Inflation/Deflation

    Executive Summary At our monthly view meeting on Monday, BCA strategists voted to change the House View to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight. The view of the Global Investment Strategy service is somewhat more constructive, as I think it is still more likely than not that the US will avoid a recession; and that if a recession does occur, it will be a fairly mild one. Nevertheless, the risks to my view have increased. I now estimate 40% odds of a recession during the next 12 months, up from 20% a month ago. In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Bottom Line: With the S&P 500 down 27% in real terms from its highs at the time of the meeting, the view of the Global Investment Strategy service is that a modest overweight is appropriate. However, investors should refrain from adding to equity positions until more clarity emerges about the path for inflation and growth. Heading For Recession? Every month, BCA strategists hold a view meeting to discuss the most important issues driving the macroeconomy and financial markets. This month’s meeting, which was held yesterday, was especially pertinent as it comes on the heels of a substantial decline in global equities. The key issue that we grappled with was whether the Fed could achieve a proverbial soft landing or whether the US and the rest of the global economy were spiraling towards recession (if it wasn’t already there). I began the meeting by showing one of my favorite charts, a deceptively simple chart of the US unemployment rate (Chart 1). The chart makes three things clear: 1) The US unemployment rate is rarely stable; It is almost always either rising or falling; 2) Once it starts rising, it keeps rising. In fact, the US has never averted a recession when the 3-month average of the unemployment rate has risen by more than a third of a percentage point; and 3) As a mean-reverting series, the unemployment rate is most likely to start rising when it is very low. Chart 1In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Taken at face value, the chart paints a damning picture about the economic outlook. The US unemployment rate is near a record low, which means that it has nowhere to go but up. And once the unemployment rate starts going up, history suggests that a recession is inevitable. Five Caveats Despite this ominous implication, I did highlight five caveats. First, the observation that even a modest increase in the unemployment rate invariably heralds a recession is based on a limited sample of business cycles from the US. Across the G10, soft landings have occurred, Canada being one example (Chart 2). Second, unlike the unemployment rate, the employment-to-population ratio is still 1.1 percentage points below its pre-pandemic level, and 4.6 percentage points below where it was in April 2000. A similar, though less pronounced, pattern holds if one focuses only on the 25-to-54 age cohort (Chart 3). Chart 2G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment Chart 3The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels   While the number of people not working either because they are worried about the pandemic, or because they are still burning through their stimulus checks, has been trending lower, it is still fairly high in absolute terms (Chart 4). As my colleague Doug Peta discussed in his latest report, one can envision a scenario where job growth remains positive, but the unemployment rate nonetheless edges higher as more workers rejoin the labor force. Chart 4ALabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Chart 4BLabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II)     Third, the job vacancy rate is extremely high today – much higher than a pre-pandemic “Beveridge Curve” would have predicted (Chart 5). This provides the labor market with a wide moat against an increase in firings. As Fed governor Christopher Waller has emphasized, the main effect of the Federal Reserve’s efforts to cool labor demand could be to push down vacancies rather than to push up unemployment. Fourth, as we have highlighted in past research, the Phillips curve is kinked at very low levels of unemployment (Chart 6). This means that a decline in unemployment from high to moderate levels may do little to spur inflation, but once the unemployment rate falls below its full employment level, then watch out! Chart 5The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The converse is also true, however. If a small decrease in unemployment can trigger a large increase in inflation, then a small increase in unemployment can trigger a large decrease in inflation, provided that long-term inflation expectations remain reasonably well anchored in the meantime. In other words, it is possible that the so-called “sacrifice ratio” — the amount of output that has to be sacrificed to reduce inflation — may be quite low. Fifth, and perhaps most importantly, there is a lot of variation from one recession to the next in how much unemployment rises. In general, the greater the financial and economic imbalances going into a recession, the deeper it tends to be. US household balance sheets are in reasonably good shape these days. Households are sitting on $2.2 trillion in excess savings (Chart 7). Yes, most of those savings belong to relatively well-off households. But as Chart 8 illustrates, even rich people spend well over half of their income. Chart 7Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Chart 8Even The Rich Spend The Majority Of Their Income Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question     The ratio of household debt-to-disposable income in the US is down by a third since its peak in 2008. Despite falling equity prices, the ratio of household net worth-to-disposable income is still up nearly 50 percentage points since the end of 2019, mainly because home prices have risen (Chart 9). As is likely to be the case in many other countries, home prices in the US will level off and quite possibly decline over the next few years. In and of itself, that may not be such a bad outcome for equity markets since lower real estate prices will cool aggregate demand, thus lowering inflation without the need for much higher interest rates. The danger, of course, is that we could see a replay of the GFC. This risk cannot be ignored but is probably quite small. The quality of mortgage lending has been very strong over the past 15 years. Moreover, unlike in 2007, when there was a large glut of homes, the homeowner vacancy rate today is at a record low. Tepid homebuilding has pushed the average age of the US residential capital stock to 31 years, the highest since 1948 (Chart 10). Chart 9The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic Chart 10Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC   A Bleaker Picture Outside The US The situation is admittedly dicier outside the US. Putin’s despotic regime continues to wage war on Ukraine. While European natural gas prices are still well below their March peak, they have recently surged as Russia has begun to throttle natural gas exports (Chart 11). The euro area manufacturing PMI clocked in a respectable 54.6 in May but is likely to drop over the coming months as higher energy prices restrain production. The only saving grace is that fiscal policy in Europe has turned more expansionary. The IMF’s April projection foresaw the structural primary budget balance easing from a surplus of 1.2% of GDP between 2014 and 2019 to a deficit of 1.2% of GDP between 2022 and 2027, the biggest swing among the major economies (Chart 12). Even the IMF’s numbers probably underestimate the fiscal easing that will transpire considering the need for Europe to invest more in energy independence and defense. Chart 11The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices Chart 12Euro Area Fiscal Policy Is Expected To Be More Expansionary In The Years To Come Than Before The Pandemic Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The Chinese economy continues to suffer from the “triple threat” of renewed Covid lockdowns, a shift of global demand away from manufactured goods towards services, and a floundering property market. We expect the Chinese property market to ultimately succumb to the same fate that befell Japan 30 years ago. Chart 13Chinese Stocks Are Cheap Chinese Stocks Are Cheap Chinese Stocks Are Cheap Unlike Japanese stocks in the early 1990s, however, Chinese stocks are trading at fairly beaten down valuations – 10.9-times earnings and 1.4-times book for the investable index (Chart 13). With the Twentieth Party Congress slated for later this year and the population jaded by lockdowns, the political incentive to shower the economy with cash and loosen the reins on regulation will intensify. A Scenario Analysis For The S&P 500 Corralling all these moving parts is no easy matter. We would put the odds of a US recession over the next 12 months at 40%. This is double what we would have said a month ago when we tactically upgraded stocks after the S&P 500 fell below the 4,000 mark. The May CPI report was clearly a shocker, both to the Fed and the markets. The median dot in the June Summary of Economic Projections sees the Fed funds rate rising to 3.8% next year, smack dab in the middle of our once highly out-of-consensus estimate of 3.5%-to-4% for the neutral rate of interest. With interest rates potentially moving into restrictive territory next year, equity investors are right to be concerned. Yet, as noted above, if a recession does occur, it is likely to be a fairly mild one. At the time of the BCA monthly view meeting, the S&P 500 was already down 23% in nominal terms and 27% in real terms from its peak in early January. We assume that the S&P 500 will fall a further 10% in real terms over the next 12 months in a “mild recession” scenario (30% odds) and by 25% in a “deep recession” scenario (10% odds). Conversely, we assume that the S&P 500 will be 20% higher in 12 months’ time in a “no recession” scenario (60% odds). Note that even in a “no recession” scenario, the real value of the S&P 500 would still be down 12% in June 2023 from its all-time high. On a probability-weighted basis, the expected 12-month real return across all three scenarios works out to 6.5%, or 8% with dividends (Table 1). That is enough to justify a modest overweight in my view – but given the risks, just barely. Investors focused on capital preservation should consider a more conservative stance. Table 1S&P 500 Drawdowns Depending On Whether The US Will Enter A Recession And How Severe It Will Be Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Most of my colleagues were more cautious than me, as they generally thought that the odds of a recession were greater than 50%. They voted to shift the BCA house view to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight (10 for underweight; 9 for neutral; and 6 for overweight). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Special Trade Recommendations Current MacroQuant Model Scores Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question  

Executive Summary Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition should occur later this year. Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession will eventually be required to push inflation from 4% down to the Fed’s 2% target. Economic growth will slow going forward, but we won’t see enough weakness for the Fed to abandon its tightening cycle within the next 6-12 months.       Bottom Line: US bond investors should keep portfolio duration close to benchmark, underweight TIPS versus nominal Treasuries and maintain a defensive posture on corporate bond spreads (underweight IG and neutral HY). The Fed Goes Big Chart 1Inflation Expectations Inflation Expectations Inflation Expectations The US Federal Reserve continued to prove its inflation-fighting mettle last week with a 75 basis point rate hike, the largest single-meeting increase since 1994. Chair Powell had initially telegraphed 50 basis point rate increases for both the June and July FOMC meetings, but he made it clear during last week’s press conference that the committee was spooked by May’s surprisingly high CPI number and by the recent jump in 5-10 year household inflation expectations (Chart 1). Alongside the 75 basis point rate hike, committee members revised up their fed funds rate forecasts. The median FOMC member now expects the funds rate to reach a range of 3.25% to 3.5% by the end of 2022. That is consistent with three more 50 basis point rate hikes and one more 25 basis point hike at this year’s four remaining FOMC meetings. Looking further out, the median committee member anticipates 25-50 bps additional upside in the fed funds rate in 2023 but is then forecasting a modest reduction in 2024. Critically, the fed funds rate is still expected to be above estimates of long-run neutral by the end of 2024. Chart 2 shows how current market expectations compare to the Fed’s forecasts. We see that, even after the Fed’s upward forecast revisions, the market still anticipates a somewhat faster pace of tightening this year. The market is also priced for rate cuts in 2023, likely due to the increasingly widespread expectation that a recession is coming within the next 12 months. Chart 2Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed The Fed’s Near-Term Plan As for what we can expect going forward, we found two comments from Chair Powell’s press conference particularly enlightening. First, he called last week’s 75 basis point rate increase “unusually large” and said that he “doesn’t expect moves of that size to be common.” Second, Powell said that the Committee will need to see “convincing” and “compelling” evidence of falling inflation before it starts to moderate its tightening pace.1 From these statements we deduce the following near-term plan: 1. The Fed’s baseline expectation is to lift rates by 50 bps at each meeting. 2.  A significant upside surprise in either the monthly core CPI data or long-dated inflation expectations would cause the Fed to lift by 75 bps instead of 50 bps. 3.  The Fed will not reduce the pace of tightening to 25 bps per meeting until there is clear and convincing evidence that inflation is trending down. Bottom Line: Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition from 50 bps per meeting to 25 bps per meeting should occur later this year, meaning that the Fed will tighten no more quickly than what is already priced into the yield curve for the remainder of 2022. Inflation: All Clear To 4%, 2% Will Be More Challenging It’s evident from the above discussion that inflation remains the critical input for both monetary policy and US bond yields. In particular, the key questions are: 1. Will inflation trend down, and if so, how quickly? 2. Is an economic recession required to curtail inflation? Our answer to these questions is that core US inflation should fall naturally to a trend rate of roughly 4-5%, even in the absence of recession. However, an economic recession and its associated labor market weakness are likely required to move inflation from 4% back to the Fed’s 2% target. Chart 3Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation To arrive at these conclusions, we seek out different ways of estimating inflation’s underlying trend (Chart 3). The first method we consider is the Atlanta Fed’s decomposition of core inflation into “flexible” and “sticky” components. As defined by the Atlanta Fed, “flexible” items tend to change price more frequently compared to “sticky” items. Items like hotels and new & used vehicles fall into the flexible index, while rent and medical care fall into the sticky index.2 As of May, 12-month core flexible inflation is running at a rate of 12.3%. Meanwhile, core sticky inflation is running at 5.0% (Chart 3, top panel). Second, we consider the New York Fed’s Underlying Inflation Gauge (UIG). The UIG uses a dynamic factor model to derive a measure of trend inflation from a broad set of data.3 In total, the measure uses 346 data series encompassing price measures and other nominal, real and financial variables. The New York Fed has demonstrated that the UIG provides better forecasts of CPI inflation than other measures of core and trimmed mean inflation. At present, the UIG is running at 4.9% (Chart 3, panel 2). A second “prices only” UIG measure that includes only price data and no other economic or financial variables is running hotter at 6.0%. Finally, we can assess inflation’s underlying trend by looking at wage growth. Specifically, we can look at unit labor costs, a measure of wages relative to productivity. Unit labor costs are volatile, but they tend to track core inflation over long periods of time. Unit labor costs grew at an extremely high rate of 8.2% in the four quarters ending in Q1, but this is partly due to huge post-pandemic swings in productivity growth. If we create a more stable measure of underlying wage pressure by subtracting annualized 5-year productivity growth from the 12-month growth rate in average hourly earnings, we see that this trend inflation measure is running at only 3.8% (Chart 3, bottom panel). Chart 4Auto Inflation Will Slow Auto Inflation Will Slow Auto Inflation Will Slow We conclude from our analysis that 12-month core CPI inflation will fall from its current 6.0% back down to its trend level of roughly 4-5% without the Fed needing to slam the brakes on economic growth. This will occur because we will finally see the normalization of some prices that were pushed dramatically higher during the pandemic. Auto price inflation, for example, shot up above 20% last year because the pandemic and the fiscal response to the pandemic conspired to cause a surge in auto sales at the same time as a slump in production (Chart 4). Now, for reasons that have nothing to do with monetary policy but everything to do with the waning impact of the pandemic, we see auto sales rolling over as production ramps up. This will push prices lower in the second half of this year. All that said, once core inflation reaches its 4-5% trend level, more economic pain will be required to push it lower. Shelter, for example, carries a huge weight in the Atlanta Fed’s core sticky CPI and it is highly correlated with the economic cycle. A rising unemployment rate, and an economic recession, will eventually be required to push shelter inflation down. Bottom Line: Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession and a rising unemployment rate will eventually be required to push inflation from 4% down to the Fed’s 2% target. The Risk Of Recession Just because US inflation can fall to 4% in the absence of recession doesn’t mean that the Fed won’t get impatient and cause one anyways. In fact, the Fed made it clear last week that it isn’t interested in nuanced inflation forecasts. The Fed will tighten aggressively until it is apparent that inflation is rolling over, even if it causes economic pain. In this section, we run through several economic and financial market indicators that often send signals near the peak of Fed tightening cycles and in advance of recessions. We conclude that economic growth is slowing, but we do not yet see any evidence of an imminent recession or of any growth slowdown that would be large enough for the Fed to pause or reverse its tightening cycle. First, we look at financial conditions (Chart 5). The Goldman Sachs Financial Conditions Index has tightened rapidly during the past few months and that tightening is broad-based across all five of the index’s components. That said, the index has still not quite moved into “restrictive” territory. Typically, Fed tightening cycles only end once financial conditions are already restrictive, and in this cycle, high inflation means that the Fed will likely tolerate even more tightening of financial conditions than usual. Second, we observe that the end of a Fed tightening cycle is often marked by a dip in the ISM Manufacturing PMI to below 50. Presently, the PMI is a solid 56.1 but it is falling, and regional Fed surveys suggest that it may soon dip into contractionary territory (Chart 6). Chart 5Financial Conditions Financial Conditions Financial Conditions Chart 6PMIs Are Slowing PMIs Are Slowing PMIs Are Slowing Third, residential construction activity is a strong predictor of both recession and the end of Fed tightening cycles. Specifically, we have observed that Fed tightening cycles tend to terminate once the 12-month moving average of housing starts falls below the 24-month moving average.4  At present, there is strong evidence that higher mortgage rates are starting to bite the housing market. Housing starts dipped sharply in May and homebuilder confidence is trending down (Chart 7). That said, our housing starts indicator still has a long way to go before it signals the end of the Fed’s tightening cycle (Chart 7, bottom panel). Finally, we turn to the labor market where we do not yet see any evidence of an economic slowdown. Nonfarm payroll growth usually turns negative prior to recession, but right now it is running at a rate of 4.5% during the past 12 months and 3.3% during the past three months (Chart 8). The unemployment rate, for its part, is extremely low, but this only reinforces the idea that the Fed won’t be inclined to abandon its tightening cycle anytime soon. Chart 7US Housing US Housing US Housing Chart 8The US Labor Market The US Labor Market The US Labor Market Consider that the Congressional Budget Office estimates that the natural unemployment rate is 4.4% and the median FOMC member estimates that it is 4.0%. In other words, the Fed would still consider the labor market tight even if the unemployment rate rose from its current 3.6% level to around 4%. Even though such an increase in the unemployment rate might technically be consistent with a recession, the Fed would not be inclined to ease monetary policy into such a labor market if inflation is still above its 2% target. Additionally, we must also consider that the labor force participation rate is trending up and it still has breathing room before it reaches its pre-pandemic level. Further increases in labor force participation – which seem likely – could support employment growth going forward even if the unemployment rate stops falling. Bottom Line: The Fed’s rate hikes, and tighter financial conditions more generally, will slow economic growth going forward. However, we don’t see any evidence that growth will be weak enough for the Fed to abandon its tightening cycle within the next 6-12 months. This is especially true because above-target inflation increases the amount of financial conditions tightening and labor market pain that the Fed will tolerate. Investment Implications Portfolio Duration & US Treasury Curve May’s surprisingly elevated CPI number caused US Treasury yields to move above their 2018 peaks across the entire yield curve (Chart 9). But we wouldn’t be surprised to see that uptrend take a breather during the next few months as inflation descends toward its 4-5% underlying trend. As noted above, falling inflation will likely cause the Fed to tighten by no more than what is already discounted between now and the end of the year, this should keep US Treasury yields rangebound. As a result, we advise investors to keep duration close to benchmark in US bond portfolios, with an eye toward re-evaluating this positioning once core inflation moves closer to its underlying trend. Chart 9US Treasury Yields US Treasury Yields US Treasury Yields On the Treasury curve, the 5-year note continues to trade cheap relative to the 2-year/10-year slope (Chart 9, bottom panel). We recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS Chart 10Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Investors should position for inflation falling back to trend by underweighting TIPS versus duration-matched nominal US Treasuries. Not only will falling inflation weigh on TIPS breakeven inflation rates during the next few months but a resolutely hawkish Fed will also apply downward pressure (Chart 10). We are particularly bearish on short-maturity TIPS, and we advise investors to initiate outright short positions in 2-year TIPS (Chart 10, bottom panel). In last week’s press conference, Chair Powell pointed to negative short-maturity real yields as evidence that financial conditions have room to tighten further. To us, this suggests that the Fed will not quit until real yields move into positive territory across the entire yield curve. In an environment of falling inflation, this is likely to occur because of falling TIPS breakeven inflation rates. However, the Fed has now demonstrated that even if inflation doesn’t fall it will push real yields higher with its policy rate actions and forward guidance. Corporate Credit The combination of slowing economic growth and increasingly restrictive Fed policy compels us toward a defensive positioning on corporate bond spreads. Specifically, we advise investors to carry an underweight (2 out of 5) allocation to investment grade US corporate bonds and a neutral (3 out of 5) allocation to high-yield US corporate bonds. Our slight preference for high-yield comes from the view that spread widening is likely to take a breather this year as inflation turns down and the Fed tightens by no more than what is already discounted in the yield curve. Though the long-run prospects for corporate bond returns remain bleak, if inflation moderates this year as we expect, then spreads could easily re-tighten to the average levels seen during the last tightening cycle (2017-19). That would equate to 31 bps of spread tightening for investment grade US corporate bonds (Chart 11), or roughly 300 bps of excess return versus duration-matched US Treasuries.5 For high-yield, a return to average 2017-19 spread levels would equate to 133 bps of spread tightening (Chart 12), or roughly 875 bps of excess return versus duration-matched US Treasuries.6 Chart 11IG Spreads IG Spreads IG Spreads Chart 12HY Spreads HY Spreads HY Spreads In our view, this warrants a slightly higher allocation to high-yield for the time being, though we will likely turn increasingly bearish should spreads tighten to average 2017-19 levels or once inflation converges with its 4-5% trend.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220615.pdf 2 For more info on the Atlanta Fed’s sticky and flexible CPIs please see: https://www.atlantafed.org/research/inflationproject/stickyprice 3 For more info on the Underlying Inflation Gauge please see https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 4 For more details on this indicator please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 This excess return estimate is roughly 31 bps of spread tightening multiplied by average index duration of 7.5. We then add half of the index OAS as an estimate of the carry earned during the next six months. 6 This excess return estimate is roughly 133 bps of spread tightening multiplied by average index duration of 4.3. We then add half of the index OAS, less estimated default losses of 200 bps, as an estimate of the carry earned during the next six months. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Surge In Yields Tanked Equities Surge In Yields Tanked Equities Surge In Yields Tanked Equities In this week’s report, we conduct a post-mortem analysis of the past week’s market panic and probe the effect of the new developments on US equities. Inflation is embedded. US equities won’t find a bottom until inflation turns decisively.  The Fed will continue to tighten monetary policy, and rates will rise until inflation rolls over. The Fed “put” is also no longer at play as the Fed has signaled that it cares far more about combating inflation than about the performance of the stock market. Economic growth is decelerating and is already surprising on the downside. Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth. With rates rising, the multiple will contract and will exacerbate the damage done by the earnings recession. Bottom Line: The S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize. In addition, economic growth is slowing and an earnings recession is likely. We believe US equities will follow a “fat and down” trajectory in light of the recent developments. We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals. Feature The May CPI reading showed that despite the Fed’s “heroic actions,” inflation has not yet peaked—a data point that has shocked both the market and Fed officials. In an unprecedented move, the Fed, which prides itself on its transparent communication style and its ability to move the market by guiding its expectations, leaked its intention to raise rates by 75 bps to the WSJ despite the communications blackout period. Since last Friday, equity markets around the globe have been in turmoil, with the S&P 500 falling 8%. The NASDAQ is down 7%. Is this just a leg down of the “Fat and Flat” market we have called for with a rebound waiting in the wings, or is there a structural change in the inflationary backdrop and a relentless bear market set to continue? To answer these questions, we will revisit our macroeconomic calls to better understand what expectations need to be adapted to the new reality and what we should expect for US equities over the next three to six months. Sneak Preview: US equities are likely to fall further as monetary conditions continue to tighten and earnings growth is set to contract. We believe that equities will trade in a wide “channel” with multiple rallies and pullbacks, but the general direction is down until inflation turns decisively, and fears of recession dissipate. Why Did Equities Tank? The last few days in the markets were simply brutal. What were investors (and the Fed) panicking about? Here is our hunch: Inflation is not abating, while growth is slowing. Are we in the early innings of stagflation? We believe that stagflation is certainly a high risk. The Fed’s aggressive tightening of monetary conditions is bound to further slow economic growth and taper demand. However, the Fed has no means of controlling the supply side of the equation such as prices of food or energy, which surge because of constrained supply. Will monetary tightening be even more aggressive than expected? Will 75-bps rate rises become the Fed’s new normal? During the press conference, Chairman Powell reassured the market that a 75-bps rate hike is an extraordinary measure. However, both 50-bps and 75-bps rate hikes will be on the table in July. Are the markets on the cusp of a new monetary regime, and is the easy money of the past 12 years a thing of the past? The Fed’s balance sheet has increased from $2 trillion in 2009 to an unprecedented $9 trillion in 2022. This ultra-easy monetary policy has lifted asset values both in private and public markets. The new monetary regime of liquidity being drained from the financial markets to combat inflation is bound to be a major headwind for most asset classes. We believe that it will take a while to bring inflation back to the 2% target, and easy money in the near future is no longer in the cards. It is also unlikely that such a major Fed balance sheet expansion will ever be repeated. The Fed’s tightening via both rising rates and QT will result in a dearth of liquidity in the fixed income space— a credit/counterparty “black swan” may materialize, with MBS most exposed to this risk yet again. Withdrawal of liquidity is a hit to many asset classes, from private markets to unprofitable small-cap growth companies to fixed income markets. This is a serious concern that should be monitored. Incorporating New Data Into Macro And Market Calls We have been writing about these calls for a few months—let’s revisit them here to consider what may have changed recently. Peak Inflation Is Elusive We have never quite bought the argument of transitory inflation. To us, inflation is a product of excessive demand fueled by ultra-easy fiscal and monetary policy and supply chains hobbled by the pandemic. Recently, the situation has been exacerbated by shortages of food and energy. Inflation has spread from pandemic-related goods to “stickier” service items and is broad-based (Chart 1). The wage/price spiral is relentless (Chart 2), as consumer inflation expectations are on the rise, and the job market is on fire. Chart 1Inflation Is Entrenched And Broad-based Inflation Is Entrenched And Broad-based Inflation Is Entrenched And Broad-based   While we always believed that it would take inflation a long time to reach the coveted 2% level, we assumed that peak inflation was behind us. Our view that inflation was going to roll over was more down to a base effect rather than the Fed’s actions. In addition, we observed that demand for goods pulled forward by the pandemic had started fading, suppressed by rising prices and negative real wage growth. The Citigroup Inflation Surprise Index had also turned (Chart 3). Chart 2Wage-Price Spiral Is Relentless Wage-Price Spiral Is Relentless Wage-Price Spiral Is Relentless Chart 3Inflation Was Surprising On The Downside Inflation Was Surprising On The Downside Inflation Was Surprising On The Downside   It is little consolation that we were in good company when rattled by the May headline inflation reading, which came in at 8.5% year on year, and 1% higher than in April. Headline inflation was certainly affected by the price of food and energy, while core inflation was down to a higher price of shelter and goods (Chart 4). While energy is excluded from core inflation, it permeates all aspects of the economy, increasing costs of raw materials, manufacturing, and transportation, which eventually get passed through to the prices of goods and services. The same is the case with the rising wage bill. Chart 4Inflation Picked Up Because Of Prices Of Shelter And Core Goods Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Importantly, what is next? It would help if US shale producers ramped up production, and the Saudis opened their oil spigots, bringing the price of energy down. Short of that, the price of oil should become a function of a slowing economy and fading demand for goods as interest rates rise (Chart 5). While the Fed has little control over food and energy prices, wage-price dynamics fall squarely in its court. The key channel through which the Fed controls inflation is by cooling the economy and reducing the demand for labor. Rising unemployment is the only way to extinguish inflation in a decisive way. Chart 5Rates Surged Rates Surged Rates Surged Eventually, inflation will turn but it may be in fits and starts, and each data point will have a heavy effect on the pace of monetary tightening and the direction of equity markets, with lower inflation readings igniting rallies and higher readings triggering sell-offs. Inflation is embedded. Of course, sooner or later, it will abate but until then we expect a much more aggressive monetary policy. Monetary Conditions Have Tightened Dramatically As we summarized in our “Market Capitulation Scorecard,” one of the key conditions of an equity market bottom, and potentially, even a sustainable rebound, is stabilization in monetary conditions. We hypothesized that this could happen as the Fed tightens monetary conditions and growth slows and inflation turns, pulling down long rates. We also believed that the market focus is going to start shifting away from concerns about inflation to concerns about economic growth. Friday’s inflation reading has changed that – now investors worry about inflation and growth. Rates have initially skyrocketed, with the 10-year Treasury yield moving by 30bps points over the course of three days from 3.18 to 3.48. Real rates increased from 0.38% to 0.63%. US financial conditions have tightened sharply (Chart 6), moving to the neutral level.   What’s next is the most difficult question of this report. It is likely this fast and furious move in rates has accomplished in five days what usually takes weeks. Tighter monetary policy, as it stands now, until more data comes in, is priced in. These moves capture changes in dot-plot expectations revised by the Fed, with the peak rate moving from around 3% to 4%. And, of course, that move got priced into the equity space with the S&P 500 pulling back sharply (Chart 7). Chart 6Financial Conditions Are Moving Into Restrictive Territory Financial Conditions Are Moving Into Restrictive Territory Financial Conditions Are Moving Into Restrictive Territory Chart 7Surge In Yields Tanked Equities Surge In Yields Tanked Equities Surge In Yields Tanked Equities The Fed will continue to tighten monetary policy and rates will rise until inflation rolls over. However, once inflation abates, long rates are likely to stabilize, signaling slower growth ahead. The Fed Won’t Come To The Rescue The Fed “put” is no longer at play as the Fed has signaled that it cares far more about combating inflation than the performance of the stock market. In fact, falling equities will play into Powell’s hand as a negative wealth effect is likely to put a lid on inflationary pressures, with wealthier Americans paying the toll. Kansas City Fed President Esther George, the only member of the FOMC that voted against a 75bps rate hike in the June meeting (she was in favor of 50 bps) said in May: “The Federal Reserve is not targeting equity markets in its battle against inflation, but that is "one of the avenues" where the impact of tighter monetary policy will be felt".1 Further, the Fed is very concerned about a recent pick-up in the long-term consumer inflation expectations (Chart 8) and will likely err on the side of caution to manage these expectations and avoid a self-fulfilling prophecy. Chart 8The Fed Is Worried About Inflation Expectations The Fed Is Worried About Inflation Expectations The Fed Is Worried About Inflation Expectations Economic Growth Is Slowing Fast, Both At Home And Abroad A tighter monetary policy is designed to slow economic growth. The World Bank has downgraded global GDP growth expectations from 4.1% to 2.9%, and import volumes are declining. The Atlanta GDPNow forecast is hovering around zero (Chart 9). The Philly Fed survey has just crossed into negative territory (Chart 10). Retail sales are contracting both in nominal and real terms. According to the Citi Economic Surprise Index, economic growth is surprising on the downside (Chart 11). While the probability of a recession has picked up over the past few weeks, it is earnings growth disappointment that will have an adverse effect on equities in the near term. Chart 9Consensus Expectation Are Still Too High Consensus Expectation Are Still Too High Consensus Expectation Are Still Too High Chart 10Many Signs That Economy Is Slowing Sharply Many Signs That Economy Is Slowing Sharply Many Signs That Economy Is Slowing Sharply Chart 11Economic Growth Disappoints Economic Growth Disappoints Economic Growth Disappoints   We maintain our view that economic growth is decelerating and is already surprising on the downside. Earnings Growth Will Contract And Take The Market With It       We stated in last week’s “Is An Earnings Recession In The Cards?” report that this year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, the decom- position of the total return demonstrates that the pullback was all about multiple contraction, while strong earnings growth helped absorb the blow. We hypothesized that the multiple contraction phase is complete and that the next leg of the bear market will be all about growth, and earnings growth in particular (Chart 12). Hence if rates stabilize, then multiples will stay at the current level, and returns will be a function of earnings growth. However, the 10-year Treasury rate increasing from 3.18 has resulted in the S&P 500 multiple contracting from 16.7 to 15.6 over the course of just three days, while earnings growth expectations have remained mostly intact. Currently, according to our very simple model (Chart 13), a 3.5% 10-year Treasury yield corresponds to the S&P 500 forward multiple of 16.8x, which is close to where the S&P 500 stands today. If rates rise further, the forward multiple will fall. Chart 12Multiple Contraction Will Be Followed By Earnings Growth Deceleration Multiple Contraction Will Be Followed By Earnings Growth Deceleration Multiple Contraction Will Be Followed By Earnings Growth Deceleration Chart 13Higher Rates Translate Into Lower Equity Multiples Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Our earnings growth model predicts that earnings growth will trend towards zero over the next three months (Chart 14). Chart 14Earnings Growth Will Trend To Zero And Then Contract Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Our scenario analysis matrix shows that if multiples stay stable around 17x forward earnings, while earnings contract by zero to five percent next quarter, the index will be flat to slightly down (Table 1). Broadly speaking, with a stable multiple, the market will move in line with earnings growth. If rates continue to rise and the multiple falls to 16x, going another 11% down is likely. Table 1The S&P 500 Target Scenario Analysis Adaptive Expectations: Revisiting Our Views Adaptive Expectations: Revisiting Our Views Watch rates. With rates stable, the S&P 500 performance will be a function of earnings growth, and the market is likely to be range-bound. With rates rising, a multiple will contract further, and equities will fall. Investment Implications: “Fat And Down” The SPX has discounted plenty of negative news now that it is officially in bear market territory. However, we believe that the S&P 500 is not yet close to the bottom. The market is again pricing in tighter monetary policy and rising rates, which is accompanied by multiple contraction. It is hard to see equities bottoming without inflation peaking. In addition, we are predicting that the next leg of the bear market will be driven by earnings growth, which is likely to contract due to an economic slowdown both at home and abroad. As such, “fat and down” may be a more likely outcome than just “fat and flat.” Bottom Line Equities will move in a wide range over the next three to six months. However, if rates are to rise further and earnings growth is to contract, they may be trading in a downward sloping “channel,” or “fat and down.” We recommend that investors “not be heroes” and keep sector allocation close to the benchmark. Overweight defensives vs. cyclicals.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     https://www.reuters.com/business/feds-george-policy-not-aimed-equity-markets-though-it-will-be-felt-there-cnbc-2022-05-19/#:~:text=WASHINGTON%2C%20May%2019%20(Reuters),Esther%20George%20said%20on%20Thursday.   Recommended Allocation Recommended Allocation: Addendum Is Earnings Recession In The Cards? Is Earnings Recession In The Cards?

Executive Summary The Fed has sought to convince one and all of its commitment to overcome high inflation and asset markets have taken heed, tightening financial conditions at a breakneck pace. As we write, the S&P 500 is down 23% year to date, the Bloomberg Barclays Treasury index is down 10%, its sister Corporate and High Yield indexes are down 15% and 12%, respectively, and the dollar had risen by 10% at its peak last week. According to Goldman Sachs’ Financial Conditions Index, the combination has amounted to a 3-percentage-point drag on GDP. Financial markets’ reaction function vis-a-vis monetary policy actions in this tightening cycle has been markedly different than in the previous three tightening cycles. Where tighter financial conditions had previously followed tighter monetary policy with a lengthy lag, they moved ahead of the Fed this time. If the recession is further away than moves in the bond, equity and foreign exchange markets imply, or if inflation eases across the rest of the year in line with our expectations, risk assets are poised to rebound. All Together Now All Together Now All Together Now Bottom Line: The FOMC appears to be on course to induce a recession in its quest to bring inflation to heel. The outlook for financial markets depends on when the recession arrives and how bad it will be, however, and we see scope for positive surprises on both counts. Feature 2022 has not been a good year for financial markets and the action over the last week and a half has made it decidedly worse. In six sessions through Thursday, the S&P 500 nosedived 11%, swooning into bear market territory and unwinding nineteen months of advances. The benchmark 10-year Treasury note’s yield needed just three sessions to back up 45 basis points, from 3.05% to 3.5%. The upheaval has not been unique to the US – inflation and decelerating growth are global phenomena and central banks around the world are scrambling to tighten monetary conditions to rein in rising consumer prices while markets agonize about the effect on growth – but the Fed has been at the center of the storm and last week’s FOMC meeting inspired more swings. This week’s report highlights the most important takeaways from the latest FOMC meeting and how financial markets and Fed policy may interact going forward. There are several factors that are at least slightly different this time. Those differences may keep volatility elevated but they do not condemn stocks and bonds to continued declines. Financial markets have made huge pre-emptive moves that may be subject to reversals as inflation data improve and/or growth holds up better than expected. Prioritizing Price Stability Times have changed. Until inflation began to stir last year, the Fed had been able to prioritize the full employment element of its dual mandate for the entire post-crisis period. Chair Powell made it abundantly clear that price stability is the FOMC’s top priority now, opening his post-meeting remarks with the “overarching message” that it has the means and the will to bring inflation back down to its target level. Living up to this commitment will not be as much fun as trying to prod the economy back to full employment, and it looks as if it will ultimately result in a recession. Following 150 basis points (bps) of hikes so far this year, the target range for the fed funds rate now stands at 1.5-1.75%, and the revised Summary of Economic Projections (SEP) indicated that the median FOMC participant expects another 175 bps of hikes across the year’s remaining four meetings, bringing the funds rate to 3.25-3.5% by year end, at the low end of the money markets’ expectations range (Chart 1). Chart 1Markets And The Fed Are On The Same Page Markets And The Fed Are On The Same Page Markets And The Fed Are On The Same Page During the press conference, Powell repeatedly cited the committee’s concern over rising inflation expectations, calling out the increase in 5-year inflation expectations in the University of Michigan’s preliminary June survey as “quite eye-catching.” The series rose from 30 basis points, to 3.3%, after spending the last four months at 3% and the previous ten in a tight 2.9-3.1% range. The reading was the highest since 2008, when the average national gasoline price first rose above $4 per gallon (Chart 2). Chart 2An "Eye-Catching" Move ... An "Eye-Catching" Move ... An "Eye-Catching" Move ... Threading The Needle FOMC participants’ median projections for real growth, unemployment and inflation at the end of 2022, 2023 and 2024 were benign to pollyannaish, signaling their confidence that the committee will be able to thread the needle, wrestling inflation back to target while maintaining trend growth and capping the unemployment rate at 4.1%. That would meet anyone’s definition of a soft landing, but soft landings have been notoriously elusive. It is fiendishly difficult to fine-tune a complex multi-faceted economy with central bankers’ blunt tools. Empirically, every unemployment rate increase of at least one-third of a percentage point has led to a recession (Chart 3), so even the modest one-half point rise envisioned in the SEP could bring some challenges. A closer examination of past unemployment rate increases suggests a potential way around the dour history, but it depends on reversing the decline in labor force participation that is not yet fully understood. The labor force participation rate – the share of the 16-and-over population that is either working or actively looking for a job – remains more than a percentage point below its pre-pandemic level (Chart 4). If it recovered its early 2020 share, the labor force would expand by 2.8 million people. Chart 3... That Could Put Upward Pressure On The Unemployment Rate ... That Could Put Upward Pressure On The Unemployment Rate ... That Could Put Upward Pressure On The Unemployment Rate Chart 4The Mystery Of The Missing Workers The Mystery Of The Missing Workers The Mystery Of The Missing Workers If the participation rate were restored to its pre-pandemic level, the fortified labor force would allow for payroll expansion despite the unemployment rate increases envisioned in the latest SEP, as per the population growth and household-to-establishment-survey conversion rate estimates embedded in Table 1. It is reasonable to think that the expansion could continue, or the ensuing recession would be mild, despite a rising unemployment rate if payrolls manage to keep growing. An increasing unemployment rate/increasing payrolls scenario is plausible, but we cannot deem it probable when we do not know what has impeded the participation rate’s recovery. The committee is unlikely to be of one mind on the participation rate question, but it may hold the key to reconciling the sunny projections with the observed difficulty of achieving a soft landing. Table 1A Path To A Soft Landing One Overarching Message, Multiple Potential Outcomes One Overarching Message, Multiple Potential Outcomes We’ll Take The Over We agree with Chair Powell and the FOMC’s assessment that solid consumer balance sheets and robust job gains have the economy on a sound footing, despite slowing growth. We do not see familiar underlying vulnerabilities that herald a reversal like an overreliance on debt, broad supply overhangs or an investment boom that has gone on too long. Inflation is the signal problem in the US and the rest of the world, and we continue to expect that it will recede in the second half as supply constraints in pandemic-squeezed segments ease and the pre-emptive backup in yields holds back some marginal demand for big-ticket items that require financing. No one knows the equilibrium fed funds rate in real time, but Powell indicated the committee thinks it’s around 3.5%, placing the year end 2022 median funds rate dot just shy of equilibrium and the median 2023 dot in modestly restrictive territory. A recession is the likely outcome of the rate hike campaign, but if the target rate doesn’t exceed the equilibrium rate until early next year, it may not begin until the middle of 2023 or early in 2024. Given that the consensus view now appears to be that a recession will begin this year if it hasn’t done so already, and financial markets have gone a long way toward pricing in its effects, we don’t see much upside to joining the bearish chorus now. We’ll take the over on the recession-by-year-end proposition. The Big Difference This Time When asked how high the funds rate has to go to arrest inflation, Powell offered the following description of how rate hikes work. “I … look at it this way: We move the policy rate that affects financial conditions, and that affects the economy. We have [more] rigorous ways to think about it, but ultimately it comes down to, ‘do we think financial conditions are in a place where they’re having the desired effect on the economy?’ And that desired effect is we’d like to see demand moderating.” Related Report  US Investment StrategyInflation And Investing Two questions later, he approvingly noted how much bang the committee had already gotten for its buck to this point in the tightening campaign. “[T]his year has been a demonstration of how well [guidance] can work. With us having … done very little in the way of raising interest rates, financial conditions have tightened quite significantly through the expectations channel, as we’ve made clear what our plans are. I think that’s been … very healthy[.]” We stay away from making value judgments about policy, though we can see that a central banker would be in favor of anything that shortens the lag between policy actions and their economic effect. It is immediately obvious, however, that the current rate hike campaign’s real-time impact on financial conditions contrasts sharply with the last three decades’ campaigns (Chart 5). Every one-point change in the Goldman Sachs Financial Conditions Index (FCI) is calibrated to correspond to a one-percentage-point change in real GDP. The FOMC hiked by 175 bps ahead of the 2001 recession and the FCI eventually rose four points, peaking in October 2002, 29 months after the FOMC pushed fed funds to its terminal rate and 21 after it began cutting rates. After the 2004-6 “conundrum” campaign, when financial conditions eased despite 17 consecutive quarter-point rate hikes, the FCI tightened by five points, reaching its peak almost three years after the last hike and 18 months after the first cut. Chart 5Seize The Day Seize The Day Seize The Day Chart 6Decoupling Decoupling Decoupling Some of the response is a simple reflection of the about-face in the inflation backdrop. As our Chief Emerging Markets Strategist Arthur Budaghyan predicted in February 2021, Treasury yields and stock prices have flipped from several decades of positive correlation (rising stock prices offset falling bond valuations and vice versa) in a disinflationary environment to negative correlation in an inflationary environment. Now that Treasury bond, corporate bond and stock prices have been falling together, and the safe-haven dollar has risen amidst the general flight from risk, all of the FCI’s subcomponents have been reinforcing one another, making the index jumpier. More volatile financial conditions raise the probability of overshoots. To wit, has the FCI moved too far, too soon? The volcanic upward move in the 10-year Treasury yield has severed its reliable empirical link with the gold-to-commodity ratio (Chart 6, top panel) and the relative performance of cyclical and defensive equity sectors (Chart 6, bottom panel). They suggest a retracement could be in store. Projected policy rate differentials between the Fed and other currency majors’ central banks are narrowing as monetary policy makers rush to combat inflation. Gloom about growth is widespread. Any positive global growth surprise, from China regarding COVID or stimulus, from the Ukrainian theater, or from supply chain relief, could reel in the extended dollar. Investors should not lose sight of the potential that the coming recession could be mild. A 25% selloff in the S&P 500 may be nearly enough to address that outcome. As of Thursday’s close, the index’s forward four-quarter multiple was down to 15.5 from just under 22 at the start of the year – stocks were expensive, but the nearly 30% de-rating haircut has been severe. The 15.5 multiple assumes the next four quarters’ earnings grow almost 10% year-over-year, which looks ambitious. 5% growth would yield a 16.2 multiple, while no growth would price stocks at 17 times. Those multiples are not cheap, but a lot of froth has come out of the equity market. Against the gloom that has taken over financial markets, we think the next twelve months can be rewarding for investors in risk assets. We are alert to the principal ways our constructive view could be proven wrong and will change our view if it is invalidated by the evidence, but we remain overweight equities in a multi-asset portfolio over the cyclical three-to-twelve-month timeframe. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Listen to a short summary of this report.     Executive Summary Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Oil Prices Have Shot Up Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year   That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop.  Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on        LinkedIn Twitter       View Matrix An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Special Trade Recommendations Current MacroQuant Model Scores An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East

Dear Client, Next Friday we will publish a Special Report on Gold in conjunction with our colleagues in BCA Research’s Foreign Exchange and Global Investment strategy groups.  We will return to our regular schedule of publishing on Thursdays the following week, with our June 30 ESG report.  Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade The World Bank’s somewhat sanguine expectation re stagflation risks for 2023 and beyond misreads continuing pressure on commodity markets due to low capex, and disincentives to invest. If central banks are successful in cooling consumer spending via a policy-induced recession, pressure on spare capacity in oil-producing and refining markets will lessen slightly. However, higher interest rates will increase capex costs. Weaker demand from a recession will not batter crude oil prices: core-OPEC 2.0 – KSA and the UAE – and US shale producers will maintain their production-management strategies, keeping markets relatively balanced. Our forecast for 2H22 and 2023 Brent is $115/bbl and $117/bbl on average, down ~ $6 and $5/bbl from last month’s forecast. WTI will trade $3/bbl lower. Europe will enter a recession earlier than other DMs, with natural-gas shipments to the EU from the US and Russia set to decline precipitously. This will tighten food and metals markets, and keep inflation expectations elevated. Bottom Line: Low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will offset lower demand, and continue to support crude and product prices. The odds of prices exceeding $140/bbl remain high. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). Separately, we were stopped out of our XOP, XME and PICK ETFs, with gains of 19%, 7.2% and 7.6% respectively. We will look for opportunities to re-instate them. Feature Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy While the World Bank sharply downgraded its global growth expectations for this year and next, it nonetheless maintains a somewhat sanguine view of the risk of stagflation going forward.1 The Bank notes current market conditions closely resemble those of the last bout of prolonged stagflation in the 1970s – characterized by flat-to-lower economic growth and high inflation – but differs in important ways that reduce the likelihood of a recurrence.2 In particular, the Bank cites research indicating the proximate causes of the 1970s stagflation have mostly been addressed, and how central banks are better equipped to avoid the mistakes that produced it: Thus far, markets expect that inflation in the near future will decline, albeit remaining elevated, as global growth cools, monetary policy gets tighter, fiscal support is withdrawn, energy and food prices level off, and supply bottlenecks ease. Moreover, most commentators argue that monetary policy has the tools to return inflation to target rates over time (pp. 53-4). We disagree with this assessment, and expect stagflation risks to remain elevated. This is driven by our high-conviction view that weak capex – and, importantly, continued disincentives to invest in hydrocarbon production and refining – will keep industrial-commodity markets tight well into this decade. Base metals producers also have been parsimonious in capex allocations. The Russia-Ukraine war brought forward the capex reckoning for commodity markets and inflation by highlighting the EU’s near-total dependence on Russian oil and natural gas imports, and the risks on outsourced manufacturing and refining away from domestic markets.3 Addressing long-term policy errors and re-forging global supply chains will be expensive, and will require decades of capex investment to overcome the lack of capacity needed to meet higher demand for coal, oil and natgas. This will delay the global energy-transition to a zero- or low-carbon economy and – because exploration, production, refining and distribution of hydrocarbon-based fuels remains constrained – will keep energy markets, particularly oil, tight. As a result, these markets will be predisposed to frequent price spikes, which will lift the average cost of crude oil and refined products over the foreseeable future. Downgrading Oil Demand Again We are once again downgrading our demand expectation for this year and next, on the back of the macro forces outlined in the World Bank’s June forecast: 1) Tightening monetary policy globally, led by the Fed; 2) Higher inflation, which has been exacerbated by the Russia-Ukraine war; and 3) Supply dislocations in energy and grain markets. Global GDP growth this year is expected to be close to half that of 2021 – 2.9% in real terms vs 5.7% – and was revised sharply lower vs the Bank’s January forecast of 4% growth. On the heels of the Bank’s lower growth expectation, we lowered our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast (Chart 1). For next year, we expect oil demand to grow 1.8mm b/d. Of particular interest, China’s growth in the first five months of this year was negative – actual demand from Jan-May22 averaged 15.2mm b/d vs 15.4mm b/d last year. This reflects the demand destruction caused by the lockdowns arising from China’s COVID-19 zero-tolerance policy, and is the first time since 2009 y/y growth has fallen (Chart 2). Chart 1Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Chart 2Oil Demand Destruction In China Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices OPEC 2.0 Will Adjust Output We expect core-OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the UAE – to continue to calibrate its supply to match the ebb and flow of demand. As a result we expect production declines among “the other guys” – i.e., member states that cannot increase supply or maintain current output – to not be fully compensated by the core producers if they see actual demand falling sharply in 2H22 and next year (Chart 3). As the supplier of the last resort, crude oil production from core-OPEC 2.0 tracks demand. This is the cohort of suppliers within OPEC 2.0 which has sufficient spare capacity to bring supply online and, importantly, is able to maintain higher levels of production in order to meaningfully influence oil markets. Chart 3Core-OPEC 2.0 Might Be Slower Offseting Declines Among "The Other Guys" Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices All else equal, in 2023 KSA and UAE – the two core-OPEC 2.0 nations with most spare capacity within OPEC 2.0 – will need to collectively raise supply by ~ 2mm b/d relative to average oil production in 2021 to ensure inventories do not draw sharply. OPEC 2.0 has been unable to stick to the 400 kb/d monthly crude oil production increases agreed in its July 2021 meeting, as declining investment and weak governance have plagued output from member states. Most recently, Libya has closed nearly all oil fields over the course of this month and last, taking nearly 1.1 mmb/d of oil supply off the market. The difference between the actual and agreed OPEC 2.0 output increases accumulated to ~ 2.0mm b/d as of May 2022. We continue to expect Russia to be firmly in the camp of the “other guys,” with production falling 1.6mm b/d this year and 2mm b/d in 2023 (vs 2021 levels). The production lost due to not being able to fully offset lost sales to the EU following its invasion of Ukraine could approach 3mm b/d next year (vs 2021 levels), depending on how successful Russia is in finding new customers. We also expect the US shale-oil producers to continue to maintain their capital discipline, and not ramp production in response to higher prices (Chart 4). This will be critical for maintaining access to capital markets, particularly if oil demand weakens in response to a global GDP decline. Chart 4US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline Markets Will Remain Balanced Our supply-demand assessments leave oil markets relatively balanced with slightly lower prices resulting from lower demand (Chart 5). Oil inventories likely rise somewhat before resuming their downward trajectory as supply and demand adjust to lower growth prospects (Chart 6). Chart 5Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Chart 6Oil Inventories Will Draw Oil Inventories Will Draw Oil Inventories Will Draw Importantly, OPEC 2.0’s core producers might welcome a slight rebuilding of inventories, given the relatively low levels of spare capacity available to meet unexpected supply outages or product shortages, say, for a hurricane in the US Gulf (Chart 7). This becomes particularly acute next year, when, as mentioned above, we expect core-OPEC 2.0 will have to increase their output by 2mm b/d vs 2021 levels to balance markets. Given the dynamics of our supply-demand modeling described above, our price forecasts for 2H22 and 2023 are little changed from last month’s estimates (Chart 8). We expect 2H22 Brent prices to average $115/bbl vs $121.30/bbl. This leaves the 2022 average at $110/bbl vs. $113/bbl estimate last month. For 2023, we expect Brent to average $117/bbl vs our earlier estimate of $122/bbl. Chart 7OPEC Spare Capacity Likely Will Tighten Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 8Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade These price forecasts and balances are our base case (Table 1). We do not estimate the risk premium the market is likely to impound in prices to cover the high level of uncertainty around oil, natgas and electricity prices in global markets. A sudden cut-off of Russian oil supplies to the EU could easily spike Brent prices above $140/bbl, e.g. Indeed, we continue to accord this outcome a non-trivial probability. Likewise, the Atlantic Hurricane Season starts this month, with the US Climate Prediction Center calling for a higher-than-average number of hurricanes for 2022, given above-average Atlantic temperatures and an ongoing La Niña event.4 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Investment Implications The World Bank’s weaker GDP growth forecast leads us to expect slightly lower demand in 2H22 and 2023. However, low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will keep Brent prices close to $115-117/bbl in 2H22 and 2023, which, as our base case, is not far removed from last month’s forecasts. The odds of prices exceeding $140/bbl remain high, reflecting the razor-thin back-up supply margins available to the crude and product markets globally. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). We will look for opportuities to re-establish our XOP, XME and PICK ETF positions, which were stopped out with gains of 19%, 7.2% and 7.6%, respectively, over the course of this past week.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas prices are surging on the back of a loss of exportable LNG volumes from the US Gulf, and on press reports Russia will cut exports to Germany on the Nord Stream (NS) 1 pipeline by ~ 40%. The US supply loss arises from an explosion to at a Freeport LNG terminal in Texas, which accounts for more than 15% of US LNG exports and takes ~ 5 bcm of gas out of the export market. Repairs reportedly will take three months. The loss of natgas supplies on NS1 is being blamed by Russia on an inability to move parts needed to repair the line from Canada due to sanctions imposed following its invasion of Ukraine in February. European gas prices – at the Title Transfer Facility (TTF) in the Netherlands and the National Balancing Point in the UK – surged on the back of this news, and were up 44.28% and 10.15% respectively from Monday’s close to Wednesday trading this week (Chart 9). US gas futures were down 13.81% this week, reflecting a back-up of pipeline natgas that will not make it to the LNG pool until repairs at Freeport are done. Base Metals: Bullish BCA’s China Investment Strategy reported a possible inflection point in household borrowing after nearly two decades of growth (Chart 10). Pandemic-induced lockdowns and declining home prices reduced households’ propensity to take on new debt. Household deleveraging could reduce demand for durables spending and real estate investment, driving down industrial metals’ demand. If deleveraging and lower demand becomes structural, China’s relevance in global metal demand likely will decline. Precious Metals: Bullish On the back of last Friday’s hot inflation data, the Federal Reserve announced a 75 bps rate hike following the June Federal Open Market Committee (FOMC) meeting. This likely will reduce the Fed’s credibility after Powell hinted at a 50 bps rate hike for the June meeting in last month’s meeting. The higher rate hike puts the Fed on a more hawkish path, risking the soft landing it has been aiming for. A US recession will be supportive for gold prices.   Chart 9 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 10 Chinese Households Leverage Ratio Fell The Most Since The GFC Chinese Households Leverage Ratio Fell The Most Since The GFC     Footnotes 1     Please see Stagflation Risk Rises Amid Sharp Slowdown in Growth, which includes a link to the Bank’s full June 2022 update. 2     Please see discussion beginning on p. 51 of the Banks June report, “Special Focus 1, Global Stagflation.”  This focus provides a well-researched history of the evolution of inflation. 3    Please see One Hot Mess: EU Energy Policy and Commodities' Watershed Moment, which we published 26 May and on March 10, 2022, for discussion of the EU’s energy dependence on Russia. See also La Niña And The Energy Transition, published on September 30, 2021, for a discussion of refining-concentration risks – particularly for base metals refining, where roughly half of global capacity is concentrated in China. 4    Please see NOAA predicts above-normal 2022 Atlantic Hurricane Season published on May 24, 2022.   Investment Views and Themes Recommendations  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG S&P OIL & GAS EXPLORATION & PRODUCTION (XOP) ETF TRADE ON JUNE 13, 2022 WITH A RETURN OF 19%. WE WERE STOPPED OUT OF OUR LONG MSCI GLOBAL METALS & MINING PRODUCERS (PICK) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.56%. WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS AND MINING (XME) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.17%. Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary Was FAANGM A Bubble? Was FAANGM A Bubble? Was FAANGM A Bubble? US inflation has become broad-based, and the labor market is very tight. Wages are a lagging variable, and they will be rising rapidly in the coming months, even as the economy slows. Although US growth will be slowing and global trade will be contracting, the Fed will remain hawkish over the coming months. This is an unprecedented environment and is negative for global and EM risk assets. The US trade-weighted dollar will continue to appreciate as long as the Fed sounds and acts in a hawkish manner and global trade contracts. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though EM equity and local bond valuations have become attractive, their fundamentals are still negative. A buying opportunity in EM will occur when the Fed makes a dovish pivot and China stimulates more aggressively. We reckon that these conditions will fall into place sometime in H2 this year. Bottom Line: For now, we recommend that investors stay defensive in absolute terms and underweight EM within global equity and credit portfolios. The dollar has more upside in the near term but a major buying opportunity in EM local currency bonds is approaching. Feature Last week, after a two and a half year hiatus, I travelled to Europe to visit clients. I also took the opportunity catch up with Ms. Mea, a global portfolio manager and a long-standing client. Prior to the pandemic, we met regularly to discuss global macro and financial markets. She was happy to resume our in-person meetings, and we met in Amsterdam over dinner last Friday. This report provides the key points of our conversation for the benefit of all clients. Ms. Mea: I am very happy that we are again able to meet in person. Video meetings are good, but in-person meetings are better. One’s body language often gives away their level of confidence regarding investment recommendations. Answer: Agreed. My meetings with clients this week have reminded me of the value of in-person meetings. Chart 1Our Calls On Various EM Asset Classes Our Calls On Various EM Asset Classes Our Calls On Various EM Asset Classes Ms. Mea: Before our meeting I reviewed the evolution of your investment views since the pandemic erupted. Let me try to summarize them, and correct me if I miss something. Even though you upgraded your medium-term view on Chinese growth in May 2020 due to the stimulus, you remained skeptical of the rally in global risk assets. In Q2 2020, you upgraded your stance on EM bonds and in July 2020 you lifted the recommended allocation to EM equities and currencies from underweight to neutral (Chart 1). In the summer and fall of 2020, you were still wary of a deflationary relapse in developed economies. However, since January 2021, your outlook for the US shifted drastically to overheating and inflation. Since then, you have been very vocal about inflation risks in the US. At the same time, you have been warning about a major slowdown in Chinese growth. Regarding financial markets, in March 2021, you downgraded EM stocks and bonds to underweight and recommended shorting select EM currencies versus the US dollar (Chart 1). I should say that your call on US inflation and China’s slowdown have played out very well over the past 18 months. Let’s zero in on US inflation. It was just last year that many investors and analysts claimed that inflation is good for stocks because it helps their top line growth. Why then have global markets panicked? Chart 2Record Wealth Destruction In US Stocks And Bonds Record Wealth Destruction In US Stocks And Bonds Record Wealth Destruction In US Stocks And Bonds Answer: Not many people have a deep understanding of inflation and its impact on financial markets because most investors lack experience in navigating financial markets during an inflation era. In fact, the US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP and already exceeds the wipeouts during the March 2020 crash and all other bear markets (Chart 2). The way we think about macro and markets must change in an inflation regime. In our seminal February 25, 2021 Special Report titled A Paradigm Shift In The Stock-Bond Relationship, we made the case that the US economy and its financial markets were about to enter a new paradigm of higher inflation. We argued that US core CPI would spike well above 2% and US share prices and US government bond yields would become negatively correlated.  A similar paradigm shift occurred in 1966 (Chart 3). In short, we argued that the era of low US inflation was over, and as a result, equities and bonds would selloff simultaneously. This will remain the roadmap for investors as long as core inflation is high. Chart 3A Paradigm Shift: US Stock Prices And Bond Yields Correlation Over Decades A Paradigm Shift: US Stock Prices And Bond Yields Correlation Over Decades A Paradigm Shift: US Stock Prices And Bond Yields Correlation Over Decades Ms. Mea: Do you think the Fed is behind the curve? Answer: Yes, the Fed has fallen behind the curve, and, as we have repeatedly argued over the past 12 months, the US inflation genie is out of the bottle. There is a lot of confusion in the global investment community about how we should think about inflation, and about how and when the various measures of inflation matter. As consumers, we care about headline inflation because it affects our purchasing power. So, changes in all goods and service prices, including energy and food, matter to consumers. However, this does not mean that central banks should target and set policy based on headline inflation. Rather, central banks should target genuine broad-based inflation in the economy before it becomes entrenched. Ms. Mea: Can you explain why in certain cases a surge in energy, food and other prices leads to entrenched inflation but in other cases it does not? Answer: Let me give you an example. When consumers experience rapidly rising food and energy prices, they will likely demand faster wage growth from their employers. If businesses are enjoying strong demand for their goods/services and facing a tight labor market, they might have little choice but to agree to pay raises to sustain their business. Companies will then attempt to protect their profit margins by hiking their selling prices. Households may accept higher prices given their incomes are rising. This dynamic could cause inflation to become broad-based and entrenched. In this case, central banks should lift rates to slow the economy materially and cool off the labor market to end the wage-price spiral. If employees fail to negotiate hefty pay raises, odds are that inflation will not become broad-based. The more households spend on energy and food, the less income they will have to spend on other items, causing their discretionary spending to contract. In this case, there is no rush for central banks to tighten policy. If monetary authorities tighten materially, the economy will experience a full-fledged recession. In short, wage dynamics will determine whether inflation becomes broad-based. Labor market conditions will ultimately dictate this outcome. Ms. Mea: But why are wages more important than the price of fuel or food in determining whether inflation becomes broad-based? Answer: To be technically correct, unit labor costs, not wages, are key to inflation dynamics. Unit labor cost = (wage per hour) / (productivity). Productivity is output per hour. Given that labor is the largest cost component of US businesses, unit labor costs will swell and profit margins will shrink when salaries rise faster than productivity.  CEOs and business owners always do their best to protect the their profit margins. Thus, accelerating unit labor costs will lead them to raise their selling prices. In the wake of wage gains, consumers might accept higher goods and service prices. If they do and go on to demand even higher wages, the economy will enter a wage-price spiral. This is why wage costs, more specifically unit labor costs, are the most important variable to monitor. If high energy and food prices lead employees to demand faster wage growth from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become more broad-based and genuine. If consumers push back against higher prices, i.e., reduce their spending, corporate profits will plunge, and companies will freeze investment and lay off employees. Wages will slow and inflation will wane. Ms. Mea: Are all economies currently experiencing a wage-price spiral? Answer: The US and some other countries have been experiencing a wage-price spiral over the past 12 months. In other countries, including many developing economies, a wage-price spiral is currently absent. In the US, labor demand exceeds supply by the widest margin since 1950 (Chart 4). The upshot is that wages will continue to rise in response to persistently high inflation (Chart 5). Chart 4US Labor Demand Is Exceeding Labor Supply By The Widest Margin Since 1950 US Labor Demand Is Exceeding Labor Supply By The Widest Margin Since 1950 US Labor Demand Is Exceeding Labor Supply By The Widest Margin Since 1950 Chart 5US Wage Growth Is Already Very High US Wage Growth Is Already Very High US Wage Growth Is Already Very High Wages in the US are currently rising at a rate of 6-6.5% or so. US productivity growth is around 1.5%. As a result, unit labor costs are rising at a 4.5-5% annual rate, the fastest rate for corporate America in the past 40 years (Chart 6). As Chart 6 demonstrates, unit labor costs have been instrumental in defining core CPI fluctuations over the past 70 years in the US. Chart 6US Unit Labor Costs Are Rising At The Fastest Rate Since 1982 US Unit Labor Costs Are Rising At The Fastest Rate Since 1982 US Unit Labor Costs Are Rising At The Fastest Rate Since 1982 Chart 7US Core Of Core Inflation Is High And Not Falling US Core Of Core Inflation Is High And Not Falling US Core Of Core Inflation Is High And Not Falling In short, both surging unit labor costs and the acceleration of super core CPI measures like trimmed-mean CPI and median CPI suggest that US inflation has become broad-based and a wage-inflation spiral has taken hold in the US (Chart 7). Critically, wages are a lagging variable and are not reset all at once for all employees. American employees will continue to demand substantial wage hikes both to offset the last 12 months of lost purchasing power and to protect their purchasing power for the next 12 months. Hence, we will be witnessing faster wage growth in the coming months even as the economy slows. For many continental European economies and for several EM economies, wage growth is still weak. Chart 8 illustrates that nominal wage growth in India, Indonesia, China and Mexico are very subdued. Sluggish wage gains in emerging economies are consistent with the profile of their domestic demand. Domestic demand in these large developing economies remains extremely weak. In many cases, the level of domestic demand in real terms is still below its pre-pandemic level (Chart 9). Chart 8EM Wages Are Very Tame EM Wages Are Very Tame EM Wages Are Very Tame Chart 9EM Domestic Demand Is Depressed EM Domestic Demand Is Depressed EM Domestic Demand Is Depressed   In China, deflation, rather than inflation, is the main economic threat. Headline and core inflation are within a 1-2% range (Chart 10), domestic demand is very weak, and the unemployment rate has risen in the past 12 months. Chart 10China's Inflation Is Subdued China's Inflation Is Subdued China's Inflation Is Subdued Ms. Mea: Do you expect the US economy to contract? Answer: US growth will decelerate substantially, and certain segments of the economy could shrink for a couple of quarters. My expectation is that US corporate profits will contract materially. Slowing top line growth, narrowing profit margins, shrinking global trade and a strong dollar are all major headwinds for the S&P 500 EPS. EM EPS are also heading towards a major contraction. This is why I view EM fundamentals as negative even though EM valuations have become attractive. Ms. Mea: You have recently written that global trade volumes are about to contract. What is your rationale and is there any evidence that this is already happening? Answer: US and EU demand for consumer goods ex-autos has been booming over the past two years. Households have overspent on goods ex-autos (Chart 11). Given that their disposable income is contracting in real terms and a preference to spend on services, households will markedly curtail their purchases of consumer goods in the coming months. This will hurt global manufacturing in general, and emerging Asia in particular. Some forward-looking indicators are already signaling a contraction in global trade: US retail inventories (in real terms) have swelled (Chart 12, top panel). US retailers will dramatically reduce their orders. Chart 11Global Trade Volumes Will Shrink In H2 2022 Global Trade Volumes Will Shrink In H2 2022 Global Trade Volumes Will Shrink In H2 2022 Chart 12US Import Volumes Are Set To Contract US Import Volumes Are Set To Contract US Import Volumes Are Set To Contract   Besides, US railroad carload is already shrinking, signaling reduced goods shipments (Chart 12, bottom panel). Taiwanese shipments to China lead global trade and they point to an impending slump (Chart 13, top panel). Also, the Taiwanese manufacturing shipments-to-inventory ratio has dropped below 1 (Chart 13, bottom panel). Finally, industrial metal prices are breaking down despite easing lockdowns in China and continued sanctions on Russia (Chart 14). This is a sign of downshifting global manufacturing. Chart 13A Red Flag For Global Trade A Red Flag For Global Trade A Red Flag For Global Trade Chart 14Industrial Metal Prices Are Breaking Down Industrial Metal Prices Are Breaking Down Industrial Metal Prices Are Breaking Down   Ms. Mea: Won’t a global trade contraction push down goods prices and help US inflation? Answer: Correct, it will bring down US goods inflation but not services inflation. Importantly, as we discussed above, US inflation has already spilled into wages and has become broad-based. Plus, it is hovering well above the Fed’s target. Hence, the Fed cannot dial down its hawkishness now, even if goods price inflation drops significantly. In brief, even though US growth will be slowing and global trade will be contracting over the coming months, the Fed is likely to remain hawkish. This is an unprecedented environment and is negative for global and EM risk assets. Ms. Mea: What are the financial market implications of entrenched inflation in the US and the lack of genuine inflationary pressures in many emerging economies? Answer: As long as the Fed sounds and acts in a hawkish manner and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The greenback is a countercyclical currency and rallies when global trade slumps. On the whole, the USD will likely overshoot in the near run. Consistent with a US dollar overshoot, EM financial markets will undershoot. Even though investor sentiment on EM equities and USD bonds is very low (Chart 15), a final capitulation selloff is still likely. In short, EM valuation and positioning are positive for future potential returns yet their fundamentals (business cycle, profits, return on capital, etc.) are still negative. A buying opportunity in EM will emerge when the Fed makes a dovish pivot, China stimulates more aggressively, and EM equity and bond valuations improve further. We reckon that these conditions will fall into place sometime in H2 this year. If the Fed turns dovish early without taming US inflation, it will fall behind the inflation curve and the US dollar will begin its bear market. Investors will respond by embracing EM financial assets. EM local currency bonds in particular offer value (Chart 16). Prudent macro policies and the lack of wage pressures entail a good medium-to-long term opportunity in EM local currency bonds. Chart 15Investor Sentiment On EM Stocks And USD Bonds Is Low Investor Sentiment On EM Stocks And USD Bonds Is Low Investor Sentiment On EM Stocks And USD Bonds Is Low Chart 16US TIPS Yields Should Roll Over For EM Local Bond Yields To Decline US TIPS Yields Should Roll Over For EM Local Bond Yields To Decline US TIPS Yields Should Roll Over For EM Local Bond Yields To Decline   As EM currencies put in a bottom, local yields will come down. This will help their equity markets. Ms. Mea: Speaking of a capitulation selloff, how far can it go? Both for EM stocks as well as the S&P 500? Chart 17S&P500: Where Is Technical Support Line? S&P500: Where Is Technical Support Line? S&P500: Where Is Technical Support Line? Answer: As long as US bond yields and oil prices do not start falling on a consistent basis, the S&P 500 will remain under selling pressure. Technicals can help us gauge the likely magnitude of the move. The S&P 500 has dropped to a major technical support, but it will likely be broken. The next support is around 3100-3200 (Chart 17). The EM equity index is sitting on a technical support now (Chart 18). The next support level is 15-17% below the current one. Chart 18EM Stocks in USD Terms Could Drop Another 15% EM Stocks in USD Terms Could Drop Another 15% EM Stocks in USD Terms Could Drop Another 15% Critically, US equity investors should also consider whether the US equity bull market that has been in place since 2009 is over. If it is, then the S&P 500 bear market could last long, and prices could drop significantly. Chart 19Was FAANGM A Bubble? Was FAANGM A Bubble? Was FAANGM A Bubble? A few observations that investors should keep in mind: First, over the past 12 years, FAANGM stocks have followed the profile of the Nasdaq 100 (Chart 19). In short, FAANGM stocks have risen as much as the Nasdaq 100 index did in the 1990s. Second, when retail investors rush into an asset class, it often signals the final phase of the bull market. Once the bull market ends, the ensuing bear market is vicious. The behavior of tech/internet stocks and the broader S&P 500 fits this profile extremely well. For several years after the Lehman crash, individual investors were hesitant to buy US stocks. However, the resilience of US equities led to a buy the dip mentality in 2019-20. Retail investors joined the equity party en masse in early 2020. The post retail frenzy hangover is usually very painful and prolonged. Based on this roadmap, it seems that the 2020-21 retail-driven rally was the final upleg in the S&P 500 bull market. By extension, we have entered a bear market that could be vicious and extended. All the excesses of the 10-year FAANGM and S&P500 bull markets will need to be worked out before a new bull market emerges. Finally, a high inflation regime raises the bar for the Fed to rescue the stock market. This also entails lower equity multiples than we have in the S&P500 now. Ms. Mea: What do you make of EM’s recent outperformance versus DM stocks? When will you upgrade EM versus DM? Answer: Indeed, EM stocks have recently outperformed DM stocks. We might be witnessing a major transition in global equity market leadership. We have held for some time that an equity leadership change from the US to the rest of the world and from TMT stocks to other segments of the global equity market would likely take place during or following a major market selloff. The ongoing equity bear market seems to be exactly that catalyst. Chart 20For EM Equities To Outperform, USD Needs To Weaken For EM Equities To Outperform, USD Needs To Weaken For EM Equities To Outperform, USD Needs To Weaken If the S&P 500 bull market is over, the global equity leadership will also change away from US and TMT stocks to other stock markets and sectors. That said, to upgrade EM stocks, we need to change our view on the USD because EM relative equity performance versus DM closely tracks the inverted trade-weighted US dollar (Chart 20). In the near term, we believe the greenback has more upside potential. In particular, Asian currencies and equity markets cannot outperform when the Fed is hawkish and global trade is contracting. Latin American currencies have benefited since early this year from the spike in commodity prices. However, worries about a US recession, a strong dollar and a lack of strong recovery in the Chinese economy will push industrial metal prices lower. As shown in Chart 14 above, industrial metal prices are breaking down. This is a bad omen for Latin American markets. On the whole, we will likely be upgrading EM versus DM later this year. For now, we recommend that investors stay defensive and underweight EM within global equity and credit portfolios. 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. A major buying opportunity in local currency bonds is approaching. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Executive Summary Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report  Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Worrying Signs For Global Growth Worrying Signs For Global Growth ​​​​​​ Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here ​​​​​​ Chart 4Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here ​​​​​​ For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed ​​​​​​ Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' ​​​​​​ Chart 7Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts ​​​​​​ Chart 11Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? ​​​​​​ The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? ​​​​​​ Chart 13Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a)     reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b)     the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Volcker's Ghost Volcker's Ghost The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Volcker's Ghost Volcker's Ghost Tactical Overlay Trades

In lieu of next week’s report, I will host a Webcast on Monday, June 27 to explain the recent market turmoil and how to navigate it through the second half of 2022. Please mark the date, and I do hope you can join. Executive Summary The recent sharp underperformance of the HR and employment services sector presages an imminent rise in the US unemployment rate. Central banks have decided that a recession is a price worth paying to slay inflation. In this sense, the current setup rhymes with 1981-82, when the Paul Volcker Fed made the same decision. The correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Go long the December 2023 Eurodollar (or SOFR) futures contract. While interest rates are likely to overshoot in the near term, the pain that they will unleash will require a commensurate undershoot in 2023-24. Cryptocurrencies will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal trading watchlist: Czechia versus Poland, German telecoms, Japanese telecoms, and US utilities. The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Bottom Line: An imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Feature Financial markets have collapsed in 2022, but jobs markets have held firm, at least so far. For example, the US economy has added an average of 500 thousand jobs per month1, and the unemployment rate, at 3.6 percent, remains close to a historic low. But now, an excellent real-time indicator warns that cracks are appearing in the US jobs market. The excellent real-time indicator of the jobs market is the performance of the human resources (HR) and employment services sector. After all, with its role to place and support workers in their jobs, what better pulse for the jobs market could there be than HR? What better pulse for the jobs market could there be than the human resources sector? Worryingly, the recent sharp underperformance of the HR and employment services sector warns that the pulse of the jobs market is weakening, and that consumers will soon be reporting that jobs are becoming less ‘plentiful’ (Chart I-1). In turn, consumers reporting that jobs are becoming less plentiful presages an imminent rise in the unemployment rate (Chart I-2). Chart I-1The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Chart I-2Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment 2 Percent Inflation Will Require A Sharp Rise In Unemployment The health of the jobs market has a huge bearing on the big issue du jour – inflation. Specifically, in the US, the unemployment rate (inversely) drives the inflation of rent and owners’ equivalent rent (OER) because, to put it simply, you need a steady job to pay the rent. Furthermore, with rent and OER comprising almost half of the core CPI basket, the ‘rent of shelter’ component is by far the most important long-term driver of core inflation.2 Shelter inflation at 3.5 percent equates to core inflation at 2 percent. For the past couple of decades, full employment has been consistent with rent of shelter inflation running at 3.5 percent, which itself has been consistent with core inflation running at 2 percent (Chart I-3). Hence, the Fed could achieve the Holy Grail of full employment combined with inflation running close to 2 percent. Chart I-3Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... But here’s the Fed’s problem. In recent months, there has been a major disconnect between the jobs 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-4). Chart I-4...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent This means that to bring rent of shelter and core inflation back to 3.5 percent and 2 percent respectively, the unemployment rate will have to rise by 2 percent. In other words, to achieve its inflation goal, the Fed will have to sacrifice its full employment goal. Put more bluntly, if the Fed wants to reach 2 percent inflation quickly, it will have to take the economy into recession. The cracks appearing in the HR and employment services sector suggest this process is already underway. There Are Two ‘Neutral Rates Of Interest’. Which One Will Central Banks Choose? The ‘neutral rate of interest rate’, also known as the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*, is the short-term interest rate that is consistent with the economy at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. But here’s the subtle point that many people miss. The neutral rate is defined in terms of stable inflation without stating what that stable rate of inflation is. Therein lies the Fed’s problem. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. Now let’s add a third goal of ‘financial stability’, and the message from the ongoing crash in stock, bond, and credit markets is crystal clear. The near-term neutral rate that is consistent with inflation at 2 percent is also much higher than the near-term neutral rate that is consistent with financial stability (Chart I-5 and Chart I-6). Chart I-5Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up… So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far Chart I-6When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices This leaves the Fed, and other central banks, with a major dilemma. Which neutral rate goal to pursue – full employment and financial stability, or inflation at 2 percent? In the near term, the answer seems to be inflation at 2 percent. This is because the lifeblood of central banks is their credibility. With their credibility as inflation fighters in tatters, this may be the last chance to repair it before it is shredded forever. Taking this long-term existential view, central banks have decided that a recession is a price worth paying to slay inflation and repair their credibility. In this important sense, the current setup rhymes with 1981-82 when the Paul Volcker Fed made the same decision. Therefore, the correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82, which we detailed in More On 2022-2023 = 1981-82, And The Danger Ahead. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Eventually, the central banks’ major dilemma between inflation and growth will resolve itself. The triple whammy of a recession in asset prices, profits, and jobs will unleash a strong disinflationary – or even outright deflationary – impulse, causing inflation to collapse to well below 2 percent in 2023-24. And suddenly, there will be no conflict between the neutral rate that is consistent with full employment and financial stability, and that which is consistent with inflation at 2 percent. Both neutral rates will be ultra-low.  Hence, while interest rates are likely to overshoot in the near term, the pain that they will cause will require a commensurate undershoot in 2023-24. On this basis, go long the December 2023 Eurodollar (or SOFR) futures contract (Chart I-7). Chart I-7Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Cryptos Will Bottom When The Nasdaq Bottoms The turmoil across financial markets has naturally engulfed cryptocurrencies, and this has generated the usual Schadenfreude among the crypto-doubters. But in the short-term, cryptocurrencies just behave like leveraged tech stocks, meaning that as the Nasdaq has fallen sharply, cryptos have fallen even more sharply (Chart I-8). Chart I-8In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq Most cryptocurrencies are just the tokens that secure their underlying blockchains, so their long-term value hinges on whether their underlying blockchain technologies will succeed in displacing the current ‘trusted third party’ model of intermediation. In this sense, blockchain tokens are the ultimate long-duration growth stocks, whose present values are highly sensitive to the performance of the blockchain technology sector, which in turn is highly sensitive to the long-duration bond yield. Hence, while the bear markets in bonds, Nasdaq, and cryptos appear to be separate stories, they are just one massive correlated trade! Given that nothing fundamental has changed in the outlook for blockchains, long-term investors should treat this crypto crash, just like all the previous crypto crashes, as a buying opportunity. Cryptos will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal Trading Watchlist Amazingly, while most markets have crashed, the financial-heavy Czech stock market is up by 20 percent this year, in sharp contrast to its neighbouring Polish stock market which is down by 25 percent. In fact, over the last year, Czechia has outperformed Poland by 100 percent. From both a fundamental and technical perspective, this outperformance is now vulnerable to reversal (Chart I-9). Accordingly, a recommended trade is to underweight Czechia versus Poland, setting the profit target and stop-loss at 15 percent. Elsewhere, the outperformances of German telecoms, Japanese telecoms, and US utilities are all at, or close, to points of fractal fragilities which make them vulnerable to reversals. As such, these have entered out watchlist. The full watchlist of 27 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Chart I-9Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Fractal Trading Watchlist: New Additions German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 1BRL/NZD At A Resistance Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 2Homebuilders Versus Healthcare Services Has Turned Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 3CNY/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 4US REITS Are Oversold Versus Utilities Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 5CAD/SEK Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 6Financials Versus Industrials Has Reversed Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 7The Outperformance Of Resources Versus Biotech Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 13Food And Beverage Outperformance Is Exhausted Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 14German Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 18A Potential Switching Point From Tobacco Into Cannabis Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 19Biotech Is A Major Buy Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 20Norway's Outperformance Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 21Cotton Versus Platinum Is At Risk Of Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 22Switzerland's Outperformance Vs. Germany Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 23USD/EUR Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 25A Potential New Entry Point Into Petcare Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 26GBP/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 27US Utilities Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  Based on the nonfarm payrolls. 2 Rent of shelter also includes lodging away from home, but the two dominant components are rent of primary residence and owners’ equivalent rent of residences. Fractal Trading System Fractal Trades Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-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 Bonds sold off dramatically in response to Friday’s surprisingly high CPI number. Markets are now pricing in a much more rapid increase in the fed funds rate, with some probability of a 75 bps move this week. We think a 75 bps rate hike at any one FOMC meeting is possible, but unlikely. Rather, we see the Fed continuing to hike by 50 bps per meeting until inflation shows signs of rolling over. The guts of the CPI report were less concerning than the headline figure, and it is still more likely than not that core CPI will trend down during the next 6-12 months. Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Bottom Line: Investors should maintain benchmark portfolio duration as it is unlikely that the Fed will deliver a more aggressive pace of tightening than what is already in the price. Investors should also underweight TIPS versus nominal Treasuries as a play on a hawkish Fed and moderating consumer prices. The May CPI Print Ensures An Ultra-Hawkish Fed  The “peak inflation” narrative took a blow last week when core CPI came in well above expectations for May. While the annual rate ticked down due to base effects, monthly core CPI saw its largest increase since last June (Chart 1). The bond market reacted to the news with an abrupt bear-flattening of the Treasury curve. The 2-year Treasury yield rose above 3% for this first time this cycle and the 10-year yield hit 3.27% on Monday morning (Chart 2). The 2-year/10-year Treasury slope flattened sharply, and it now sits at just 5 bps (Chart 2, bottom panel). Chart 1Strong Inflation In May Strong Inflation In May Strong Inflation In May Chart 2A Big Bear-Flattening A Big Bear-Flattening A Big Bear-Flattening With core inflation not showing any signs of slowing, the Fed will maintain its ultra-hawkish tone when it meets this week. While there’s an outside chance that the Fed will try to shock markets with a 75 basis point rate hike, we think it’s more likely that it will deliver the 50 basis point rate increase that Jay Powell teased at the last meeting while signaling that further 50 basis point rate increases are likely at both the July and September FOMC meetings. While inflation is not falling as quickly as either we or the Fed had previously anticipated, a look through the guts of the CPI report still leads to the conclusion that core inflation is more likely to fall than rise in the second half of this year. The main reason for this conclusion is that we aren’t seeing much evidence that inflation is transitioning from the goods sectors that were most heavily impacted by the pandemic to non-impacted service sectors. Rather, the main issue is that core goods inflation remains stubbornly high. Chart 3 shows the breakdown of core CPI into its three main components: (i) goods, (ii) shelter, and (iii) services excluding shelter. We can see that after only one month of decline in March, core goods prices accelerated to +0.69% in May, the largest monthly increase since January. The bulk of the May increase in goods inflation came from new and used cars (Chart 4), a sector where we should see price declines in the second half of this year now that motor vehicle production is ramping back up. Chart 3Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Chart 4Contribution To Month-Over-Month Core Goods CPI No Relief From High Inflation No Relief From High Inflation Turning to services, we observe a deceleration in May relative to April (Chart 3), and also notice that airfares continue to account for an outsized chunk of services inflation (Chart 5). Excluding airfares, core services inflation was just 0.36% in May. Chart 5Contribution To Month-Over-Month Core Services CPI (Excluding Shelter) No Relief From High Inflation No Relief From High Inflation Finally, we see that shelter CPI increased by 0.61% in May, up from 0.51% in April. Shelter is the most cyclical component of CPI and as such it tends to closely track the unemployment rate. The unemployment rate has been flat at 3.6% for three consecutive months and it is more likely to rise than fall going forward. Therefore, we don’t anticipate further acceleration in shelter inflation during the next 6-12 months. Monetary Policy & Investment Implications At the last FOMC meeting, Chair Powell went out of his way to guide market expectations toward 50 basis point rate hikes at both the June and July FOMC meetings. After which, Powell hinted that the Fed would re-assess the economic outlook and would likely continue to lift rates at each meeting in increments of either 50 bps or 25 bps, depending on the outlook for inflation. Powell clearly wanted to set a firm marker down for the pace of rate hikes so that Fed policy doesn’t “add uncertainty to what is already an extraordinarily uncertain time.”1 For this reason, we don’t expect the Fed to lift rates by more than 50 basis points at any single meeting. However, May’s elevated CPI number will likely cause Powell to tease an additional 50 basis point rate hike for September. After September, if inflation finally does soften, the Fed will likely downshift to a pace of 25 bps per meeting. Taking a look at market expectations, we see that fed funds futures are fully priced for a 50 bps rate hike this week and are even discounting a small chance of a 75 bps hike (Chart 6A). Meanwhile, the market is almost fully priced for 125 bps of tightening by the end of the July FOMC meeting, i.e., one 50 bps hike and one 75 bps hike (Chart 6B). Looking out to the September FOMC meeting, we see the market priced for 180 bps of cumulative tightening (Chart 6C). This is consistent with a little more than two 50 basis point rate increases and one 75 basis point rate increase at the next three FOMC meetings. Chart 6AJune FOMC Expectations June FOMC Expectations June FOMC Expectations Chart 6BJuly FOMC Expectations July FOMC Expectations July FOMC Expectations Chart 6CSeptember FOMC Expectations September FOMC Expectations September FOMC Expectations   Looking even further out, we find the market priced for the fed funds rate to hit 3.28% by the end of the year and to peak at 3.88% in June 2023 (Chart 7).2 Chart 7Rate Expectations Rate Expectations Rate Expectations Our own expectation is that the Fed will deliver three or four more 50 basis point rate increases this year, followed by a string of 25 basis point hikes. This will bring the fed funds rate up to a range of 2.75% to 3.25% by the end of 2022, slightly below what is currently priced in the yield curve. As for portfolio duration, we recommend keeping it close to benchmark for the time being. Many indicators – such as economic data surprises, the CRB Raw Industrials/Gold ratio and the relative performance of cyclical versus defensive equities – suggest that bond yields are too high.3 That said, with inflation surprising to the upside and the Fed in a hawkish frame of mind, it is not wise to bet too aggressively on bonds. We also reiterate our view that investors should underweight TIPS versus nominal Treasuries. It’s notable that long-maturity TIPS yields moved higher and that the 10-year TIPS breakeven inflation rate was close to unchanged on Friday, despite the surprisingly high CPI number. This tells us that the market is not pricing-in a scenario where the Fed is losing control of long-dated inflation expectations. Rather, the market is discounting a scenario where the Fed does what is necessary to bring inflation back down. Softish Or Volckerish? Chart 8The Everything Selloff The Everything Selloff The Everything Selloff Of course, the big question for financial markets is whether the Fed will be forced to cause a recession to bring inflation down, or whether it will achieve what Jay Powell called a “softish” landing.4 The Fed’s hoped for “softish landing” scenario is one where inflation recedes naturally as we gain further distance from the pandemic. This outcome would limit the speed at which the Fed is forced to lift rates and push back the expected start date of the next recession. Unfortunately, trends in financial markets suggest that investors are putting less faith in the softish landing scenario. Our BCA Counterpoint Strategy recently observed that stocks, bonds, industrial metals and gold have recently all sold off in concert (Chart 8).5 It is rare for all four of these assets to sell off at the same time, but they did in 1981 when Paul Volcker was in the midst of dramatically lifting rates to conquer inflation. If we truly are on the cusp of the Fed tightening the economy into recession, then it makes sense for all four of those assets to perform poorly. Bond yields rise because the Fed is hiking much more quickly than was previously anticipated. Stocks and industrial metals sell off because of an increase in recession fears. Finally, gold sells off because of rising expectations that the Fed will do what it takes to bring inflation back down. And it’s not just financial markets that are warning that the Fed will be forced to repeat Chairman Volcker’s aggressive tightening. Two influential macroeconomists, Larry Summers and Olivier Blanchard, recently put out papers suggesting that the Fed needs another Volcker moment.6 Summers’ paper (with two co-authors) notes that changes in how the Bureau of Labor Statistics calculates shelter inflation make historical comparisons using CPI problematic. The authors estimate what core CPI would look like prior to 1983 if the current methodology had been employed and find that year-over-year core CPI peaked at 9.9% in 1980 well below the originally published figure of 13.6% and much closer to today’s 6% (Chart 9). The implication is that inflation is already almost as out of control now as it was in the early-1980s, and it will take a similar amount of monetary policy tightening to conquer it. In his paper, Olivier Blanchard makes a similar point by noting that the gap between the real fed funds rate and 12-month core CPI is as wide today as it was in 1975. The implication is that the Fed must play a similar amount of catch-up to bring inflation back down. Chart 9Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 We think comparisons to the early-1980s are mistaken for three reasons. First, the Fed targets PCE inflation not CPI and PCE inflation does not suffer from the methodological inconsistencies that Summers et al identified. If we look at core PCE inflation, of which data only go to April, we see that 12-month core PCE inflation is currently 4.9% compared to a peak of 9.8% in 1980 (Chart 10). In other words, there is still a fair amount of distance between today’s PCE inflation and what was seen in the early 1980s. Chart 10The Fed Targets PCE Inflation The Fed Targets PCE Inflation The Fed Targets PCE Inflation Second, inflation was more broadly distributed in the 1970s/80s than it is today. At different points in the 1970s and early-1980s all three of the major components of core inflation – goods, shelter and services excluding shelter – were above 10% in year-over-year terms (Chart 11). Today, only core goods inflation has moved above 10% and year-over-year shelter and services ex. shelter inflation sit at 5.4% and 4.8%, respectively. Chart 11Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Finally, wages had been accelerating rapidly for a full decade before inflation peaked in 1980 and this led to the emergence of a wage/price spiral (Chart 12). Firms increased prices to compensate for rising labor costs and then employees demanded further wage gains to compensate for rising consumer prices. Today, the evidence of a wage/price spiral is far less convincing. Wage growth has just recently moved above 5%, and we have seen recent indications that it is already starting to moderate.7  Typically, it takes a prolonged period of rapid wage growth for long-dated inflation expectations to rise and for a wage/price spiral to take hold. At present, we have seen only a modest move up in long-dated inflation expectations (Chart 13) and, as noted above, market-based measures of long-dated inflation expectations barely budged in response to last Friday’s inflation report. Chart 12No Wage/Price Spiral Yet No Wage/Price Spiral Yet No Wage/Price Spiral Yet Chart 13Inflation Expectations Inflation Expectations Inflation Expectations The bottom line is that inflation is still more likely to fall than rise during the next 6-12 months, and this will prevent the Fed from tightening more quickly than what is already priced in the yield curve. That said, while inflation is likely to dip, it will remain above the Fed’s 2% target and a recession will eventually be required to restore price stability. That recession, however, may not occur until late-2023 and it will likely be preceded by far less aggressive monetary tightening than what Paul Volcker delivered in the early-1980s.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  For more details on the Fed’s forward guidance please see US Bond Strategy Weekly Report, “On A Dovish Hike And A 3% Bond Yield”, dated May 10, 2022. 2 These numbers are as of last Friday’s close. 3 For details on these indicators please see US Bond Strategy Webcast, “Will The Fed Get Its Soft Landing?”, dated May 17, 2022. 4 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.pdf 5 Please see BCA Counterpoint Weekly Report, “Markets Echo 1981, When Stagflation Morphed Into Recession”, dated May 19, 2022. 6 Please see Bolhius, Cramer, Summers, “Comparing Past and Present Inflation”, June 2022. https://www.nber.org/papers/w30116. And also Blanchard, “Why I worry about inflation, interest rates, and unemployment”, March 2022. https://www.piie.com/blogs/realtime-economic-issues-watch/why-i-worry-about-inflation-interest-rates-and-unemployment.  7 Please see US Bond Strategy Portfolio Allocation Summary, “The Case For A Soft Landing”, dated June 7, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns