Fixed Income

Executive Summary We posit three conjectures about the US economy: Inflation has an easy path back to 4%, but a move to 2% will require a higher unemployment rate. It will be more difficult to raise the unemployment rate than many anticipate. The Fed will tolerate a higher unemployment rate than many anticipate. Taken together, these conjectures point to a higher fed funds rate in 2023 than is currently discounted in the market. This suggests that investors should be bearish bonds on a 12-18 month investment horizon. While we are bearish bonds in the medium-to-long term, we retain an ‘at benchmark’ portfolio duration stance for the time being because numerous indicators point to lower bond yields during the next few months. We also recommend an underweight allocation to spread product versus Treasuries, though we highlight the potential for solid near-term junk bond returns. Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Bottom Line: Maintain an ‘at benchmark’ portfolio duration stance. We will recommend reducing portfolio duration if the 10-year Treasury yield falls to 2.5% or if core inflation converges with our 4%-5% estimate of its underlying trend. Feature Uncertainty in bond markets remains elevated as investors seemingly can’t decide whether the US economy is in the midst of an inflationary boom or hurtling towards recession. This week’s report details our view of the current macroeconomic environment by offering three conjectures about the state of the US economy and monetary policy. We conclude by explaining how these conjectures shape our recommended investment strategy. Conjecture #1: Inflation Has An Easy Path Back To 4%, The Path To 2% Will Be More Difficult At 5.9%, core CPI inflation is running well above the Fed’s 2% target. However, we know that some portion of that 5.9% reflects supply side constraints related to the pandemic and some portion reflects an overheating of the demand side of the US economy. This distinction is important because the pandemic-related inflation will eventually subside on its own, without the need for materially slower economic growth. In contrast, a significant economic slowdown and a higher unemployment rate will be required to tame any inflation driven by strong US demand. Chart 1Estimating Trend Inflation Estimating Trend Inflation Estimating Trend Inflation In a recent report we looked at three different techniques for distinguishing between these two types of inflation.1First, we considered the Atlanta Fed’s decomposition of core inflation into flexible and sticky components. At present, the volatile core flexible CPI is running at an 8.4% annual rate and the core sticky CPI stands at 5.4% (Chart 1). Second, we noted that the New York Fed’s Underlying Inflation Gauge is running at 4.8% (Chart 1, bottom panel). Finally, we used wage growth net of trend productivity growth as an estimate of inflation’s underlying trend and calculated that to be 3.7% (Chart 1, bottom panel). From this analysis, our general conclusion is that core CPI inflation can fall into a range of 4%-5% just from the unwinding of pandemic-induced supply-side effects. After that, the Fed will be forced to engineer an economic slowdown to bring inflation from the stickier 4% level back down to its 2% target. Inflation Progress Report Last week’s June CPI report shows that even progress back to our 4%-5% estimate of inflation’s underlying trend is proving difficult. Core CPI rose 0.71% in June, well above expectations, and monthly trimmed mean CPI was an even stronger 0.80% (Chart 2A). Base effects led to a small drop in the annual core CPI number – from 6.0% to 5.9% - but annual trimmed mean CPI moved up to 6.9% (Chart 2B). The strong CPI print has led to increased speculation that the Fed will raise rates by 100 bps this month (see Box). Chart 2AMonthly Inflation Monthly Inflation Monthly Inflation Chart 2BYearly Inflation Yearly Inflation Yearly Inflation Turning to the three major components of core inflation, we see that shelter, goods, and services ex. shelter contributed roughly equal amounts to the June core CPI reading (Chart 3). The elevated reading from core goods inflation is particularly notable because this is one area where we have been anticipating that easing supply-side constraints will send prices lower. Car prices, specifically, have been one of the principal drivers of high inflation and they remained stubbornly high in June (Chart 4). Chart 3Monthly Core CPI Inflation By Major Component Three Conjectures About The US Economy Three Conjectures About The US Economy Chart 4Contribution To Month-Over-Month Core Goods CPI Three Conjectures About The US Economy Three Conjectures About The US Economy Chart 5Supply-Side Constraints Are Easing Supply-Side Constraints Are Easing Supply-Side Constraints Are Easing While it has taken much longer than expected for core goods and other pandemic-driven components of inflation to turn down, leading indicators still suggest that these prices are more likely to fall than rise during the next few months. The New York Fed’s Global Supply Chain Pressure Index has clearly rolled over and supplier delivery times, as measured by both the ISM manufacturing and non-manufacturing surveys, have shortened (Chart 5). While core goods and autos are representative of the sort of inflation that will ease naturally as supply chain constraints abate, shelter inflation is representative of the sort of inflation that will be stickier. That is, a higher unemployment rate will be required to significantly lower shelter inflation. Chart 6Shelter CPI Model Shelter CPI Model Shelter CPI Model Shelter inflation, currently running at 5.6%, can be modeled using the unemployment rate, rental vacancies and home prices (Chart 6). Given that shelter is such a large component of core inflation, it must fall if the Fed is going to achieve its 2% inflation target. That will certainly require a higher unemployment rate and very likely a recession. Bottom Line: Core inflation will move down in the second half of this year, as easing supply-side constraints lead to lower goods prices. Inflation’s downtrend will subside once it reaches its trend level of 4%-5%, at which point a higher unemployment rate and economic recession will be required to move it even lower, back to the Fed’s 2% target. BOX 75 bps Or 100 bps At The Next FOMC Meeting? Guidance provided by Fed Chair Jay Powell at the last meeting FOMC meeting suggested that the committee will choose between lifting rates by 50 bps or 75 bps when it meets later this month. The implication was that any negative inflation surprise would push the committee towards 75 bps. Certainly, last month’s strong employment report and hot CPI print justify a 75 bps move within Powell’s framework. But is it possible that Powell’s guidance from the June FOMC meeting is already stale? Chart B1July FOMC Expectations July FOMC Expectations July FOMC Expectations Investors are increasingly betting that it is, and the market is now discounting some chance of a 100 bps rate hike this month (Chart B1). The reason for this pricing is that the Fed has already backtracked on its guidance once before. Powell ruled out 75 bps rate hikes at the May FOMC press conference. Then, the committee delivered a 75 bps increase in June after core CPI came in hot. Kansas City Fed President Esther George dissented from the June decision because she objected to the Fed flip-flopping on its guidance so quickly. George explained her dissent in a recent speech by saying that “communicating the path for interest rates is likely far more consequential than the speed with which we get there.”2 Where does this leave us for the July meeting? Our expectation is that the Fed will stick to its guidance and deliver a 75 bps increase this month. However, if the market moves to fully price-in a 100 bps move then the committee may be tempted to deliver on those expectations. In other words, the Fed’s recent track record of abandoning its forward rate guidance means that both a 75 bps rate hike and a 100 bps rate hike are in play for July. Conjecture #2: The Labor Market Will Be More Resilient Than Is Widely Believed Chart 7An Extremely Tight Labor Market An Extremely Tight Labor Market An Extremely Tight Labor Market Our second conjecture is that it will be more difficult to lift the unemployment rate than many people think. This view stems from the fact that the labor market is incredibly tight. As Fed officials have often pointed out, there are currently almost two job openings for every unemployed worker in the country (Chart 7). Further, we noted in last week’s report that while the employment readings from both ISM surveys are in contractionary territory, respondents to those surveys were much more likely to cite concerns about the supply side of the labor market than they were to cite concerns about hiring demand.3 In other words, an economy where there are twice as many job openings as unemployed workers and where firms are complaining about a shortage of labor is not one where we are likely to see an immediate surge in layoffs, even as demand starts to soften. Conjecture #3: The Fed Will Tolerate A Higher Unemployment Rate Than Is Widely Believed Chart 8Optimal Control Monetary Policy Optimal Control Monetary Policy Optimal Control Monetary Policy Our final conjecture is that the Fed will persistently run a much more restrictive monetary policy than many investors anticipate. We detailed our logic in a recent report where we argued that the Fed will adopt an optimal control approach to monetary policy.4 An optimal control strategy is employed when the Fed is unlikely to perfectly hit both its full employment goal and its 2% inflation target. In such environments, Janet Yellen has argued that the Fed should set monetary policy to minimize the joint deviations of inflation from target and of the unemployment rate from estimates of its full employment level.5 Chart 8 presents an example of an optimal control loss function that consists of adding together the squared deviations of inflation from 2% and of the unemployment rate from the Congressional Budget Office’s estimate of NAIRU. Using this framework, the Fed’s goal is to minimize the output of the loss function shown in the top panel. The dashed lines in Chart 8 illustrate a scenario where core PCE inflation falls to 4% but where the output from the loss function is held flat. That scenario implies an increase in the unemployment rate from its current level of 3.6% all the way up to 6.7%! This exercise demonstrates that, under an optimal control framework, the Fed would be willing to tolerate an unemployment rate of 6.7% or lower in order to move core inflation back to 4%. We don’t see the unemployment rate hitting 6.7% any time soon. The main point of this analysis is to illustrate that Fed policy is likely to retain a restrictive bias until inflation returns to 2% or lower. It won’t move toward easing policy at the first sign of a higher unemployment rate, as has been the pattern in recent years when inflation was much more contained. Investment Implications To summarize, our three conjectures about the US economy are that: (i) a higher unemployment rate will be required to move inflation from 4% to the Fed’s 2% target, (ii) a lot of demand destruction will be required before we see a significant rise in the unemployment rate and (iii) in its pursuit of lower inflation, the Fed will tolerate a higher unemployment rate than many people expect. Taken together, these three conjectures imply that the fed funds rate will be higher in 2023 than what is currently priced in the curve. At present, the market is priced for the fed funds to peak at 3.67% in March 2023 and then fall back to 3.13% by the end of the year (Chart 9). If our three conjectures pan out, then we think it’s likely that the fed funds rate will move above 4% next year and that it will be higher than 3.13% by the end of 2023. Chart 9Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Portfolio Duration Chart 10High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Obviously, this view makes us inclined toward a ‘below-benchmark’ portfolio duration stance on a 12-18 month investment horizon. That said, we recommend keeping portfolio duration close to benchmark for now because many indicators suggest that bond yields could fall during the next few months (Chart 10). More specifically, with core CPI still above our 4%-5% estimate of its underlying trend, we see inflation as more likely to fall than rise during the next six months. At the same time, aggregate demand will be slowing as the Fed tightens policy and the unemployment rate is more likely to rise than fall. These factors will keep bond yields contained between now and the end of the year. While we recommend an ‘at benchmark’ portfolio duration stance on a 6-12 month horizon, we will reduce portfolio duration if the 10-year Treasury yield moves back to 2.5% or once core inflation converges to our 4%-5% estimate of trend. At that point, we think inflation will be stickier and it will make sense to position for higher bond yields. Spread Product Our three conjectures also imply a negative environment for spread product. Monetary policy will become increasingly restrictive, and it will be a long time before the Fed moves toward interest rate cuts – the traditional signal to pile into spread product. We therefore advocate an underweight allocation to spread product versus Treasuries in US bond portfolios. One exception to our underweight spread product allocation is that we retain a neutral allocation to high-yield. Our reasoning is that high-yield spreads are elevated and they have the potential to tighten during the next few months as inflation converges toward our estimate of trend. As inflation falls and fears of immediate recession abate, it’s conceivable that junk spreads could revert to their 2017-19 average, the level that prevailed during the previous tightening cycle (Chart 11), and such a move would lead to roughly 8.4% of excess return.6 If such a move were to occur within the next six months, then we would be inclined to reduce our junk bond exposure to underweight. A Quick Note On 2-Year TIPS Chart 11Junk Spreads Are Elevated Junk Spreads Are Elevated Junk Spreads Are Elevated Chart 122-Year TIPS Yield Is Positive Three Conjectures About The US Economy Three Conjectures About The US Economy In last week’s report we recommended upgrading TIPS from underweight to neutral relative to duration-matched nominal Treasuries. However, given that the 2-year TIPS yield was still negative, we did not close our recommendation to short 2-year TIPS or our recommended 2/10 real yield curve flattener and 2/10 inflation curve steepener positions. The 2-year real yield has continued to rise during the past week and, at +9 bps, it is now in positive territory (Chart 12). We were confident that the 2-year TIPS yield would turn positive because the Fed has implied that it is targeting positive real yields across the entire curve. But now that the yield is positive, we are no longer confident in the trade’s upside. Bottom Line: Investors should close out their short 2-year TIPS positions, as well as their 2/10 real yield curve flatteners and 2/10 inflation curve steepeners. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 2     https://www.kansascityfed.org/Speeches/documents/8875/2022-George-MidAm… 3    Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Low Conviction US Bond Market”, dated July 12, 2022. 4    Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 5    https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 6    Return estimate assumes default losses of 1.8% and that the spread tightening occurs over a six month period.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.     Executive Summary The TIPS Market Foresees A Sharp Deceleration In Inflation What If The TIPS Are Right? What If The TIPS Are Right? TIPS breakevens are pointing to a rapid decline in US inflation over the next two years. If the TIPS are right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising again. This will bolster consumer confidence, making a recession less likely. The surprising increase in analyst EPS estimates this year partly reflects the contribution of increased energy profits and the fact that earnings are expressed in nominal terms while economic growth is usually expressed in real terms. Nevertheless, even a mild recession would probably knock down operating earnings by 15%-to-20%. While a recession in the US is not our base case, it is for Europe. A European recession is likely to be short-lived with the initial shock from lower Russian gas flows counterbalanced by income-support measures and ramped-up spending on energy infrastructure and defense. We are setting a limit order to buy EUR/USD at 0.981. Bottom Line: Stocks lack an immediate macro driver to move higher, but that driver should come in the form of lower inflation prints starting as early as next month. Investors should maintain a modest overweight to global equities. That said, barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. US CPI Surprises to the Upside… Again        Investors hoping for some relief on the inflation front were disappointed once again this week. The US headline CPI rose 1.32% month-over-month in June, above the consensus of 1.1%. Core inflation increased to 0.71%, surpassing consensus estimates of 0.5%. The key question is how much of June’s report is “water under the bridge” and how much is a harbinger of things to come. Since the CPI data for June was collected, oil prices have dropped to below $100/bbl. Nationwide gasoline prices have fallen for four straight weeks, with the futures market pointing to further declines in the months ahead. Agriculture and metals prices have swooned. Used car prices are heading south. Wage growth has slowed to about 4% from around 6.5% in the second half of last year. The rate of change in the Zillow rent index has rolled over, albeit from high levels (Chart 1). The Zumper National Rent index is sending a similar message as the Zillow data.  All this suggests that inflation may be peaking. The TIPS market certainly agrees. It is discounting a rapid decline in US inflation over the next few years. This week’s inflation report did little to change that fact (Chart 2). Chart 1Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Chart 2Investors Expect Inflation To Fall Rapidly Over The Next Few Years What If The TIPS Are Right? What If The TIPS Are Right? TIPS Still Siding with Team Transitory If the TIPS market is right, this would have two important implications. First, the Fed would not need to raise rates more quickly over the next six months than the OIS curve is currently discounting (although it probably would not need to cut rates in 2023 either, given our higher-than-consensus view of where the US neutral rate lies) (Chart 3). The second implication is that real wages, which have declined over the past year, will start rising again as inflation heads lower. Falling real wages have sapped consumer confidence. As real wage growth turns positive, confidence will improve, helping to bolster consumer spending (Chart 4). To the extent that consumption accounts for nearly 70% of the US economy – and other components of GDP such as investment generally take their cues from consumer spending – this would significantly raise the odds of a soft landing.  Chart 3The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 Chart 4Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Chart 5Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Of course, the TIPS market could be wrong. Bond traders do not set prices and wages. Businesses and workers, interacting with each other, ultimately determine the direction of inflation. Yet, the view of the TIPS market is broadly in sync with the view of most households and businesses. Expected inflation 5-to-10 years out in the University of Michigan survey has risen since the pandemic began, but at about 3%, it is close to where it was for most of the period between 1995 and 2015 (Chart 5). As we pointed out in our recently published Third Quarter Strategy Outlook, and as I discussed in last week’s webcast, the fact that long-term inflation expectations are well anchored implies that the sacrifice ratio – the amount of output that must be forgone to bring down inflation by a given amount — may be quite low. This also raises the odds of a soft landing. Investors Now See Recession as the Base Case Our relatively sanguine view of the US economy leaves us in the minority camp. According to recent polling, more than 70% of US adults expect the economy to be in recession by year-end. Within the investment community, nearly half of retail traders and three-quarters of high-level asset allocators expect a recession within the next 12 months (Chart 6). Chart 6Many Investors Now See Recession As Baked In The Cake What If The TIPS Are Right? What If The TIPS Are Right? Reflecting the downbeat mood among investors, bears exceeded bulls by 20 points in the most recent weekly poll by the American Association of Individual Investors (Chart 7). A record low percentage of respondents in the New York Fed’s Survey of Consumer Expectations believes stocks will rise over the next year (Chart 8). Chart 7Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Chart 8Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Resilient Earnings Estimates Admittedly, while sentiment on the economy and the stock market has soured, analyst earnings estimates have yet to decline significantly. In fact, in both the US and the euro area, EPS estimates for 2022 and 2023 are higher today than they were at the start of the year (Chart 9). What’s going on? Part of the explanation reflects the sectoral composition of earnings. In the US, earnings estimates for 2022 are up 2.4% so far this year. Outside of the energy sector, however, 2022 earnings estimates are down 2.2% year-to-date and down 2.9% from their peak in February (Chart 10). Chart 9US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date Another explanation centers on the fact that earnings estimates are expressed in nominal terms while GDP growth is usually expressed in real terms. When inflation is elevated, the difference between real and nominal variables can be important. For example, while US real GDP contracted by 1.6% in Q1, nominal GDP rose by 6.6%. Gross Domestic Income (GDI), which conceptually should equal GDP but can differ due to measurement issues, rose by 1.8% in real terms and by a whopping 10.2% in nominal terms in Q1. Chart 10Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates How Much Bad News Has Been Discounted? Historically, stocks have peaked at approximately the same time as forward earnings estimates have reached their apex. This time around, stocks have swooned well in advance of any cut to earnings estimates (Chart 11). At the time of writing, the S&P 500 was down 25% in real terms from its peak on January 3. Chart 11Unlike In Past Cycles, Stocks Peaked Well Before Earnings What If The TIPS Are Right? What If The TIPS Are Right? This suggests that investors have already discounted some earnings cuts, even if analysts have yet to pencil them in. Consistent with this observation, two-thirds of investors in a recent Bloomberg poll agreed that analysts were “behind the curve” in responding to the deteriorating macro backdrop (Chart 12). Chart 12Most Investors Expect Analyst Earnings Estimates To Come Down What If The TIPS Are Right? What If The TIPS Are Right? Nevertheless, it is likely that stocks would fall further if the economy were to enter a recession. Even in mild recessions, operating profits have fallen by about 15%-to-20% (Chart 13). That is probably a more severe outcome than the market is currently discounting. Chart 13Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Subjectively, we would expect the S&P 500 to drop to 3,500 over the next 12 months in a mild recession scenario where growth falls into negative territory for a few quarters (30% odds) and to 2,900 in a deep recession scenario where the unemployment rate rises by more than four percentage points from current levels (10% odds). On the flipside, we would expect the S&P 500 to rebound to 4,500 in a scenario where a recession is completely averted (60% odds). A probability-weighted average of these three scenarios produces an expected total return of 8.3% (Table 1). This is enough to warrant a modest overweight to stocks, but just barely. Barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. Table 1A Scenario Analysis For The S&P 500 What If The TIPS Are Right? What If The TIPS Are Right? What’s the Right Framework for Thinking About a European Recession? Whereas we would assign 40% odds to a recession in the US over the next 12 months, we would put the odds of a recession in Europe at around 60%. With a recession in Europe looking increasingly probable, a key question is what the nature of this recession would be. The pandemic may provide a useful framework for answering that question. Just as the pandemic represented an external shock to the global economy, the disruption to energy supplies, stemming from Russia’s invasion of Ukraine, represents an external shock to the European economy. In the initial phase of the pandemic, economic activity in developed economies collapsed as millions of workers were forced to isolate at home. Over the following months, however, the proliferation of work-from-home practices, the easing of lockdown measures, and ample fiscal support permitted growth to recover. Eventually, vaccines became available, which allowed for a further shift to normal life. Just as it took about two years for vaccines to become widely deployed, it will take time for Europe to wean itself off its dependence on Russian natural gas. Earlier this year, the IEA reckoned that the EU could displace more than a third of Russian gas imports within a year. The more ambitious REPowerEU plan foresees two-thirds of Russian gas being displaced by the end of 2022. In the meantime, some Russian gas will be necessary. Canada’s decision over Ukrainian objections to return a repaired turbine to Germany for use in the Nord Stream 1 gas pipeline suggests that a full cutoff of Russian gas flows is unlikely. Chart 14The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP During the pandemic, governments wasted little time in passing legislation to ease the burden on households and businesses. The European energy crunch will elicit a similar response. Back when I worked at the IMF, a common mantra in designing lending programs was that one should “finance temporary shocks but adjust to permanent ones.” The current situation Europe is a textbook example for the merits of providing income support to the private sector, financed by temporarily larger public deficits. The ECB’s soon-to-be-launched “anti-fragmentation” program will allow the central bank to buy the government debt of Italy and other at-risk sovereign borrowers without the need for a formal European Stability Mechanism (ESM) program, provided that the long-term debt profile of the borrowers remains sustainable. Get Ready to Buy the Euro All this suggests that Europe could see a fairly brisk rebound after the energy crunch abates. If the euro area recovers quickly, the euro – which is now about as undervalued against the dollar as anytime in its history (Chart 14) – will soar. With that in mind, we are setting a limit order to buy EUR/USD at 0.981.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn & Twitter   Global Investment Strategy View Matrix What If The TIPS Are Right? What If The TIPS Are Right? Special Trade Recommendations Current MacroQuant Model Scores What If The TIPS Are Right? What If The TIPS Are Right?

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ 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

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis 6-12 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-4Indicators 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 Chart II-5Indicators 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 Bond investors can’t seem to decide whether the US economy is in the midst of an inflationary boom or hurtling toward recession. Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. The 5-year US Treasury yield has tightened relative to the rest of the curve in recent weeks, and the 2-year maturity now looks like the most attractive spot for investors. TIPS breakeven inflation rates have also declined markedly in recent weeks, and TIPS no longer look expensive on our models. TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Bottom Line: US bond investors should keep portfolio duration close to benchmark. They should also shift Treasury curve allocations from the 5-year maturity to the 2-year maturity and upgrade TIPS from underweight to neutral. Whipsaw Inflationary boom or recession? US bond investors can’t seem to decide and yields are swinging back and forth depending on the latest economic data. Just in the past month we’ve seen the 10-year US Treasury yield peak at 3.49%, fall to 2.82% and then finally move back above 3% following last week’s strong employment report. Not surprisingly, implied interest rate volatility is the highest it’s been since the Global Financial Crisis (Chart 1). Our sense is that, while US economic growth is clearly slowing, we don’t see the unemployment rate rising enough for the Fed to abandon its tightening cycle any time soon. This is especially true because the Fed will tolerate a significant rise in the unemployment rate as long as inflation stays above target.1 Turning to the evidence, decelerating US economic activity is apparent in the manufacturing and non-manufacturing PMIs, which are both falling rapidly from high levels (Chart 2). Though both indexes remain firmly above the 50 boom/bust line, trends in financial conditions suggest that they could dip below 50 within the next few months. Chart 1A Highly Volatile Rates Market A Highly Volatile Rates Market A Highly Volatile Rates Market Chart 2US Growth Is Slowing US Growth Is Slowing US Growth Is Slowing The employment components of both indexes are already in contractionary territory (Chart 2, bottom panel), but this is due to concerns about labor supply, not demand. For example, last week’s ISM non-manufacturing PMI release included three representative quotes from respondents about labor market conditions.2 All three quotes reference concerns about labor supply: Unable to fill positions with qualified applicants. Extremely hard to find truck drivers. Demand for talent is higher, but availability of candidates to fill open roles continues to keep employment levels from increasing. This doesn’t sound like an economy that is on the cusp of surging unemployment, and this is exactly what the Fed is counting on. The Fed’s hope is that slower demand will bring down the large number of job openings without leading to a significant increase in layoffs or a significant rise in the unemployment rate. In that regard, it is notable that job openings ticked down in May, both in absolute terms and relative to the number of unemployed. Meanwhile, the rates of hiring and layoffs held steady (Chart 3). Chart 3Some Hope For A Soft Landing Some Hope For A Soft Landing Some Hope For A Soft Landing Investment Implications Our investment strategy hinges on two key economic views related to the labor market and inflation. First, while a surge doesn’t seem imminent, slowing economic activity means that the unemployment rate is more likely to edge higher between now and the end of the year than it is to fall. Second, as we’ve written in previous reports, US inflation has a relatively easy path back to its underlying trend of approximately 4%.3 After that, it will be more difficult for policymakers to bring inflation from 4% back down to 2%, and we could see the Fed push rates above 4% next year to accomplish this task. Taken together, these two views suggest that growth will be slowing and inflation falling between now and the end of the year. This combination could easily push bond yields lower, especially if recession worries flare up again. High frequency bond yield indicators such as the CRB Raw Industrials / Gold ratio and the relative performance of cyclical versus defensive equities also suggest that bond yields have room to fall (Chart 4). That said, the market is currently priced for the fed funds rate to peak at 3.74% in May 2023 and to fall back to 3.19% by the end of 2023. We see strong odds that inflation will be sticky enough (and the labor market resilient enough) for the Fed to push rates above those levels next year. This leaves us with an ‘at benchmark’ stance on portfolio duration for the time being, with an inclination to turn more bearish on bonds later this year if our base case forecast pans out. More specifically, we would likely reduce portfolio duration if the 10-year Treasury yield falls back to 2.5% or if inflation reverts to its 4% underlying trend. Conversely, we will turn more bullish on bonds if we see signs in the labor market data that point to a Fed pause (or Fed rate cuts) being necessary. For now, growth in nonfarm employment and aggregate weekly payrolls (wages x hours x employment) suggest we aren’t close to this outcome (Chart 5). Chart 4High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators High-Frequency Bond Yield Indicators Chart 5The US Labor Market Is Strong The US Labor Market Is Strong The US Labor Market Is Strong Sliding Down The Yield Curve Since early April we’ve been recommending that investors position long the 5-year Treasury note and short a duration-matched barbell consisting of the 2-year and 10-year notes to take advantage of a US yield curve that was quite steep out to the 5-year maturity point and quite flat beyond that. That trade is now played out. The 5 over 2/10 butterfly spread has tightened back to zero and the 2-year note is now the most attractively priced security on the US Treasury curve. Chart 6 shows that the spread between the 2-year note and a duration-matched barbell consisting of cash and the 5-year note offers an extraordinary yield advantage of 92 bps. What’s more, Table 1 shows that, with the exception of the unloved 20-year bond, the 2-year note offers the most attractive 12-month carry on the curve, largely a result of the 18 bps of rolldown attributable to the still-steep slope between the 1-year and 2-year maturity points. Chart 6Shift Into 2s Shift Into 2s Shift Into 2s Table 112-Month Carry Across The US Treasury Curve A Low Conviction US Bond Market A Low Conviction US Bond Market This large shift in relative pricing compels us to close our prior position (long 5-year bullet versus 2/10 barbell) and open a new position: long the 2-year note and short a duration-matched cash/5 barbell. This new position (long 2yr over cash/5) offers attractive 12-month carry, but given the current volatile interest rate environment, it should mainly be expected to profit in the event of a steepening of the 2/5 Treasury slope. With that in mind, it’s notable that the 2/5 slope recently inverted. Inversions of the 2/5 slope are historically rare. They tend to occur near the end of Fed tightening cycles and, with the exception of the early-1980s, they tend to not last that long (Chart 7). Chart 72/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting 2/5 Inversions Are Rare And Fleeting Going forward, we see three plausible scenarios for the 2/5 slope during the next 6-12 months. First, the Fed achieves something close to the soft landing it is aiming for. Inflation starts to fall and the unemployment rate edges higher. However, unemployment never reaches levels that necessitate a complete reversal of Fed tightening. The 2/5 Treasury slope bear-steepens in this scenario as the market discounts that the Fed will have to push rates above 4% to hit its inflation target. Second, a deep recession and complete reversal of Fed tightening occur much more quickly than we anticipate. The 2/5 Treasury slope would bull-steepen in this scenario as the front-end of the curve is pulled down by the Fed’s pivot. Third, inflation shows no signs of reversing course. Long-dated inflation expectations jump and the Fed determines that it has no choice but to follow the example of Paul Volcker and tighten, even if the economy falls into a deep recession. As was the case in the early-1980s, the 2/5 Treasury slope could become deeply inverted in this scenario. Our sense is that the first two scenarios are much more likely than the third. We have written in prior reports about how the current spate of inflation is much different than what was seen in the early 1980s.4  This makes us willing to bet against a prolonged deep inversion of the 2/5 slope. Bottom Line: US Treasury curve investors should exit their positions long the 5-year bullet versus a duration-matched 2/10 barbell. They should initiate a position long the 2-year bullet versus a duration-matched cash/5 barbell. Upgrade US TIPS To Neutral Finally, we note that TIPS breakeven inflation rates have declined markedly during the past month. The 10-year TIPS breakeven inflation rate is currently 2.38%, near the lower-end of the Fed’s 2.3%-2.5% target range, and the 5-year/5-year forward TIPS breakeven inflation rate is a mere 2.12%, well below target (Chart 8). We also note that the 5-year/5-year forward TIPS breakeven inflation rate is back below survey estimates of what inflation will be 5-10 years in the future (Chart 8, bottom panel). Chart 8TIPS Breakevens TIPS Breakevens TIPS Breakevens We have been recommending an underweight position in TIPS versus nominal US Treasuries since early April, but the recent valuation shift means it’s time to add some exposure. Critically, our TIPS Breakeven Valuation Indicator has also increased to +0.6, moving into “TIPS cheap” territory (Chart 9). Historically, the 10-year TIPS breakeven inflation rate has averaged an increase of 28 bps in the 12 months following a reading between +0.5 and +1.0 from our Indicator (Table 2). Chart 9TIPS Are No Longer Expensive TIPS Are No Longer Expensive TIPS Are No Longer Expensive Table 2TIPS Breakeven Valuation Indicator Track Record A Low Conviction US Bond Market A Low Conviction US Bond Market The drop in TIPS breakeven inflation rates has been most prominent at the front-end of the curve. The 2-year TIPS breakeven inflation rate is down to 3.22% from a peak of 4.93%. The high correlation between short-maturity TIPS breakevens and realized CPI inflation means that short-dated breakevens can fall further as inflation continues to trend down, but already we see that 3.22% looks like a much more reasonable estimate of average inflation for the next two years than did the 4.93% peak. While we advise investors to upgrade TIPS from underweight to neutral relative to nominal US Treasuries, we continue to recommend an outright short position in 2-year TIPS. The 2-year TIPS yield has risen sharply since its 2021 low (Chart 10), but recent comments from Fed officials imply that the Fed would like to see positive real yields across the entire curve before it declares monetary policy sufficiently restrictive.5 This means that there is still some room for the 2-year TIPS yield to increase, from its current level of -0.10% back into positive territory. Such a move should also lead to more flattening of the 2/10 TIPS curve, and we continue to recommend holding that position as well (Chart 10, bottom panel). Chart 10Stay Short 2-Year TIPS Stay Short 2-Year TIPS Stay Short 2-Year TIPS Bottom Line: Investors should upgrade TIPS from underweight to neutral relative to nominal US Treasuries but maintain outright short positions in 2-year TIPS. 2/10 TIPS curve flatteners and 2/10 inflation curve steepeners also continue to make sense. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on how to think about the tradeoff between the Fed’s inflation and employment goals please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 2 https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/june/ 3 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 4 Please see US Bond Strategy Weekly Report, “No Relief From High Inflation”, dated June 14, 2022. 5 Please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? On A Bull Case, Bubbles And Commodity Prices On A Bull Case, Bubbles And Commodity Prices Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? Will The S&P 500's Technical Support Hold? Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation Keep An Eye On Rising US Trimmed-Mean Inflation Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 The Anatomy Of The US Equity Bear Market In 2000-2002 The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards A Broad-Based Contraction In Global Trade Is In The Cards A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies A Free Fall In EM Ex-China Stocks And Currencies A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? On A Bull Case, Bubbles And Commodity Prices On A Bull Case, Bubbles And Commodity Prices The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well US TMT Stocks: Exponential Growth Rarely Ends Well US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective The S&P 500 and Operating Profits: A Long-Term Perspective The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops Equity Issuance Marks Market Tops Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures Investors Have Been Long Commodity Futures Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction China: The Economy Is Struggling To Gain Traction China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices? A Major Top In Commodity Prices? A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The 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 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL AT REVERSAL AT REVERSAL Chart 13AT REVERSAL AT REVERSAL AT REVERSAL Chart 14The 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 15The 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 16A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 26Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting 6-12 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-4Indicators 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 Chart II-5Indicators 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