that China’s reversion to autocracy, US domestic divisions, and Russia’s commodity leverage would produce a toxic brew for global investors in 2022. By January 27 it was clear to us that Russia would invade Ukraine, so the storm was arriving sooner than we thought, and we doubled down on our defensive and risk-averse market positioning. We derived these three key views from new cyclical trends and the way they interact with our underlying strategic themes – Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism (Table 1). These themes are mutually reinforcing, rooted in solid evidence over many years, and will not change easily. Table 1Three Geopolitical Strategic Themes Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm The Ukraine war reinforces them: Russia took military action to increase its security relative to the US and NATO; the West imposed sanctions that reduce globalization with Russia and potentially other states; Russian aggression stemmed from nationalism and caused a spike in global prices that will spur more nationalism and populism going forward. In this report we examine how these trends will develop in the second quarter and beyond. We see stagflation taking shape and recommend investors prepare for it by continuing to favor defensive sectors, commodities, and value plays. Checking Up On Our Russia View For 2022 Our third key view for 2022 – that oil producers like Russia and Iran possessed immense geopolitical leverage and would most likely use it – is clearly the dominant geopolitical trend of the year, as manifested in the Russian invasion of Ukraine.1 Russia first invaded Ukraine in 2014 and curtailed operations after commodity prices crashed. It launched a new and larger invasion in 2022 when a new commodity cycle began (Chart 1). Facing tactical setbacks, Russia has begun withdrawing forces from around the Ukrainian capital Kyiv. But it will redouble its efforts to conquer the eastern Donbas region and the southern coastline. The coast is the most strategic territory at stake (Map 1). Chart 1Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Map 1Russian Invasion Of Ukraine, 2022 Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The most decisive limitation on Russia’s military effort would come from a collapse of commodity exports or prices, which has not happened yet. Europe continues to buy Russian oil and natural gas, although it is debating a ban on the $4.4 billion worth of coal that it imports. With high energy prices making up for a drop in export volumes, Russian armed forces can still attempt a summer and fall campaign (Chart 2). The aim would be to conquer remaining portions of Donetsk and Luhansk, the “land bridge” to Crimea, and potentially the stretch of land between the Dnieper river and eastern Moldova, where Russian troops are already stationed. Chart 2Russia’s War Financing Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Ukraine’s military neutrality is the core Russian objective. Ukraine is offering neutrality in exchange for security guarantees in the current ceasefire talks. Hence a durable ceasefire is possible if the details of neutrality are agreed – Ukraine forswears joining NATO and hosting foreign military infrastructure while accepting limitations on military exercises and defense systems. The security guarantees that Ukraine demands are mostly symbolic, as the western powers that would be credible guarantors are already unwilling to use military force against Russia (e.g. the US, UK, NATO members). However, Russia’s withdrawal from Kyiv will embolden the Ukrainians, so we do not expect a durable ceasefire in the second quarter. Global investors will be mistaken if they ignore Ukraine in the second quarter, at least until core problems are resolved. What matters most is whether the war expands beyond Ukraine: The likelihood of a broader war is low but not negligible. So far the Russian regime is behaving somewhat rationally: Moscow attacked a non-NATO member to prevent it from joining NATO; it limited the size of the military commitment; and it is now accepting reality and withdrawing from Kyiv while negotiating on Ukrainian neutrality. But a major problem emerges if Russia’s military fails in the Donbas while Ukraine reneges on offers of neutrality. Any ceasefire could fall apart and the war could re-escalate. Russia could redouble its attacks on the country or conduct a limited attack outside of Ukraine to trigger a crisis in the western alliance. Moreover, if sanctions keep rising until Russia’s economy collapses, Moscow could become less rational. Finland and Sweden have seen a shift of public opinion in favor of joining NATO. Any intention to do so would trigger a belligerent reaction from Russia. These governments are well aware of the precarious balance that must be maintained to prevent war, so war is unlikely. But if their stance changes then Russia will threaten to attack. Russia would threaten to bomb these states since it cannot now credibly threaten invasion by land (Charts 3A & 3B). Chart 3ANordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​ Chart 3BNordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​​ The Black Sea is vulnerable to “Black Swan” events or military spillovers. Russia is re-concentrating its military efforts in the Donbas and land bridge to Crimea. Russia could expand its offensive to Odessa and the Moldovan border. Or Russia could attempt to create a new norm of naval dominance in the Black Sea. Or ships from third countries could hit mines or become casualties of war. For these and other reasons, investors should not take on additional risk in their portfolios on the basis that a durable ceasefire will be concluded quickly. Russia’s position is far too vulnerable to encourage risk-taking. Moscow could escalate tensions to try to save face. It is also critical to ensure that Russia and Europe maintain their energy trade: Neither side has an interest in total energy cutoff. Russia needs the revenue to finance its war and needs to discourage Europe from fulfilling its pledges to transition rapidly to other sources and substitutes. Europe needs the energy to avoid recession, maintain some tie with Russia, and enable its energy diversification strategy. So far natural gas flows are continuing (Chart 4). Chart 4Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) ​​​​​​ Chart 5Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance ​​​​​​ However, risks to energy trade are rising. Russia is threatening to cut off energy exports if not paid in rubles, while the EU is beginning to entertain sanctions on energy. Russia can reduce oil or gas flows incrementally to keep prices high and prevent Europe from rebuilding stockpiles for fall and winter. Partial energy cutoff is possible. Europe’s diversification makes Russia’s predicament dire. Substantial sanction relief is highly unlikely, as western powers will want to prevent Russia from rebuilding its economy and military. Russia could try to impose significant pain on Europe to try to force a more favorable diplomatic solution. A third factor that matters is whether the US will expand its sanction enforcement to demand strict compliance from other nations, at pain of secondary sanctions: Secondary sanctions are likely in the case of China and other nations that stand at odds with the US and help Russia circumvent sanctions. In China’s case, the US is already interested in imposing sanctions on the financial or technology sector as part of its long-term containment strategy. While the Biden administration’s preference is to control the pace of escalation with China, and thus not to slap sanctions immediately, nevertheless substantial sanctions cannot be ruled out in the second quarter. Secondary sanctions will be limited in the case of US allies and partners, such as EU members, Turkey, and India. Countries that do business with Russia but are critical to US strategy will be given waivers or special treatment. Russia is not the only commodity producer that enjoys outsized geopolitical leverage amid a global commodity squeeze. Iran is the next most critical producer. Iran is also critical for the stability of the Middle East. In particular, the consequential US-Iran talks over whether to rejoin the 2015 nuclear deal are likely to come to a decision in the second quarter. Chart 6Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply If the US and Iran agree to a strategic détente, then regional tensions will briefly subside, reducing global oil disruption risks and supply pressures. Iran could bring 1.3 million barrels per day of oil back online, adding to President Biden’s 1 million per day release of strategic petroleum reserves. The combination would amount to 2.3% of global demand and more than cover the projected quarterly average supply deficit, which ranges from 400k to 900k barrels per day for the rest of 2022 (Chart 5). If the US and Iran fail to agree, then the Middle East will suffer another round of instability, adding a Middle Eastern energy shock on top of the Russian shock. Not only would Iran’s 1.3 million barrels per day be jeopardized but so would Iraq’s 4.4 million, Saudi Arabia’s 10.3 million, the UAE’s 3.0 million, or the Strait of Hormuz’s combined 24 million per day (Chart 6). This gives Iran leverage to pursue nuclear weaponization prior to any change in US government that would strengthen Israel’s ability to stop Iran. We would not bet on an agreement – but we cannot rule it out. The Biden administration can reduce sanctions via executive action to prevent a greater oil shock, while the Iranians can accept sanction relief in exchange for easily reversible moves toward compliance with the 2015 nuclear deal. But this would be a short-term, stop-gap measure, not a long-term strategic détente. Conflict between Iran and its neighbors will revive sooner than expected after the deal is agreed, as Iran’s nuclear ambitions will persist. OPEC states are already producing more oil rapidly, suggesting no quick fix if the US-Iran deal falls apart. While core OPEC states have 3.5 million barrels per day in spare capacity to bring to bear, a serious escalation of tensions with Iran would jeopardize this solution. Finally, if commodity producers have geopolitical leverage, then commodity consumers are lacking in leverage. This is clear from Europe’s inability to prevent Russia’s attack or ban Russian energy. It is clear from the US’s apparent unwillingness to give up on a short-term deal with Iran. It is clear from China’s inability to provide sufficient monetary and fiscal stimulus as it struggles with Covid-19. Turkey, Egypt, and Pakistan are geopolitically significant importers of Russian and Ukrainian grain that are likely to face food insecurity and social unrest. We will address this issue below under our Populism/Nationalism theme. Bottom Line: Investors should not be complacent. Russia’s military standing in Ukraine is weak, but its ability to finance the war has not yet collapsed, which means that it will escalate the conflict to save face. What About Our Other Key Views For 2022? Our other two key views for 2022 are even more relevant in the wake of the Ukraine re-invasion. China’s reversion to autocracy is a factor in China’s domestic and foreign policy: Domestically China needs economic and social stability in the advance of the twentieth national party congress, when President Xi Jinping hopes to clinch 10 more years in power. In pursuit of this goal China is easing monetary and fiscal policy. However, with depressed animal spirits, a weakening property sector, and high debt levels, monetary policy is proving insufficient. Fiscal policy will have to step up. But even here, inflation is likely to impose a limitation on how much stimulus the authorities can utilize (Chart 7). Chart 7China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation ​​​​​​ Chart 8Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 China is also trying but failing to maintain a “Covid Zero” policy. The more contagious Omicron variant of the virus is breaking out and slipping beyond the authorities’ ability to suppress cases of the virus to zero. Shanghai is on lockdown and other cities will follow suit. China will attempt to redouble its containment efforts before it will accept the reality that the virus cannot be contained. Chinese production and shipping will become delayed and obstructed as a result, putting another round of upward pressure on global prices (Chart 8). Stringent pandemic restrictions could trigger social unrest. China is ripe for social unrest, which is why it launched the “Common Prosperity” program last year to convince citizens that quality of life will improve. But this program is a long-term program that will not bring immediate relief. On the contrary, the economy is still suffering and the virus will spread more widely, as well as draconian social restrictions. The result is that the lead up to the national party congress will not be as smooth as the Xi administration had hoped. Global investors will remain pessimistic toward Chinese stocks. In foreign affairs, China’s reversion to autocracy is reinforced by Russia’s clash with the West and the need to coordinate more closely. Xi hosted Putin in Beijing on February 4, prior to the invasion, and the two declared that their strategic partnership ushers in a “new era” of “multipolarity” and that their cooperation has “no limits,” which really means that military cooperation is not forbidden. China agreed to purchase an additional 10 billion cubic meters of Russian natural gas over 30-years. While this amount would only replace 3% of Russian natural gas exports to Europe, it would mark a 26% increase in Russian exports to China. More importantly it acts as a symbol of Chinese willingness to substitute for Europe over time. There is a long way to go for China to replace Europe as a customer (Chart 9). But China knows it needs to convert its US dollar foreign exchange reserves, vulnerable to US sanctions, into hard investments in supply security within the Eurasian continent. Chart 9Long Way To Go For China NatGas Imports To Replace EU Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours China is helping Russia circumvent sanctions. China’s chief interest is to minimize the shock to its domestic economy. This means keeping Russian energy and commodities flowing. China could also offer military equipment for Russia. The US has expressly warned China against taking such an action. China could mitigate the blowback by stipulating that the assistance cannot be used in Ukraine. This would be unenforceable but would provide diplomatic cover. While China is uncomfortable with the disturbance of the Ukraine war – it does not want foreign affairs to cause even larger supply shocks. At the same time, China does not want Russia to lose the war or Putin’s regime to fall from power. If Russia loses, Taiwan and its western allies would be emboldened, while Russia could pursue a détente with the West, leaving China isolated. Since China faces US containment policy regardless of what happens in Russia, it is better for China to have Putin making an example out of Ukraine and keeping the Americans and Europeans preoccupied. Chart 10China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China must also preserve ties with Europe. Diplomacy will likely succeed in the short run since Europe has no interest or desire to expand sanctions to China. The Biden administration will defer to Europe on the pace of sanctions – it is not willing or able to force Europe to break with China suddenly. Eventually Europe and China may sever relations but not yet – China has a powerful incentive to preserve them (Chart 10). China will also court India and other powers in an attempt to hedge its bets on Russia while weakening any American containment. Beyond the party congress, China will be focused on securing the economic recovery and implementing the common prosperity agenda. The first step is to maintain easy monetary and fiscal policy. The second step is to “let 100 flowers bloom,” i.e. relaxing social and regulatory controls to try to revive entrepreneurship and animal spirits, which are heavily depressed. Xi will have the ability to do this after re-consolidating power. The third step will be to try to stabilize economic relations with Europe and others (conceivably even the US temporarily, though no serious détente is likely). The remaining key view for 2022 is that the Biden administration’s domestic focus will be defensive and will invite foreign policy challenges. The Ukraine war vindicates this view but the question now is whether Biden has or will change tack: The Biden administration is focused on the midterm elections and the huge risk to the Democratic Party’s standing. Biden has not received a boost in opinion polls from the war. He is polling even worse when it comes to handling of the economy (Chart 11). While he should be able to repackage his budget reconciliation bill as an energy security bill, his thin majorities in both houses make passage difficult. Chart 11Biden And Democrats Face Shellacking In Midterm Election Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Biden’s weak standing – with or without a midterm shellacking – raises the prospect that Republicans could take back the White House in 2024, which discourages foreign nations from making any significant concessions to the United States in their negotiations. They must assume that partisanship will continue to contaminate foreign policy and lead to abrupt policy reversals. In foreign policy, the US remains reactive in the face of Russian aggression. If Russia signs a ceasefire, the US will not sabotage it to prolong Russian difficulties. Moreover Biden continues to exempt Europe and other allies and partners from enforcing the US’s most severe sanctions for fear of a larger energy shock. Europe’s avoidance of an energy ban is critical and any change in US policy to try to force the EU to cut off Russian energy is unlikely. China will not agree to structural reform or deep concessions in its trade negotiations, knowing that former President Trump could come back. The Biden administration’s own trade policy toward China is limited in scope, as the US Trade Representative Katherine Tai admitted when she said that the US could no longer aim to change China’s behavior via trade talks. Biden’s only proactive foreign policy initiative, Iran, will not bring him public kudos if it is achieved. But American inconstancy is one of the reasons that Iran may walk away from the 2015 nuclear deal. Why should Iran’s hawkish leaders be expected to constrain their nuclear program and expose their economy to future US sanctions if they can circumvent US sanctions anyway, and Republicans have a fair chance of coming back into power as early as January 2025? Biden’s unprecedented release of strategic petroleum reserves will not be able to prevent gasoline prices from staying high given the underlying supply pressures at home and abroad. This is especially true if the Iran talks fail as we expect. Even if inflation abates before the election, it is unlikely to abate enough to save his party from a shellacking. That in turn will weaken the global impression of his administration’s staying power. Hence Biden will focus on maintaining US alliances, which means allowing Europe, India, and others to proceed at a more pragmatic and dovish pace in their relations with Russia and China. Bottom Line: China’s reversion to autocracy and America’s policy insularity suggest that global investors face considerable policy uncertainty this year even aside from the war in Europe. Checking Up On Our Strategic Themes For The 2020s Russia’s invasion strongly confirmed our three strategic themes of Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. These themes are mutually reinforcing: insecurity among the leading nation-states encourages regionalization rather than globalization, while populism and nationalism encourage nations to pursue economic and security interests at the expense of their neighbors. First, the Ukraine war confirms and exacerbates Great Power Rivalry: Chart 12China And Russia Both Need To Balance Against US Preponderance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Russia’s action vindicates the “realist” school of international relations (in which we count ourselves) by forcing the world to wake up to the fact that nations still care primarily about national security defined in material ways, such as armies, resources, and territories. The paradox of realism is that if at least one of the great nations pursues its national self-interest and engages in competition for security, then all other nations will be forced to do the same. If a nation neglects its national security interests in pursuit of global economic engagement and cooperation, then it will suffer, since other nations will take advantage of it to enhance their security. Hence, as a result of Ukraine, nations will give a higher weight to national security relative to economic efficiency. The result will be an acceleration of decisions to use fiscal funds and guide the private economy in pursuit of national interests – i.e. the Return of Big Government. Since actions to increase deterrence will provoke counteractions for the same reason, overall insecurity will rise. For example, the US and China will take extra precautions in case of future sanctions and war. But these precautions will reduce trust and cooperation and increase the probability of war over the long run. For the same reason, China cannot reject Russia’s strategic overture – it cannot afford to alienate and isolate Russia. China and Russia have a shared interest in countering the United States because it is the only nation that could conceivably impose a global empire over all nations (Chart 12). The US could deprive Beijing and Moscow of the regional spheres of influence that they each need to improve their national security. This is true not only in Ukraine and Taiwan but in other peripheral areas such as Belarus, the Caucasus, Central Asia, and Southeast Asia. China has much to gain from Russia. Russia is offering China privileged overland access to Russian, Central Asian, and Middle Eastern resources and markets. This resource base is vital to China’s strategic needs, given its import dependency and vulnerability to US maritime power (Chart 13). Chart 13China’s Maritime Vulnerability Forces Eurasian Strategy, Russian Alliance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Investors should understand Great Power Rivalry in a multipolar rather than bipolar sense. As Russia breaks from the West, investors are quick to move rapidly to the bipolar Cold War analogy because that is what they are familiar with. But the world today has multiple poles of political power, as it did for centuries prior to the twentieth. While the US is the preponderant power, it is not hegemonic. It faces not one but two revisionist challengers – Russia and China. Meanwhile Europe and India are independent poles of power that are not exclusively aligned with the US or China. For example, China and the EU need to maintain economic ties with each other for the sake of stability, and neither the US nor Russia can prevent them from doing so. The same goes for India and Russia. China will embrace Russia and Europe at the same time, while hardening its economy against US punitive measures. India will preserve ties with Russia and China, while avoiding conflict with the US and its allies (the maritime powers), whom it needs for its long-term strategic security in the Indian Ocean basin. Ultimately bipolarity may be the end-game – e.g. if China takes aggressive action to revise the global order like Russia has done – but the persistence of Sino-European ties and Russo-Indian ties suggest we are not there yet. Second, the Ukraine war reinforces Hypo-Globalization: Since the pandemic we have argued that trade would revive on the global economic snapback but that globalization – the deepening of trade integration – would ultimately fall short of its pre-2020 and pre-2008 trajectory. Instead we would inhabit a new world of “hypo-globalization,” in which trade flows fell short of potential. So far the data support this view (Chart 14). Chart 14Globalization Falling Short Of Potential Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The Ukraine war has strengthened this thesis not only by concretely reducing Russia’s trajectory of trade with the West – reversing decades of integration since the fall of the Soviet Union – but also by increasing the need for nations to guard against a future Chinese confrontation with the Western world. Trust between China and the West will further erode. China will need to guard against any future sanctions, and thus diversify away from the US dollar and assets, while the US will need to do a better job of deterring China against aggression in Asia, and will thus have to diversify away from Chinese manufacturing and critical resources like rare earths. While China and Europe need each other now, the US and China are firmly set on a long-term path of security competition in East Asia. Eventually either the US or China will take a more aggressive stance and Europe will be forced to react. Since Europe will still need US support against a decaying and aggressive Russia, it will likely be dragged into assisting the US against China. Third, the Ukraine war reflects and amplifies Populism/Nationalism: Populism and nationalism are not the same thing but they both stem from the slowing trend of global income growth, the rise of inequality, the corruption of the elite political establishments, and now the rise in inflation. Nations have to devote more resources to pacifying an angry populace, or distracting that populace through foreign adventures, or both. The Ukraine war reflects the rise in nationalism. First, the collapse of the Soviet Union ushered in a period in which Moscow lost control of its periphery, while the diverse peoples could pursue national self-determination and statehood. The independence and success of the Baltic states depended on economic and military cooperation with the West, which eroded Russian national security and provoked a nationalist backlash in the form of President Putin’s regime. Ukraine became the epicenter of this conflict. Ukraine’s successful military resistance is likely to provoke a dangerous backlash from Moscow until either policy changes or the regime changes. American nationalism has flared repeatedly since the fall of the Soviet Union, namely in the Iraq war. The American state has suffered economically and politically for that imperial overreach. But American nationalism is still a potent force and could trigger a more aggressive shift in US foreign policy in 2024 or beyond. European states have kept nationalism in check and tried to subsume their various nationalist sentiments into a liberal and internationalist project, the European Union. The wave of nationalist forces in the wake of the European debt crisis has subsided, with the exception of the United Kingdom, where it flowered in Brexit. The French election in the second quarter will likely continue this trend with the re-election of President Emmanuel Macron, but even if he should suffer a surprise upset to nationalist Marine Le Pen, Europe’s centripetal forces will prevent her from taking France out of the EU or euro or NATO (Chart 15). Over the coming decade, nationalist forces will revive and will present a new challenge to Europe’s ruling elites – but global great power competition strongly supports the EU’s continued evolution into a single geopolitical entity, since the independent states are extremely vulnerable to Russia, China, and even the US unless they unite and strengthen their superstructure. Chart 15Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective In fact the true base of global nationalism is migrating to Asia. Chinese and Indian nationalism are very potent forces under President Xi Jinping and Prime Minister Narendra Modi. Xi is on the verge of clinching another ten years in power while Modi is still favored for re-election in 2024, so there is no reason to anticipate a change anytime soon. The effects are various but what is most important for investors is to recognize that as China’s potential GDP has fallen over the past decade, the Communist Party has begun to utilize nationalism as a new source of legitimacy, and this is expressed through a more assertive foreign policy. President Xi is the emblem of this shift and it will not change, even if China pursues a lower profile over certain periods to avoid provoking the US and its allies into a more effective coalition to contain China. Chart 16Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism The surge in global prices will destabilize regimes that lack food security and contribute to new bouts of populism and nationalism. Turkey is the most vulnerable due to a confluence of political, economic, and military risks that will unsettle the state. But Egypt is vulnerable to an Arab Spring 2.0 that would have negative security implications for Israel and add powder to the Middle Eastern powder keg. Pakistan is already witnessing political turmoil. Investors may overlook any Indonesian unrest due to its attractiveness in a world where Russia and China are scaring away western investment (Chart 16). All three of these strategic themes are mutually reinforcing – and they tend to be inflationary over the long run. Great powers that redouble the pursuit of national interest – through defense spending and energy security investments – while simultaneously being forced to expand their social safety nets to appease popular discontent, will drive up budget deficits, consume a lot of natural resources, and purchase a lot of capital equipment. They will also more frequently engage in economic or military conflicts that constrain supply (Chart 17). Chart 17War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary Bottom Line: The Ukraine war is a powerful confirmation of our three strategic themes. It is also a confirmation that these themes have inflationary macroeconomic implications. Investment Takeaways Chart 18Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Now that great power rivalry is intensifying immediately and rapidly, and yet China’s and Europe’s economies are encountering greater difficulties, we expect stagflation to arrive sooner rather than later. High headline and core inflation, the Ukraine war, tacit Chinese support for Russia, persistent Chinese supply kinks, US and EU sanctions, US midterm elections, and a potential US-Iran diplomatic breakdown will all weigh on risk sentiment in the second quarter. In Ukraine, Russia’s position is too weak to give comfort for investors, who should continue to favor defensive over cyclical equities and US stocks over global stocks. Russia’s break with the West, and the West’s use of sanctions to prevent Russia from accessing its foreign exchange reserves, has raised new questions about the global currency reserve system and the dollar’s status within that system. Over the coming years China will redouble the efforts it began in the wake of the Great Recession to reduce its dependency on US dollar assets within its reserve basket, while also recycling new current account surpluses into non-dollar assets. However, the evidence does not suggest that King Dollar will suffer a structural breakdown. First, the world lacks alternative safe-haven assets to US Treasuries – and net foreign purchases of US bonds rose in the face of the Ukraine war (Chart 18). Second, the return of war to Europe will weaken the perceived long-term security of European currency and government bonds relative to US counterparts. Even if the Ukraine war is contained in the short run, as we expect, Russia is in structural decline and will remain a disruptive player for some time. We are not at all bearish on the euro or European bonds but we do not see the Ukraine war as increasing their value proposition, to put it lightly. The same logic extends to Japanese bonds, since China, like Russia, is an autocratic and revisionist state that threatens to shake up the security order in its neighborhood. Japan is relatively secure as a nation and we are bullish on the yen, but China’s de facto alliance with Russia weakens Japan’s security outlook over the very long run, especially relative to the United States. Thus, on a cyclical basis the dollar can depreciate, but on a structural basis the US dollar will remain the dominant reserve currency. The US is not only the wealthiest and most secure country in the world but also the largest oil producer. Meanwhile Chinese potential growth, domestic political stability, and foreign relations are all worsening. The US-Iran talks are the most critical geopolitical dynamic in the second quarter aside from Russia’s clash with the West. The fate of the 2015 nuclear deal will be decided soon and will determine whether an even bigger energy shock begins to emanate from the Middle East. We would not bet on a new US-Iran deal but we cannot rule it out. Any deal would be a short-term, stop-gap deal but would prevent an immediate destabilization of the Middle East this year. As such it would reduce the risk of stagflation. Since we expect the deal to fail, we expect a new energy shock to emerge. We see stagflation as more likely than the BCA House View. It will be difficult to lift productivity in an environment of geopolitical and political uncertainty combined with slowing global growth, rising interest rates, and a worsening commodity shock (Chart 19). We will gladly revise this stance if Biden clinches an Iran deal, China relaxes its Covid Zero policy and stabilizes domestic demand, Russia and Europe maintain energy trade, and commodity prices fall to more sustainable levels for global demand. Chart 19Stagflation Cometh Stagflation Cometh Stagflation Cometh Strategically we remain long gold, overweight US equities, overweight UK equities, long British pound and Japanese yen, long aerospace/defense stocks and cyber security stocks. We remain short Chinese renminbi and Taiwanese dollar and short emerging European assets. Our short Chinese renminbi trade and our short Taiwanese versus Korean equity trade are our worst-performing recommendations. However, the above analysis should highlight – and the Ukraine war should underscore – that these two economies face a fundamentally negative geopolitical dynamic. Both Chinese and Taiwanese stocks have been underperforming global peers since 2021 and our short TWD-USD trade is in the money. While we do not expect war to break out in Taiwan this year, we do expect various crisis events to occur, particularly in the lead up to the crucial Taiwanese and American 2022 midterms and 2024 presidential election. We also expect China to depreciate the renminbi when inflation peaks and commodity prices subside. Cyclically we remain long North American and Latin American oil producers and short Middle Eastern producers, based on our pessimistic read of the Iran situation. The Americas are fundamentally better protected from geopolitical risks than other regions, although they continue to suffer from domestic political risks on a country-by-country basis. Cyclically we continue to take a defensive positioning, overweighting defensive sectors and large cap equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      That the Russian threat fell under our third key view for 2022 implies that we did not get our priorities straight. However, consider the timing: shortly after publishing our annual outlook on December 15, the Russians issued an ultimatum to the western powers demanding that NATO stop expanding toward Russia. Diplomats from Russia and the West met on January 12-13 but Russia’s demands were not met. We upgraded the odds that Russia would invade Ukraine from 50% to 75% on January 27. Shuttle diplomacy ensued but failed. Russia invaded on February 24. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Fed policy and the US stock market are on a collision course. US core inflation will not fall below 3.5% unless the economy slows considerably below its potential for a few quarters. As long as US share prices do not fall considerably, i.e., financial conditions do not tighten substantially, the Fed has no reason to halt its tightening and revert its hawkish posture. Odds are that US profit margins and equity multiples will compress, leading to lower share prices in the coming months. In China, monetary and fiscal stimulus have so far been insufficient to produce an economic recovery given the headwinds from the property sector and the rolling lockdowns. A broad-based EM rally will occur only when a commodity bull market is demand driven. The recent spike in commodity prices has been due to supply curtailment. Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Bottom Line: Maintain an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive. We are waiting to buy EM local bonds later this year using the potential weakness in their currencies.     After a two-year hiatus, I traveled to the US last week for in-person meetings with clients. This report summarizes the key questions and points of discussion that emerged during these exchanges. Question: What are the key risks to EM markets at the moment? Answer: First, Fed policy and the US stock market are on a collision course. This is in fact a threat to global risk assets – not just US ones. Second, rolling lockdowns in China and the property market slump will delay the recovery of the mainland economy. Third, after the latest rebound in risk assets, geopolitical risks are underestimated. Before the situation in Ukraine stabilizes, President Putin will likely escalate the conflict to obtain a better negotiating position. The combination of these three risks warrants a cautious stance on EM assets. Chart 1The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation The 1960s: US Inflation Outbreak And Negative Stock Price-To-Bond Yield Correlation Question: Let’s start with the Fed. Why do you think US share prices and the Fed are on a collision course? Historically, there were episodes during which the S&P 500 rallied even though the Fed was hiking rates. Why is this time different? Answer: Extremely elevated US core inflation, rising inflation expectations as well as very expensive equity valuations make this current episode different from those periods in the 1990s, 2000s and even 2010s when US equities advanced amid Fed tightening.  In fact, share prices and bond yields were negatively correlated for 30 years between 1966 and 1997. The current episode is reminiscent of the late 1960s when core inflation spiked, and equity prices became negatively correlated with Treasury yields (Chart 1). As to the interaction between the Fed and financial markets, our reasoning is as follows: As long as US share prices do not fall and US credit spreads do not widen considerably, i.e., financial conditions do not tighten substantially, then the Fed has no reason to halt its tightening and revert its hawkish posture. The basis is that US core inflation is well above target, and inflation expectations are ratcheting up and could become entrenched. Question: Do you expect US inflation to moderate and in turn allow the Fed to go on hold? Answer: Investors and policymakers should differentiate between the annual inflation rate (a statistical measure) and a genuine inflation outbreak. The annual inflation rate is too high, and will likely drop in H2 this year. Chart 2Super Core US Consumer Inflation Is At 5% Super Core US Consumer Inflation Is At 5% Super Core US Consumer Inflation Is At 5% However, US inflationary pressures are genuine and broad-based. If these pressures are not contained, they will spiral out of control. Our measure of US average core inflation is currently around 5% (Chart 2). This series is an average of seven measures of core consumer price inflation from the Fed: core CPI and PCE, median CPI, market-based core PCE, trimmed-mean CPI and PCE, and sticky core CPI. Hence, this measure is not influenced by price movements of individual components. The annual rate of core CPI will drop in the US but we do not expect core CPI and PCE to fall below 3.5% unless the economy slows considerably below its potential for a few quarters, and labor market conditions deteriorate leading to lower wage growth. The reasoning is that underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be contained without bringing economic growth down below potential growth and weakening the labor market.  Chart 3US Wage Growth Is Between 4.3% and 7.7% US Wage Growth Is Between 4.3% and 7.7% US Wage Growth Is Between 4.3% and 7.7% The labor market is presently very tight, and wage growth will continue accelerating. Given that real wages have shrunk dramatically in the past 12 months, labor will be demanding wage increases that are on par or above the inflation rate. With sales still strong, companies will have to pay higher wages to maintain and attract skilled employees. US nominal wage growth is presently ranging between 4.3-7.7%, depending on the measure (Chart 3). With US underlying productivity growth unlikely to be more than 2% at best, unit labor costs are therefore rising at a rate of 2.5-5.5% and will accelerate further. Chart 4 illustrates that unit labor costs have been a major driver of core consumer price inflation in the US over the past 60 years. If unit labor costs accelerate, core inflation will not drop much from its current elevated levels. As core inflation proves to be sticky and does not fall rapidly below 3.5%, the Fed will have no choice but to keep raising interest rates… until something breaks. Chart 4Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Unit Labor Costs Are The Key To Core Inflation Question: What will be the first thing to break? Do you think Fed rate hikes will push the US economy into recession? Answer: Equity markets will be the first to break. It is hard to make a judgement about whether US real GDP will contract, but odds are high that US/global share prices will drop as the Fed tightens. The S&P 500 can drop 20-25% from its early January high without a recession in the American economy. Drivers of this selloff will be compressing equity multiples and shrinking profit margins. Chart 5Rising Rates = Lower Equity Multiples Rising Rates = Lower Equity Multiples Rising Rates = Lower Equity Multiples First, there are three drivers of equity returns – the top line, profit margins and valuation multiples. We believe that two of these three – profit margins and multiples – will be negative for the US market in the coming months. Valuation multiples will compress as US interest rates rise further (Chart 5).  Profit margins will shrink as wage growth accelerates well above productivity gains, i.e., unit labor costs spike. Even if corporates’ top-line growth stays robust, the negative impact of compressing valuation multiples and lower profit margins will be overwhelming for equities. Hence, corporate profits could shrink mildly and share prices would drop materially even as real GDP does not contract. Second, it is important to mention that equity returns could be negative outside reccessions. Let’s recall what happened in 2000-2001 in the US. Nominal growth was robust, real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming (Chart 6, top panel). Yet, the S&P 500 EPS plunged by 30% and the stock index was down by 50% (Chart 6, bottom two panels). We do not mean that US profits are about to crash by 30% and share prices will plunge by 50% like they did in the bear market of 2000-2002. The point is that profits could experience a mild contraction despite solid consumer spending. Chart 6S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 S&P 500 EPS Can Shrink Even If Nominal GDP Growth Is Solid, As Happened In 2001 Chart 7US Real Consumption Of Goods: A Mean Reversion Ahead? US Real Consumption Of Goods: A Mean Reversion Ahead? US Real Consumption Of Goods: A Mean Reversion Ahead? Third, there is chance of a stagflation scare. US purchases of goods ex-autos have been extremely strong due to generous fiscal transfers to households and pandemic dynamics that discouraged service spending and boosted goods purchases. Americans’ real spending on goods ex-autos has been running well above its pre-pandemic trend and is likely to experience some sort of mean reversion (Chart 7).  A shift in consumption away from goods ex-autos will weigh down on goods producers globally. Notably, manufacturers rather than service providers dominate equity markets outside the US. Hence, a period when US inflation is sticky, and the Fed is tightening while the global manufacturing cycle is slowing is a possibility. This will upset investors and lead them to pare back their equity holdings. Question: As we all know, the US dollar is very important for EM economies and financial markets. So, what is the outlook for the greenback? Answer: As long as the Fed sounds hawkish and continues tightening, the US dollar will strengthen. The motive is that when the central bank is willing to tighten and the economy does not collapse, the currency tends to appreciate. Even as the S&P 500 sells off, the risk-off phase is also positive for the US currency. The trade-weighted dollar will put a major top and will start depreciating only when the Fed does a dovish tilt. Odds are that this will take place later this year when the S&P 500 is down 25% or so. Yet, US inflation will still be entrenched. In other words, the Fed will fall behind the inflation curve. A central bank falling behind the inflation curve is bearish for the currency. Chart 8Mainstream EM Currencies: An Air Pocket? Mainstream EM Currencies: An Air Pocket? Mainstream EM Currencies: An Air Pocket? Concerning mainstream EM (excluding China, Korea and Taiwan) currencies, the total return index (including carry) versus the US dollar has hit a technical resistance (Chart 8). We expect a near-term relapse in EM exchange rates as a mirror image of US dollar strength and the risk-off trade in global markets. However, a major buying opportunity in EM currencies and fixed-income markets as well as EM equity markets will transpire later this year when the US dollar peaks. Question: Let’s turn to China. Growth continues to be disappointing. The COVID-related lockdowns are depressing economic activity. Have authorities stimulated enough for the business cycle to recover soon? Answer: We believe that monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus is sizable (Chart 9), but it has not yet fully entered the economy. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has not yet bottomed (Chart 10). Chart 9China's Fiscal Stimulus Is In The Pipeline China's Fiscal Stimulus Is In The Pipeline China's Fiscal Stimulus Is In The Pipeline Chart 10China: Corporate and Household Credit Impulse Has Not Bottomed Yet China: Corporate and Household Credit Impulse Has Not Bottomed Yet China: Corporate and Household Credit Impulse Has Not Bottomed Yet With rolling lockdowns impairing service employment and, hence, denting household income, and without sizable fiscal transfers to consumers, the economy will struggle to recover. Local government finances are squeezed by lack of revenues from land sales and their borrowing is limited by quotas set by the central government. So, only the central government is in a position to provide meaningful fiscal support to households, but it has not yet done so. Question: You mentioned that the current geopolitical climate remains a risk to financial markets as Putin will likely escalate before de-escalating. Is this not bullish for commodities? Also, you have argued over the years that commodity prices positively correlate with EM equity performance. Yet, there has been a major decoupling between commodity prices and EM equity absolute and relative performance (Chart 11). How do you explain this phenomenon? Chart 11Decoupling Between EM Stocks And Commodity Prices Decoupling Between EM Stocks And Commodity Prices Decoupling Between EM Stocks And Commodity Prices Answer: Re-escalation on the part of the Kremlin will be bullish for commodities in the short run. In the medium term however, as we argued in a report in early March, commodity prices will be very volatile, with upside risks for some (like wheat) but not for all of them. It all depends on how much of its resource exports Russia can sell/ship abroad. It is hard to forecast this in view of sanctions by Western governments and their private sectors, as well as the breakdown in existing market infrastructures (such as payment systems, freight, insurance, etc.). The breakdown between commodity prices and EM absolute and relative share prices is due to the following: When commodity prices rise due to demand from the real economy, EM stocks tend to rally and outperform. This is especially true when it is China’s demand that is driving commodity prices higher. The reason is that China is important for overall EM economies, and robust demand growth in China is bullish for EM assets. In such a scenario (a demand-driven commodity bull market), not only do commodity producers rally (Latin America) but also commodity consumers (Asia) perform well in absolute terms. The recent spike in commodity prices has been due to supply curtailment rather than demand strength. That has benefited commodity producers (Latin America) but not commodity consumers (Asia). Finally, TMT stocks have come to make up a large share of EM markets in recent years. So wild swings in their performance have distorted the correlation between the EM equity index and commodity prices. Question: Will equity and currency markets of commodity producers continue rallying? Answer: The key signals to monitor are the trend in the US dollar and the global risk-on/risk-off environment. If a risk-off move transpires and the US dollar firms (as we expect), share prices and currencies in commodity-producing countries will relapse in absolute terms. Also, Chart 12 illustrates net long positions in ZAR, BRL and MXN among asset managers and leveraged funds are elevated. In short, investors are already very long, and these currencies could correct. Finally, the prices of some commodities for which Russia and Ukraine are not major producers, like platinum, have already been relapsing. In fact, platinum prices correlate well with EM non-TMT share prices in US dollar terms and are currently pointing to downside risks (Chart 13). Chart 12Investors Are Very Long EM Commodity Currencies Investors Are Very Long EM Commodity Currencies Investors Are Very Long EM Commodity Currencies Chart 13Not All Commodity Prices Are Rising Not All Commodity Prices Are Rising Not All Commodity Prices Are Rising Question: Could high food and energy prices heighten political risks in some developing countries? How serious is this risk? Answer: This risk has already manifested itself in some countries, with protests in Peru and the 15% devaluation in Egypt. More countries could experience public demonstrations and political turbulence. An overarching theme for many developing nations will be a drag on growth from high food and energy prices. Unlike the US, wages in emerging economies are not rising fast, and labor markets are not tight. As a result, employees have no bargaining power, and their wages will shrink in real terms (adjusted for headline inflation). Given that food and energy make up a larger share of the consumer basket in emerging economies, high energy and food prices will meaningfully reduce household income available for discretionary spending. Consequently, EM household spending will disappoint. In light of lackluster consumer demand, business investment will not pick up much either. Finally, monetary and fiscal policies in EM are reasonably tight. In Latin America, the credit and fiscal spending and monetary impulses are pointing to economic weakness ahead (Chart 14).  Overall, potential political volatility and disappointing domestic demand are risks to EM financial markets. Chart 14Latin American Economies Will Decelerate Latin American Economies Will Decelerate Latin American Economies Will Decelerate Chart 15A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year A Buying Opportunity in EM Domestic Bonds Will Occur Later This Year Question: What is your recommended investment strategy for EM overall and country allocation? Answer: We continue recommending an underweight position in EM equities and credit in global equity and credit portfolios, respectively. EM local currency bonds are becoming attractive as their yields have spiked (Chart 15). We are waiting to buy EM local bonds later this year using the potential weakness in their currencies. For now, we have the following positions in individual local rates: long 10-year Brazilian bonds, currency unhedged; receiving 10-year swap rates in China and Malaysia; betting on yield curve flattening in Mexico; receiving 10-year Czech / paying 10-year Polish swap rates. The list of country allocation for EM equity, credit and domestic bond portfolios is presented in Table 1. Table 1Our Country Allocation Across Asset Classes What Are Clients Asking? What Are Clients Asking? ​​​​​​​   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     What Are Clients Asking? What Are Clients Asking? What Are Clients Asking? What Are Clients Asking?

Executive Summary Long Small Cap Energy Versus Large Cap Investment Takeaways Investment Takeaways President Biden has not received a boost in opinion polls from the Ukraine war. If he has not by now then it is increasingly unlikely that he will do so. Yet Biden performs worse in polls for his handling of economic policy than foreign policy, despite falling unemployment and rising real wages. The economy should help stabilize his approval rating but not in time to prevent Democrats from losing the Senate as well as the House this fall.  Biden’s decision to tap the strategic petroleum reserve exemplifies our 2022 trend of executive action. However, the oil outlook still depends on Biden’s Iran talks and OPEC’s reaction. Recommendation Inception Level Inception Date Return Long Small Vs. Large Cap Energy 0.56 26-Jan-22 14.9% Bottom Line: The return of gridlock is bad for stocks in 2022 but good in 2023. Feature Investors need answers to three questions about US policy at the moment: 1.   Will President Biden’s reaction to the Ukraine war exacerbate the hit to the global and US economy? 2.   Will Biden’s domestic agenda revive? If so, how will it impact corporate earnings expectations? 3.   Will Biden’s foreign and domestic policies cause any changes to the midterm election outlook and hence US policy in 2023-24? In recent reports we have answered these questions as follows. Related Report  US Political StrategySecond Quarter Outlook: Gridlock Looms First, Biden will continue to pursue a defensive or reactive foreign policy, meaning that he will not force Europe or other allies to adopt Russia sanctions beyond their near-term economic and political capabilities. If Europe wants to boycott Russian energy then that is fine but it is Europe’s decision. In fact, Europe is pursuing gradual rather than immediate diversification. Russia needs the funds. So Europe is unlikely to experience a sharp energy cutoff that plunges its economy into recession. Nevertheless, the risk is substantial enough that we remain long DXY and defensive US sectors on a tactical time frame. Second, Biden’s congressional agenda is getting back on track, with the war providing Democrats with a basis for redesigning and rebranding their budget reconciliation bill. Therefore we did not downgrade our 65% subjective odds that Congress will pass a bill. The bill will be close to deficit neutral and focused especially on energy policy. The Senate version of the bill is not yet available but we will examine the likeliest policy options in a forthcoming special report with our US Equity Strategy. Third – our focus for this report – current political changes do not substantially alter the midterm election odds, which suggest Republicans will retake Congress. Gridlock will return – and is the norm in US policy. In an inflationary context gridlock may well be positive for equities in 2023 since it will curb fiscal spending. However, uncertainty is negative for equities this year. We remain tactically defensive. We recommend renewable energy, cyber stocks, defense stocks, and infrastructure stocks as cyclical plays. Biden’s Approval Stabilizing At Low Level Foreign policy shocks are likely to hurt the ruling party – especially if the nature of the shock exacts a toll on the voter’s pocketbook. We showed evidence to this effect just before Russia re-invaded Ukraine. We concluded that Biden would experience a bounce in opinion polls as the nation rallied around him in the face of the Russian menace but the likely rise in gasoline prices would end up hurting the Democratic Party in the midterm elections.  Yet 40 days after Russia’s attack Biden’s general job approval is still at the lowest of his presidency, in the 41-42% range, while his disapproval is still high, in the 52-53% range. So far the war has not given him an appreciable boost, outside of his own party (where the boost has still been small). The results are even worse when it comes to his handling of the economy. Here his approval is 39% and disapproval 54%. In foreign policy, Biden’s approval stands at 40% and disapproval at 52% (Chart 1). Presidential approval has a big influence on the midterm election – as does perception of the two parties. Republicans have taken the lead in the generic congressional ballot, at 43.7% support versus 42.2% for Democrats. The war has blunted the Republican rally but nothing more. The economy is the likeliest source of good news for Biden and the Democrats over the coming six months but even here there is not a basis for optimism among Democrats, as we will see in the next section.  Chart 1No ‘War Bounce’ For Biden War Not Helping Biden So Far War Not Helping Biden So Far Jobs And Wages Not Boosting Biden Either Our Political Capital Index shows that the Biden administration now has weak or moderate political capital in every category except economic conditions and financial markets (Appendix). Yet economic conditions are still mixed. While they will likely improve before November, they do not look to improve enough to change the election outlook: Both Republicans and Democrats are viewing the economy more negatively. Republican economic sentiment declined by 16% in March, while Democrat economic sentiment declined by 6%. The partisan gap widened, which means Republicans will remain motivated to vote (Chart 2). Manufacturing activity is slowing down (though not shrinking). The reading slipped lower than its level in November 2020, when Biden took office. This drop is the first sign of the negative effect of inflation and geopolitical risk on the economy. New manufacturing orders declined while inventories increased. The new-orders-to-inventories ratio, which should be a leading indicator of economic activity, fell by 15.7% compared to its February reading. It is now the weakest since May 2020 (Chart 3). Chart 2Economic Sentiment Declines For Both Parties Economic Sentiment Declines For Both Parties Economic Sentiment Declines For Both Parties The budget deficit is “normalizing” and weighing on demand. The fiscal thrust – or change in the budget deficit – turned negative as the stimulus of 2020 waned. The intensity of the drag is now lessening, both on the federal and state level, but it would require a massive new crisis for the US to outdo the stimulus of 2020, so the drag will persist for the foreseeable future (Chart 4). Any last-minute reconciliation bill from congressional Democrats would reduce the drag further, but not generate positive thrust, and not in time to affect the election. To pass the bill, Democrats need to reduce the deficit impact in the face of inflation and paper-thin congressional majorities. Chart 3First Sign Of Inflation, Geopolitics Hitting Manufacturing First Sign Of Inflation, Geopolitics Hitting Manufacturing First Sign Of Inflation, Geopolitics Hitting Manufacturing Chart 4US Fiscal Drag In Wake Of 2020 Stimulus US Fiscal Drag In Wake Of 2020 Stimulus US Fiscal Drag In Wake Of 2020 Stimulus Most worrisome for President Biden, his approval rating has suffered despite a tight labor market and real wage growth. The headline unemployment rate declined to 3.6% in March, down 3.1 percentage points since November 2020. The ISM manufacturing employment index stands at the highest point since March of 2021, and 17% higher than in November 2020 (Chart 5). Inflation is apparently eating away the benefits of low unemployment. Real wages grew by 3.3% on an annual basis in February, up from 2.5% in January. This wage growth is higher than that of November 2020, at 2.2%. Biden’s approval rating is probably in the process of stabilizing, if we assume that unemployment stays low and real wages keep growing. But it is stabilizing at a low level and not perking up as a result of the Russian menace. The likeliest culprit for Biden’s troubles is inflation. Fortunately for the Democrats inflation is likely to fall in the coming months. However, voters are likely to respond to year-on-year rather than month-on-month inflation. And voters make up their minds early in midterm election years. Plus, if inflation does not subside, or if Biden is perceived as making a foreign policy mistake, then his approval rating will not stabilize. Bottom Line: Biden’s approval rating is not perking up despite a foreign threat. His approval on economic policy is even worse than on foreign policy, despite low unemployment and real wage growth higher than when he took office. A drop in inflation would improve his fortunes but taken together the evidence suggests that the war has not helped, and may have hurt, the Democrats’ chances this fall. Chart 5Will Jobs And Real Wages Stabilize Presidential Approval? Will Jobs And Real Wages Stabilize Presidential Approval? Will Jobs And Real Wages Stabilize Presidential Approval? Biden Taps Strategic Oil Reserve But Implications Depend On Iran One of our key views for 2022 (reiterated in our Q2 outlook) is the Biden administration’s transition from congressional to executive action. Biden’s decision to tap the strategic petroleum reserve (SPR) on March 31 exemplifies this trend. Gasoline prices have spiked to $4.20 per gallon, which is more than double the level in November 2020 (Chart 6). Biden’s SPR order aims to mitigate the rise in prices. Biden ordered the release of 1 million barrels per day of crude oil over the next 180 days (six months). This would constitute the largest release since the SPR came into being in 1975 (Chart 7).1 Chart 6Prices At The Pump Trigger Red Alert In White House Prices At The Pump Trigger Red Alert In White House Prices At The Pump Trigger Red Alert In White House Chart 7Biden Taps Strategic Petroleum Reserve Biden Taps Strategic Petroleum Reserve Biden Taps Strategic Petroleum Reserve The Strategic Petroleum Reserve (SPR) originated in the wake of the Arab oil embargo to protect the US from supply shocks. Faced with “severe petroleum supply interruptions” the president can authorize a maximum drawdown of 396 million barrels over 90 days, which begin reaching the market roughly 13 days after the decision. The current inventory is 570 million barrels of sweet and sour crude, which could last 92 days of crude imports and 72 days of crude and petroleum product imports (Chart 8). Unlike during the 1970s, today the US is the world’s largest oil and refined products producer. It is a net exporter as well. However, it is still vulnerable to external shocks. It imports 6.3 million barrels per day and has already cut off 283 thousand barrels per day of imports from Russia (Chart 9). Global price shocks still affect the US prices at the pump, as Chart 6 above shows in the relationship between domestic gasoline prices and Brent crude. Chart 8SPR Can Be Tapped For Six-To-Nine Months Easily SPR Can Be Tapped For Six-To-Nine Months Easily SPR Can Be Tapped For Six-To-Nine Months Easily Chart 9US Energy Independent But Still Vulnerable To Shocks US Energy Independent But Still Vulnerable To Shocks US Energy Independent But Still Vulnerable To Shocks The Ukraine crisis is just the sort of geopolitical crisis that the SPR was invented to address – but the magnitude of Biden’s action is larger than normal. The SPR was tapped for 21 million barrels in 1990-91, during the Iraqi invasion of Kuwait, and for 30 million barrels in 2011, when Libyan production fell to zero amid the revolution. However, because of US net exporter status, Biden has much more room for maneuver. The SPR would be tapped for 180 million barrels if Biden’s current plan is fully implemented. The SPR can be released at a rate of 4.4 million barrels per day for about 90 days, though after that the drawdown rate begins to decline for technical reasons (e.g. contaminants). Biden’s 180 days would end in early October, a month before the midterm election. If the SPR has at least 282 million barrels left (90 days of US net crude imports in 2021), the president can continue to release oil from it. The minimum storage level is 282 million barrels of crude. Thus at the end of Biden’s current order, he would have 390 million barrels left and would still be able to release 1 million barrels per day for 108 days.  There are various interpretations of Biden’s decision to tap the SPR today: Currently the Russians and Europeans are in a standoff over energy flows. Russia is demanding payment in rubles and Europe is rejecting Russia’s demands while threatening to ban Russian coal imports. Since crude oil is generally interchangeable, an EU-Russia breakdown in crude trade would not prevent Russian barrels from reaching global markets eventually (Chart 10). In short Biden did not tap the SPR in anticipation of a breakdown. Biden could have tapped the SPR because of difficulties convincing the core OPEC states to increase production. Saudi Arabia, the UAE, and Kuwait are rapidly increasing production already, though their 90-day spare capacity enables them to bring out as much as 3.5 million additional barrels per day. But on March 31 they ruled out any massive near-term adjustments. Their relations with the US under the Biden administration have been strained, namely as Biden is still trying to rejoin the 2015 Iranian nuclear deal. If the US and Iran rejoin the 2015 deal, the US would lift sanctions and Iran could quickly bring about 1.3 million barrels per day back to global markets. Biden’s SPR release is roughly equal to this amount, which means it could be insurance for a failure to do a deal (Chart 11). Chart 10Russian Oil Exports To Europe And World War Not Helping Biden So Far War Not Helping Biden So Far An Iran deal on top of the SPR release would add 2.3 million barrels per day in positive supply surprises, while reducing the short-term risk of a military conflict in the Persian Gulf. This would have a significant short-term negative impact on oil prices this year. Chart 11Biden Struggles For Help From OPEC Biden Struggles For Help From OPEC Biden Struggles For Help From OPEC What is clear is that our Geopolitical Strategy’s base case of a failure of US-Iran talks would imply a significantly higher risk of oil disruptions in the Middle East over the short and long run. In that case the OPEC states would need to change their position and increase production or else a new supply shock would be added on top of the Russian shock. Biden’s SPR release would make up for production bottled up in Iran but regional supply disruptions would intensify and Iran would threaten the Strait of Hormuz. Biden’s executive action to tap the SPR removes one option from the table. The ultimate impact of this move depends on whether Biden also uses executive action to do a deal with Iran. We cannot rule it out, because Biden has the authority to lift sanctions unilaterally, but we would not bet on it. Bottom Line: Market fundamentals suggest that Brent prices will fall from their current $105 per barrel toward their likely average of $93 per barrel this year and in 2023. Quant Model Points To Republican Senate Last week we highlighted that our Senate election model flipped from predicting the status quo to predicting a Republican victory, in line with our subjective view of the situation. The latest model findings, using data from the state coincident economic indicators released on April 5, suggests that Republicans have a 51.6% chance of gaining control of the Senate (Chart 12). Democrats only need to lose a single seat to slip from 50 to 49 seats and thus yield the majority. The model suggests they will lose two seats, in Arizona and Georgia. The result is a Republican majority of 52-48 seats. Chart 12Senate Election Model Flips To Republicans War Not Helping Biden So Far War Not Helping Biden So Far Our presidential election model still shows Democrats holding onto the White House in 2024 with 308 electoral college votes but their chances are declining. Specifically Democrats’ odds of retaining the White House have fallen from 54.9% to 54.7% now that the March data is taken into account (Chart 13). North Carolina is still considered a toss-up state, with a 45% probability that Democrats win it, but that means that a single percentage point drop puts it firmly in the Republican camp, along with Arizona and Georgia. Democrats’ odds are falling in Florida, Pennsylvania, and Nevada especially, although they are improving in Wisconsin and Minnesota. Chart 13Presidential Election Model Still Slightly Favors Democrats War Not Helping Biden So Far War Not Helping Biden So Far Florida presents an interesting difference between the two models: the Senate model gives Florida to the Republicans, while the presidential model gives it to the Democrats. This requires some explanation: The incumbent advantage plays a role. Biden did not win Florida in 2020 but that does not stop the model from ascribing Democrats a good chance of winning Florida given that they are the incumbent party. Incumbency would be punished if Democrats held the White House for eight years due to the variable that accounts for the public sentiment that it is “time for change.” The Senate model works differently. The model only helps the party that controls a state Senate seat by means of the partisan leaning of the state in recent elections. This is helpful for Republicans in the model’s 2022 prediction. Meanwhile the model only punishes an incumbent party if it has held control of the US Senate for three or more terms, which is not the case today. Our sample periods across the two election models are the same (1984-2020), but in this period, Democrats only held Senate seats for three out of nine changes. There have been nine different senators from Florida since 1989, three of which have been Democrats. The last Democratic senator was Bill Nelson but he was beaten by Republican Rick Scott in 2018. The other Senate seat has been held by a Republican since around 2004, most recently Marco Rubio, who is up for re-election in 2022. So the model will “lean” more Republican based on total outcomes and how recently recurring they were. Finally, a caveat: we should be careful about explicitly comparing the two election models. Although they are both Probit models, the variables are not all the same. Some are shared but their interaction with one another and the election outcome (dependent variable) should not be assumed to be exactly the same. There can be little doubt in the model’s outlook for the Florida Senate race. Senator Marco Rubio is a young incumbent, has strong name recognition, and is up for re-election in a favorable year for Republicans. As of February he was leading his top Democratic opponent Val Demings by 12 percentage points in opinion polls. Confirming the state’s Republican leaning, Governor Ron DeSantis was leading his Democratic opponent Charlie Crist by 21 percentage points in February polls, with over 50% favoring DeSantis. (Other than former President Trump, DeSantis is currently the favored Republican nominee for 2024.) Moreover the presidential model is catching up to the Senate model, with the odds of a Democratic win in Florida dropping from 59% to 55% over the past month alone. If the odds fall beneath 50% then the model naturally awards all of Florida’s 29 electoral votes to the Republicans. This would leave Democrats hanging by a thread at 279 votes. What is clear is that the 2024 election is a long way off. Democrats benefit from an incumbent advantage as a political party, aside from whether President Biden runs again. Yet the quantitative model suggests that the US will experience another hotly contested presidential election. Bottom Line: Republicans are now tipped to take the Senate in our quantitative model as well as our subjective judgment. Meanwhile Democrats are still favored to win the 2024 election but only slightly, and their odds are falling. These views support the market consensus but in general US investors will remain risk averse ahead of the midterm election.  Investment Takeaways Stay tactically long the US dollar and defensive stocks like in the health care sector. Russia is threatening to cut off energy exports to Europe, which is considering a ban on Russian coal. Until this dispute is resolved, risk appetite will suffer, the euro will be limited, and the dollar will stay strong. Stay long renewable energy, cyber security stocks, infrastructure stocks, defense stocks, oil and gas distribution, and small cap energy stocks (Chart 14). Chart 14Investment Takeaways Investment Takeaways Investment Takeaways Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst guyr@bcaresearch.com   Footnotes 1     See White House, “FACT SHEET: President Biden’s Plan to Respond to Putin’s Price Hike at the Pump,” March 31, 2022, whitehouse.gov; Department of Energy, “Strategic Petroleum Reserve: Providing Energy Security For America,” March 28, 2022, energy.gov; and Heather L. Greenley, “The Strategic Petroleum Reserve: Background, Authorities, and Considerations,” Congressional Research Service, R46355, May 13, 2020, crsreports.congress.gov.   Appendix Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix War Not Helping Biden So Far War Not Helping Biden So Far Table A3US Political Capital Index War Not Helping Biden So Far War Not Helping Biden So Far Chart A1Presidential Election Model War Not Helping Biden So Far War Not Helping Biden So Far Chart A2Senate Election Model War Not Helping Biden So Far War Not Helping Biden So Far Table A4APolitical Capital: White House And Congress War Not Helping Biden So Far War Not Helping Biden So Far Table A4BPolitical Capital: Household And Business Sentiment War Not Helping Biden So Far War Not Helping Biden So Far Table A4CPolitical Capital: The Economy And Markets War Not Helping Biden So Far War Not Helping Biden So Far  

Highlights Chart 1Reduce Credit Exposure Reduce Credit Exposure Reduce Credit Exposure Corporate bond spreads staged a nice rally during the past month. The average index spread for investment grade corporates is only 22 bps above its pre-COVID low and 33 bps above last year’s trough. The average High-Yield index spread is 5 bps above its pre-COVID low and 49 bps above last year’s trough (Chart 1). This rally occurred even as inflation data continued to surprise to the upside and employment data confirmed that the US labor market is extremely tight. With the economic data justifying the Fed’s hawkish pivot, the Treasury curve has flattened dramatically, and both the 2-year/10-year and 3-year/10-year slopes are now inverted (Chart 1, bottom panel). An inverted yield curve is a reliable late-cycle indicator, and we think current spread levels offer a good opportunity to reduce corporate bond exposure. This week, we downgrade investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5), placing the proceeds into Treasuries. We also downgrade our recommended allocations EM Sovereigns (see page 8) and TIPS (see page 11), upgrade our recommended allocation to CMBS (see page 13) and adjust our recommended yield curve positioning (see page 10). Feature Table 1Recommended Portfolio Specification The Beginning Of The End The Beginning Of The End Table 2Fixed Income Sector Performance The Beginning Of The End The Beginning Of The End Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 86 basis points in March, bringing year-to-date excess returns up to -154 bps. Our quality-adjusted 12-month breakeven spread shifted down to its 21st percentile since 1995 (Chart 2). As noted on the first page of this report, corporate spreads have rallied to within striking distance of their pre-COVID lows at the same time as the yield curve has become inverted beyond the 2-year maturity. We showed in last week’s report that an inversion of the 2-year/10-year Treasury slope is not necessarily a harbinger of imminent recession, but it does typically coincide with very low (and often negative) excess corporate bond returns.1 The combination of reasonably tight spreads and an inverted yield curve causes us to recommend downgrading investment grade corporate bond allocations from neutral (3 out of 5) to underweight (2 out of 5). It’s important to note that corporate balance sheets remain healthy (bottom panel) and we see no indication that a recession or default cycle will unfold during the next 6-12 months. That said, we must acknowledge that an inverted yield curve signals that the economic recovery is entering its late stages. Economic growth will be slower going forward and corporate spreads are unlikely to tighten much, especially from current depressed levels. Against this backdrop it makes sense to be more cautious on credit, sacrificing small positive excess returns in the near-term to ensure that we aren’t invested when the next downturn hits. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Beginning Of The End The Beginning Of The End Table 3BCorporate Sector Risk Vs. Reward* The Beginning Of The End The Beginning Of The End High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 119 basis points in March, bringing year-to-date excess returns up to -96 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – shifted down to 3.7% (Chart 3). An inverted yield curve sends the same negative signal for high-yield excess returns as it does for investment grade. However, high-yield valuation is currently more attractive. The option-adjusted spread differential between Ba-rated bonds and Baa-rated bonds remains elevated at 86 bps, 41 bps above its pre-COVID low (panel 3). It is also likely that economic growth will remain sufficiently strong for defaults to come in below the spread-implied threshold of 3.7% during the next 12 months (bottom panel). The greater attractiveness of high-yield valuations relative to investment grade causes us to maintain a higher allocation to the sector, even as we downgrade our portfolio’s overall credit risk exposure. We therefore recommend a neutral (3 out of 5) allocation to high-yield corporates.     MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -74 bps. The zero-volatility spread for conventional 30-year agency MBS tightened 3 bps on the month as a 4 bps tightening of the option-adjusted spread (OAS) was partially offset by a 1 bp increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.2 This valuation picture is starting to change. The option cost is now up to 40 bps, its highest level since 2016, and refi activity is slowing as the Fed lifts rates. At 28 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS.       Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to -505 bps. EM Sovereigns outperformed the Treasury benchmark by 40 bps on the month, bringing year-to-date excess returns up to -609 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 62 bps, dragging year-to-date excess returns down to -439 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 7 bps in March. This comes on the heels of a sharp underperformance in February that was driven by Russian bonds which have since been removed from the index. Russian bonds have also been purged from the EM Corporate & Quasi-Sovereign Index, and this index underperformed duration-matched US corporates by 11 bps in March (Chart 5). The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we downgrade our recommended allocation to EM sovereigns from underweight (2 out of 5) to maximum underweight (1 out of 5). In sharp contrast, the EM Corporate & Quasi-Sovereign Index continuous to offer a significant yield advantage (panel 4). We retain our neutral (3 out of 5) recommendation for EM Corporates & Quasi-Sovereigns. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to -122 bps (before adjusting for the tax advantage). While the war in Ukraine has introduced a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past two months. The 10-year Aaa Muni / Treasury yield ratio is currently at 94%, up significantly from its 2021 trough of 55%. The yield ratios between 12-17 year munis and duration-matched corporate bonds are also up significantly off their lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 93%. The same measure for 17-year+ Revenue bonds stands at 101%, meaning that Revenue bonds carry a before-tax yield advantage versus duration-matched corporates. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve’s bear-flattening trend continued through March. The 2-year/10-year Treasury slope flattened 35 bps on the month and the 5-year/30-year Treasury slope flattened 44 bps. These slopes are now both inverted, sitting at -6 bps and -12 bps respectively. In last week’s report we noted the unusually wide divergence between very flat slopes at the long end of the yield curve and very steep slopes at the front end.3 For example, the 5-year/10-year Treasury slope is -18 bps but the 3-month/5-year slope is 204 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced in the market but lasts longer, as is our expectation. By entering our new 5-year bullet over 2-year/10-year barbell trade we also close our previous 2-year bullet over cash/10-year barbell trade at a loss. We continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in March, bringing year-to-date excess returns up to +271 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 21 bps. Since last May we have been recommending that clients maintain a neutral allocation to TIPS versus nominal Treasuries at the long end of the curve and an underweight allocation to TIPS at the front end. This recommendation was premised on the view that the breakeven curve would steepen as falling inflation put downward pressure on short-maturity TIPS breakevens and long-dated breakevens remained at levels close to the Fed’s target. Recently, the 10-year TIPS breakeven inflation rate has shot up to levels well above the Fed’s 2.3%-2.5% target range (Chart 8) and our TIPS Breakeven Valuation Indictor has shifted into “expensive” territory (panel 2). Further, while inflation has remained high for longer than we expected, it still seems more likely than not that it will roll over between now and the end of the year as pandemic fears fade and consumers shift their spending patterns away from goods and toward services. As such, we think investors should take this opportunity to further reduce exposure to TIPS versus nominal Treasuries at both the short and long ends of the curve. That is, within our overall underweight allocation to TIPS we continue to recommend positioning in breakeven curve steepeners and in real yield curve flatteners. We also continue to recommend an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in March, dragging year-to-date excess returns down to -31 bps. Aaa-rated ABS underperformed by 21 bps on the month, dragging year-to-date excess returns down to -27 bps. Non-Aaa ABS underperformed by 49 bps on the month, dragging year-to-date excess returns down to -51 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in March, bringing year-to-date excess returns up to -78 bps. Aaa Non-Agency CMBS outperformed Treasuries by 25 bps on the month, bringing year-to-date excess returns up to -67 bps. Non-Aaa Non-Agency CMBS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -110 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, commercial real estate (CRE) lending standards have recently shifted into “net easing” territory and demand for CRE loans is strengthening (Chart 10). In light of today’s downgrade of corporate credit, non-agency CMBS look like an attractive alternative to add some spread to a portfolio. Increase exposure from neutral (3 out of 5) to overweight (4 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 17 basis points in March, dragging year-to-date excess returns down to -39 bps. The average index option-adjusted spread widened 5 bps on the month. It currently sits at 48 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 255 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Beginning Of The End The Beginning Of The End Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -55 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Beginning Of The End The Beginning Of The End Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 2 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 3 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022.   Recommended Portfolio Specification The Beginning Of The End The Beginning Of The End Other Recommendations The Beginning Of The End The Beginning Of The End Treasury Index Returns Spread Product Returns

Executive Summary Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth 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 INFLATION EXPECTATIONS INFLATION EXPECTATIONS 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 Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Chart I-3Rising Wages Are In Lockstep With Rising Prices Rising Wages Are In Lockstep With Rising Prices Rising 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 Inflation Expectations Are Unmoored Inflation Expectations Are Unmoored Chart I-5Supply Chains Remain Disrupted Supply Chains Remain Disrupted Supply 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 High Inflation Saps Consumer Confidence High Inflation Saps Consumer Confidence Chart I-7Food And Energy Prices Have Surged Food And Energy Prices Have Surged Food 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... Sector Chart Pack Commentary Sector Chart Pack Commentary Chart I-9Many Consumers Are Struggling Many Consumers Are Struggling Many 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 Sector Chart Pack Commentary Sector Chart Pack Commentary Chart I-11The Market Expects The Fed To Move Aggressively To Combat Inflation The Market Expects The Fed To Move Aggressively To Combat Inflation The 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 Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Chart I-13The GDP Forecasts Have Not Been Revised Down To Reflect New Challenges The GDP Forecasts Have Not Been Revised Down To Reflect New Challenges The 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 Sector Chart Pack Commentary Sector Chart Pack Commentary 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 The Business Cycle Indicator Signals Slowdown The Business Cycle Indicator Signals Slowdown Chart I-1510-Year Treasury Yield Less 3-Months Treasury Bills Segment Is Not Inverted 10-Year Treasury Yield Less 3-Months Treasury Bills Segment Is Not Inverted 10-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 The LEI YoY% Is Way Above Zero The LEI YoY% Is Way Above Zero Chart I-17The Fed Funds Rate Is Far From Neutral The Fed Funds Rate Is Far From Neutral The 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 Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash Table II-1Performance Sector Chart Pack Commentary Sector Chart Pack Commentary Table II-2Valuations And Forward Earnings Growth Sector Chart Pack Commentary Sector Chart Pack Commentary Footnotes 1     "Recession Risks Are Rising. Can the Fed Stick a Soft Landing?" Barron's (barrons.com)   Recommended Allocation Recommended Allocation: Addendum Sector Chart Pack Commentary Sector Chart Pack Commentary  

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 Bumping Up Against Tactical Limits 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 Investing Inflation And Investing 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 Extreme Inflation Squashes Earnings Extreme 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 High Inflation: Surging Nominal Earnings, Fierce De-Rating High 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 Moderate Inflation Is Great For Growth Moderate 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 Moderately Low Inflation Is The Enduring Equity Sweet Spot Moderately 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 Once Prices Deflate, The Danger Has Already Passed Once 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 Investing Inflation And Investing 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 Inflation And Investing Inflation And Investing 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 Equities May Have Reached Another Short-Term Turning Point Equities 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 Inflation And Investing Inflation And Investing