Inflation/Deflation

Executive Summary Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Following the re-normalization of economic activity after reopening, China’s recovery will be U-shaped, rather than V-shaped. Global manufacturing and exports are heading into contraction. Contracting global trade is bullish for the trade-weighted US dollar given that it is a counter-cyclical currency. A hawkish Fed is also positive for the greenback. Hence, the US dollar will likely overshoot. EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Asian Currencies Will Depreciate Bottom Line: Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Feature Global equity and fixed-income portfolios should maintain an underweight allocation to EM. That said, we will likely be upgrading EM versus DM later this year. EM currencies have more downside. Global and EM risk assets will likely continue selling off. Our major macro themes remain intact. Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Meanwhile, global growth is slowing rapidly, and global trade volumes are on the verge of contracting. US and EU demand for consumer goods (ex autos) is set to shrink.  EM ex-China domestic demand will be weakening from already very low levels.  Following the re-normalization of Chinese economic activity after the reopening, China’s recovery will be U-shaped, rather than V-shaped. Overall, global profits − including US and EM –will contract. Our bias is that equity markets have not fully discounted a profit contraction. The combination of shrinking corporate profits and a hawkish Fed  that is focused on taming inflationary pressures is bearish for global stocks and risk assets. As long as the Fed maintains its hawkish bias and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The USD will likely overshoot in the near term. Contracting global trade is bullish for the counter-cyclical greenback. EM currencies will therefore continue to depreciate, weighing on EM bonds and stocks. Typically, EM stocks do not out outperform DM ones when the dollar is strengthening. Even though global risk assets have already sold off significantly and there is a temptation to buy, odds are high that there will be another downleg. Several markets are already breaking down below their technical support lines: The Nasdaq 100 index is slipping below its 3-year moving average which proved to be a major support in past selloffs (Chart 1, top panel). The average exchange rate of AUD, NZD and CAD (which are all cyclical commodity currencies) versus the US dollar has fallen below its 3-year moving average (Chart 1, bottom panel). In the commodity space, we have similar breakdowns. Share prices of gold mining companies, silver prices and the silver-to-gold price ratio have all clearly crossed below their 3-year moving averages (Chart 2). Chart 1Breakdowns in The Nasdaq 100 And Commodity Currencies Chart 2Precious Metal Prices Are Breaking Down Too   Emerging Asian financial markets underscore that growth is relapsing and demand for raw materials is weak. The top panel of Chart 3 illustrates that Korean materials stocks have broken below their 3-year moving average. Further, in China, rebar steel, rubber, cement and plate glass prices are all falling (Chart 3, middle and bottom panels). Chart 3Bearish Signals For Raw Materials From Asia The charts below provide more evidence, supporting our macro themes and investment strategy. Investment Conclusions Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Global equity and fixed-income portfolios should continue underweighting EM. That said, we will likely be upgrading EM versus DM later this year. The US dollar has more upside. EM/Asian FX and commodity currencies are vulnerable. 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 buying opportunity in global and EM risk assets will emerge once US Treasury yields roll over decisively, the US dollar begins its descent and China provides more stimulus. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com The US Equity Bear Market: How Advanced Is It? If this US equity selloff is part of an ongoing bull market that began in 2009, then the drop in share prices is probably over. However, if this same bull market has reached its end, then this selloff has further room to go. Our best guess is that it is the latter, i.e., we might be witnessing the end of the S&P 500 bull market that commenced in 2009. Our S&P 500 Capitulation Indicator is low, but it can drop further. Also, the S&P 500 will likely break below its 3-year moving average, which acted as a support in the 2011, 2015-16 and 2018 selloffs. Chart 4The US Equity Bear Market: How Advanced Is It? US Corporate Credit And Share Prices The US corporate credit market does not yet point to a durable bottom in US share prices. Rising corporate HY ex-energy bond yields, and the underperformance of HY ex-energy corporate credit versus IG credit, point to lower share prices for now. Chart 5US Corporate Credit And Share Prices Chart 6US Corporate Credit And Share Prices The US Inflation Genie Is Out Of The Bottle US labor demand is outstripping labor supply by a record margin since 1950. US wages have accelerated and will remain sticky in the coming months. High wage growth and weaker output entail rising unit labor costs. The latter is a key driver of core inflation. Unless the unemployment rate rises, US core inflation will not drop below 3.5-4%. In fact, median and trimmed-mean CPI have continued rising even though core CPI has rolled over. Chart 7The US Inflation Genie Is Out Of The Bottle Chart 8The US Inflation Genie Is Out Of The Bottle       Chart 9The US Inflation Genie Is Out Of The Bottle Chart 10The US Inflation Genie Is Out Of The Bottle   US Manufacturing Is Downshifting Rapidly Railroad carload is declining, and new orders from the US regional Feds’ manufacturing surveys are in free fall. The ISM new orders index will drop below the critical 50 line. Chart 11US Manufacturing Is Downshifting Rapidly Chart 12US Manufacturing Is Downshifting Rapidly Chart 13US Manufacturing Is Downshifting Rapidly     The US Is Entering A Major Growth Slump US household demand for consumer goods ex-autos will shrink. The basis is excessive goods purchases in the last two years, falling household disposable income in real terms and a shift in preference for services versus goods. US retail inventories of consumer goods ex-autos have surged. Retailers will substantially cut back on their orders. Asian/Chinese exports are set to shrink. US consumption of gasoline is also contracting. Chart 14The US Is Entering A Major Growth Slump Chart 15The US Is Entering A Major Growth SlumpChart 16The US Is Entering A Major Growth Slump       Global Manufacturing And Exports Are Heading Into Contraction The relative performance of global cyclical stocks versus defensives points to a major relapse in global manufacturing. Chinese import volumes have been contracting and EM import volumes will drop too with the deteriorating purchasing power of households across many developing economies. Chart 17Global Manufacturing And Exports Are Heading Into Contraction Chart 18Global Manufacturing And Exports Are Heading Into Contraction Chart 19Global Manufacturing And Exports Are Heading Into Contraction     Contracting Asian Exports Are Negative For Asian Currencies There are already signs of contraction in Asian manufacturing/exports. Downshifting global trade typically leads to Asian currency depreciation. Chart 20Contracting Asian Exports Are Negative For Asian Currencies Chart 21Contracting Asian Exports Are Negative For Asian Currencies       Chart 22Contracting Asian Exports Are Negative For Asian Currencies Chart 23Contracting Asian Exports Are Negative For Asian Currencies   The USD Has More Upside, EM FX More Downside The EM ex-China currency total return index has failed to break above its technical resistance line. This entails a major downside. The underperformance of global cyclicals versus defensives points to lower Asian currencies. The US dollar (shown inverted on Chart 24) will be supported by a deceleration in global US dollar liquidity. Chart 24The USD Has More Upside, EM FX More Downside Chart 25The USD Has More Upside, EM FX More Downside     Chart 26The USD Has More Upside, EM FX More Downside EM Equity Capitulation Our EM Equity Capitulation Indicator has dropped significantly but is still above its 2008, 2015-16 and 2020 lows. Given the global and EM macro backdrops, odds point to an undershoot in EM share prices. Chart 27EM Equity Capitulation EM Equity And Bond Sentiment Investor sentiment on EM stocks and EM USD bonds is downbeat. This is positive from a contrarian perspective. However, as global risk assets continue selling off and the US dollar overshoots, EM stocks and bonds might undershoot. Chart 28EM Equity And Bond Sentiment Chart 29EM Equity And Bond Sentiment EM Equity Valuations And Profits Based on our cyclically adjusted P/E ratio, EM equity valuations have improved to one standard deviation below the mean. Relative to the S&P 500, EM stock valuations are at their record low based on a similar measure. Nevertheless, EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Chart 30EM Equity Valuations And Profits Chart 31EM Equity Valuations And Profits       Chart 32EM Equity Valuations And Profits Chart 33EM Equity Valuations And Profits   Four Large-Cap EM Stocks The four largest EM stocks (by market value) might not be out of the woods. Alibaba is facing resistance at its 200-day moving average. Tencent, TSMC and Samsung will likely drop to their next technical support lines. Chart 34Four Large-Cap EM Stocks Chart 35Four Large-Cap EM Stocks       Chart 36Four Large-Cap EM Stocks Chart 37Four Large-Cap EM Stocks   Chinese And EM ex-China Stocks The rally in the Chinese onshore CSI 300 stock index will probably dwindle at its 200-day moving average. Technical supports have held up for Chinese investable TMT and non-TMT stocks. However, the recent rebound is unlikely to be sustained if the global selloff continues. Finally, EM ex-China stocks have been in a free fall. Chart 38Chinese And EM ex-China Stocks Chart 39Chinese And EM ex-China Stocks       Chart 40Chinese And EM ex-China Stocks Chart 41Chinese And EM ex-China Stocks   Global Cross-Asset Interlinkages Rising US TIPS yields will keep upward pressure on EM local bond yields and downward pressure on EM currencies. The mainstream EM ex-China currencies are not cheap. Without EM currencies rallying, it will be difficult for EM stocks to outperform DM ones. Chart 42Global Cross-Asset Interlinkages Chart 43Global Cross-Asset Interlinkages Chart 44Global Cross-Asset Interlinkages     A Structural Breakdown In Chinese Real Estate The Chinese real estate market is experiencing a structural breakdown, as is illustrated by the collapse in share prices of Chinese property developers and their corporate bond prices. The breakdown in property developers’ financing heralds lower construction volumes with negative implications for raw material prices. Chart 45A Structural Breakdown In Chinese Real Estate Chart 46A Structural Breakdown In Chinese Real Estate       Chart 47A Structural Breakdown In Chinese Real Estate Chart 48A Structural Breakdown In Chinese Real Estate   Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese imports of various commodities and goods have been contracting over the past 12 months. The resilience of commodity prices has not been due to China. As investors start pricing in the US economic downturn and the need for inflation protection wanes, commodity prices could gap down. Chart 49Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 50Chinese Domestic Demand Has Been Absent Over The Past 12 Months     Will The Pendulum Swing From Inflation To Deflation? The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion of their respective market value, respectively. This adds up to a combined $15 trillion or about 60% of US GDP, which already exceeds the wipeouts that occurred during the March 2020 crash and all other bear markets. Such wealth destruction and a hawkish Fed could swing the pendulum from inflation to deflation. Commodity prices are currently vulnerable. Stay tuned. Chart 51Will The Pendulum Swing From Inflation To Deflation? Chart 52Will The Pendulum Swing From Inflation To Deflation? Chart 53Will The Pendulum Swing From Inflation To Deflation?     Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Bank Credit Analyst

Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Feature Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.1 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.2 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.3 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. Footnotes 1This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 2 Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 3 A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.

Bank Credit Analyst

Highlights We now recommend that investors maintain a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds. We still believe that the US will likely avoid a recession over the coming year, but we are less convinced that this is true than we were a few months ago. The fact that mortgage rates have risen to neutral territory means it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand in the form of a sharp decline in real wages – are currently present or soon will be. In addition, the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Headline inflation has seemingly been a more impactful driver of long-term inflation expectations than core measures, implying that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints in order to contain rising inflation expectations. That would be clearly negative for economic growth and is potentially recessionary in nature. We see no compelling signs of an acceleration in European or Chinese growth that could act as a ballast to support the global economy. The European energy situation is worsening, China’s post-lockdown rebound has so far been tepid, and market-based indicators of Chinese economic growth are deteriorating. The US equity market is not priced for a typical “income-statement” recession induced by monetary policy. We expect the S&P 500 to fall to 3100 in a recession scenario, driven mostly by declining earnings. In a recession scenario, we do not expect long-maturity government bond yields to fall enough to offset a likely increase in the equity risk premium. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight, or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we soon see a substantial slowdown in the US headline inflation rate. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Downgrading Risky Assets To Neutral Every month, BCA strategists hold a house view meeting to discuss the most important issues driving the macroeconomy and financial markets. As highlighted in a recent Special Alert from our Global Investment Strategy service,1 BCA strategists voted at our June meeting to change our House View to a neutral asset allocation stance towards equities, with a slight plurality favoring an outright underweight. Table I-1We Now Recommend More Conservative Positioning Than We Did In May The view of the Bank Credit Analyst service is in line with the consensus of BCA strategists on this issue, and we consequently recommend a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds (Table I-1). We noted in our April report2 – when the S&P 500 index stood at 4530 – that the outlook for equities had deteriorated meaningfully since the beginning of the year and that investors should maintain at most a very modest overweight toward equities in a global multi-asset portfolio. A formal downgrade to neutral is thus not a large change in our recommended positioning, but it reflects what we view as a legitimate increase in the odds of a US recession over the coming year. It is not yet our view that a US recession is a probable outcome, but it is important to distinguish between one’s forecast of the economic outlook and the appropriate investment strategy. The unique inflationary pressure created by the COVID-19 pandemic has created a large confidence interval around our forecast, underscoring that an aggressive stance towards risky assets is not warranted. Financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see a substantial slowdown in the US headline inflation rate. But as we will discuss below, that slowdown will have to materialize soon in order for us to recommend an overweight risky asset stance. Reviewing Our Previously Constructive View On US Economic Growth Chart I-1Recessionary Concerns Have Escalated Significantly Since The 2-10 Yield Curve Inverted Concerns about a potential US recession have been growing since the Fed’s hawkish pivot in November, especially following Russia’s invasion of Ukraine. Previously, these concerns centered around two core issues: the aggressive pace at which the Fed communicated it would raise the policy rate, and the fact that the 2-10 yield curve flattened sharply in the first quarter and finally inverted (based on closing prices) on April 1st (Chart I-1). We had pushed back against those concerns, for several reasons. Our deeply-held view is that recessions typically occur when a significant shock to aggregate demand emerges against the backdrop of tight monetary policy. Sometimes the debt-service and credit demand impact of high interest rates itself is the shock. In other cases, recessions have been triggered in an environment of restrictive monetary policy by a sudden change in key input costs (such as oil prices), the bursting of a financial asset bubble, or a major shift in fiscal spending (typically following a period of war). But the core point is that recessions rarely occur when monetary policy is easy, even when shocks to aggregate demand occur. We abstract here from special cases such as the recession that occurred during the early phase of the COVID-19 pandemic. That event saw the introduction of government policies that purposely arrested economic activity, which in our view would have caused a recession under any conceivable fiscal and/or monetary policy alignment. As a business cycle indicator, the yield curve is significant for investors because it essentially represents the bond market’s assessment of the monetary policy stance. The 2-10 yield curve inversion in early April occurred, in part, because of the speed at which the Fed signaled it would raise interest rates, but also because the 10-year Treasury yield stood just under 2.4% at the point of inversion. This level of long-maturity bond yields reflected the view of both the Fed and most investors that the neutral rate of interest permanently fell following the 2008/2009 global financial crisis (GFC), a view that we have argued against in several previous reports.3 As such, the first reason we pushed back against earlier recessionary concerns is that we believe that the natural/neutral rate of interest is higher than the Fed and investors believe (even though we warned that a recessionary scare was quite likely). Chart I-2A Large Portion Of Currently Elevated Inflation Is Due To Supply-Side And Pandemic-Related Factors The second reason that we had pushed back against recessionary concerns was our view that a meaningful portion of currently elevated US inflation is a function of supply-side and pandemic-related factors that will eventually abate. Chart I-2 highlights credible estimates showing that roughly half of the year-over-year change in the headline PCE deflator is the result of supply-side factors, versus 40-50% for core inflation. It has been and remains our view that a substantial portion of these supply-side and pandemic-related factors will dissipate as the pandemic continues to recede in importance, with several price categories likely to deflate outright. Chart I-3Excess Savings Should Still Support Higher Services Spending Finally, we have argued in several reports that US goods spending has been well above-trend and is likely to slow, but also that services spending is far too low and is likely to rise. Chart I-3 highlights that close to $3 trillion in excess savings have accrued during the pandemic, which formed because of a combination of rising disposable income and falling services spending. We noted that the continued transition of the US and global economies towards a post-pandemic state would boost services spending, providing (an admittedly atypical) source of support for overall aggregate demand.   Why The Odds Of A US Recession Have Increased We still believe that the US will more likely than not avoid a recession over the coming year, but it is true that the strength of all three of the arguments presented above has weakened. Regarding the stance of monetary policy, Charts I-4 and I-5 highlight that it is still true that the Fed funds rate and 5-year/5-year forward Treasury yields remain below our estimate of the neutral rate (nominal potential GDP growth). However, Chart I-6 highlights that the sharp rise in consumer price inflation has caused a substantial reduction in real wage growth, which certainly constitutes a non-monetary aggregate demand shock. Chart I-4The Policy Rate Is Not Yet At Neutral, But Mortgage Rates Are Chart I-5Long-Maturity Government Bond Yields Would Have Room To Move A Lot Higher Absent Any Shocks To Demand...       Chart I-6...Unfortunately, US Consumers Are Clearly Experiencing A Shock In The Form Of Sharply Lower Real Wages Panel 2 of Chart I-4 also shows that the 30-year mortgage rate in the US is now at neutral levels, in contrast to government bond yields and the US policy rate. Chart I-7 highlights that our models for US home sales and starts, featured in last month’s report,4 are still not pointing to a severe slowdown in the housing market. However, the fact that mortgage rates have risen to neutral territory means that it is possible that the usual ingredients for a recession – tight monetary policy plus a shock to aggregate demand – are currently present or soon will be. On the question of services spending acting as a support for US economic growth as goods spending slows, we continue to believe that services spending will recover back towards its pre-pandemic trend – funded by excess savings that accrued during the pandemic. However, Chart I-8, presented by my colleague Arthur Budaghyan in a recent Emerging Markets Strategy report,5 underscores the extent of the wealth destruction that has occurred because of the joint effect of falling stock and bond prices. At least some of the services-boosting effect of excess savings will likely be blunted by a negative wealth effect stemming from these financial market losses, especially since the remaining excess savings in the US are likely held by middle-to-upper income households – who are the disproportionate holders of publicly-traded financial assets. Chart I-7No Sign Yet Of A Sharp Slowdown In The Housing Market, But The Ingredients Of A Typical Recession May Be Present Chart I-8A Significant Wealth Shock May Blunt The Deployment Of The Excess Savings Accrued During The Pandemic   On the inflation front, the May CPI release – and the Fed’s reaction to it – underscores that the US economy is at risk of a recession unless supply-side inflation dissipates quickly. Chart I-9 highlights that the May CPI release directly contradicted the view that the monthly rate of change in inflation has peaked. In addition, Chart I-10 presents a breakdown of the percent change in May’s headline consumer price index, with each bar in the chart representing the contribution of that category to headline CPI rising faster than 4% (annualized). The note next to each bar highlights our view of the main driver of that price category, and the color of the bars denotes how probable it is that we will soon see a significant easing in price pressure. Chart I-9The May CPI Report Was Clearly Inconsistent With A Peak Inflation Narrative Chart I-10Some Elements Of Outsized CPI Will Dissipate Soon. Others May Not.     The chart makes it clear that certain price categories that have been strongly contributing to outsized headline inflation are likely to peak or even turn deflationary over the next few months. Gasoline and fuel oil inflation is clearly being driven by the trend in crude oil prices, which in our view will likely be flat for the rest of the year. In addition, motor vehicles and parts inflation continues to be driven by the impact of supply-chain shortages on vehicle production. Over the past year, the volume of industrial production of motor vehicle assemblies has averaged just 83% of its pre-pandemic level, which we noted in last month’s report now finally seems to be normalizing (Chart I-11). And while airlines have experienced legitimate cost increases due to rising fuel prices and COVID-related labor shortages, panel 2 of Chart I-11 highlights that real airfares have risen well above their pre-pandemic level. This underscores that a moderation in airfares is quite likely over the coming several months. However, Chart I-10 also highlights that there are several price categories that are less likely to ease quickly. Outsized food and energy services inflation has recently been tied to natural gas prices, given that natural gas is used to generate electricity and is a key element used in the production of fertilizer. Chart I-12 highlights that food inflation has been strongly correlated with the producer price index for pesticide, fertilizer, and other agricultural chemicals, and that there is no sign yet of the latter abating. Despite the fact that global wheat prices have recently been falling, the recent increase in European natural gas prices is likely to exacerbate US food inflation, as fertilizer is used to produce all major planted crops. In addition, European energy insecurity has created an even stronger link between the US and European natural gas markets than what prevailed prior to the Ukrainian war, because of what is likely to be permanently higher LNG demand from Europe. Chart I-11Vehicle And Airfare Inflation Is Likely To Ease Soon Chart I-12Food Inflation May Remain Elevated For Some Time   On top of what is likely to be persistent food and energy services inflation, shelter inflation is likely to stay elevated for some time – a point highlighted by my esteemed former colleague, Martin Barnes, in Section 2 of this month’s report. The unemployment rate and house prices are the two main drivers of shelter inflation, and the effect of the latter clearly lags because owner’s equivalent rent is a surveyed measure. The fact that mortgage rates have risen so significantly points to a meaningful slowdown in house price appreciation and possibly even mild deflation, so shelter inflation will eventually slow. The Federal Reserve has made it clear, however, that they are now focused on quickly bringing down consumer prices, even at the cost of a recession. The justification for the Fed’s impatience comes straight from the Modern-Day Phillips Curve, which we discussed in great detail in our January 2021 Special Report.6 Economic theory dictates that inflation should be “normal” when the economy is in equilibrium – defined as economic growth in line with potential growth, no economic/labor market slack, and no supply-side shocks affecting prices. In the minds of many investors, “normal” inflation means the central bank’s target for inflation, but that is not necessarily the case. The experience of the 1970s highlighted that “normal” inflation is the rate that is expected by households and firms, and that the Fed will only succeed at achieving target inflation under normal economic conditions if inflation expectations are consistent with its target. The Fed’s failure to prevent inflation expectations from shifting higher on a structural basis led to two debilitating recessions in the early 1980s, and a prolonged period over which the Fed had to maintain comparatively tight monetary policy. This is a mistake that the Fed does not want to make again. Chart I-13Headline Inflation, Not Core, Is Driving Long-Term Inflation Expectations Consistent with that view, Jerome Powell made it clear during the June FOMC meeting press conference that the Fed is now very concerned that long-term household inflation expectations may become unanchored to the upside. Powell implicitly referenced the University of Michigan’s 5-10 year median household inflation expectations survey during the press conference, which we have described in several previous reports as one of the most important macro data series for investors to monitor. The final reading for June came in materially lower than what was suggested by the preliminary report, but they were already at risk of a breakout even before the June release. In addition, Chart I-13 highlights that it is headline inflation (not core) that appears to be the main driver of rising long-term household inflation expectations, which raises a troubling point. If the Fed decides that inflation expectations need to be quickly reined in even at the cost of a higher unemployment rate, that decision implies that it is headline inflation that needs to return rapidly towards the Fed’s target, not just core. Given that some price categories shown in Chart I-10 are likely to be sticky for some time, and that the chart accounted for deviations in headline inflation from 4% (which itself is above the Fed’s target), the implication is that the Fed may have to crowd out demand for goods and services that are comparatively less affected by supply-side constraints. That would be clearly negative for economic growth, and is potentially recessionary in nature. As a final point, it is not just the potential for future economic weakness that concerns us. The US economy was already slowing prior to the Fed’s hawkish pivot and Russia’s invasion of Ukraine, and important indicators for economic activity continue to deteriorate. Chart I-14 highlights that the S&P Global US manufacturing and services PMIs fell meaningfully in June, and Chart I-15 highlights that the Conference Board’s US leading economic indicator continues to deteriorate. In fact, the Conference Board’s LEI has now decreased for three consecutive months, and the bottom panel of Chart I-15 highlights that four consecutive month-over-month declines have all essentially been associated with a recession. 2006 seemingly stands out as an exception to this rule, but given the fact that the housing market downturn began two years before the recession officially started, we simply regard this as an early recessionary signal rather than a false one. Chart I-14The US Is Losing Economic Momentum Chart I-15The Conference Board's LEI May Soon Send A Recessionary Signal     No Help From Europe Or China An overweight stance towards global equities might still be warranted in the face of a significant slowdown in US economic activity if economic growth in Europe or China were accelerating. However, the European outlook has been strongly tied to natural gas flows from Russia since the invasion of Ukraine, which tightened meaningfully in June in response to Europe’s oil ban, the looming expansion of NATO, and Europe’s success at replenishing its amount of natural gas in storage. Russia has not fully weaponized its natural gas exports and its actions so far have fallen well short of a complete cutoff, but prices have risen close to 70% over the past month, forcing Germany to trigger the alert level of its emergency gas plan. Aside from the negative impact that higher natural gas prices will have on headline inflation globally, this is obviously incrementally negative for European economic activity. Chart I-16 highlights that the German IFO business climate indexes have led the S&P Global Germany PMI lower over the past few months, and that they imply further manufacturing weakness. And while the services climate index for Germany ticked higher, it remains meaningfully below the levels that prevailed last summer and implies a deterioration in German services activity over the coming few months. In China, we see no compelling signs of a sustainable pickup in economic activity that will provide a ballast to slowing growth in the DM world. We have seen a bounce back in some activity indicators following the significant easing of restrictions in Shanghai and Beijing (Chart I-17). These indicators, however, are still quite weak, and it is likely that China will experience significant further COVID outbreaks over the coming 6-12 months. Chart I-16Europe's Economy Is Likely To Slow Further Chart I-17China's Post-Lockdown 'Recovery' Remains Tepid   While Chinese stocks have been rallying in absolute terms over the past few weeks, Chart I-18 highlights that this is essentially the only positive market-based signal about the pace of economic activity in China. The chart highlights that our market-based China Growth Indicator has experienced a renewed down leg, and that the diffusion index never rose above the boom/bust line earlier this year. The recent decline in industrial metals prices is also not a positive market-based signal for Chinese economic activity (Chart 19). Some investors have argued that weak metals prices reflect growth concerns outside of China, but even if that is the case, it implies that China’s reopening will not be forceful enough to offset slowing global ex-China growth. Chart I-18Market-Based Signals Are Not Pointing To An Improvement In Chinese Economic Activity Chart I-19Metals Prices Are Now Falling, Highlighting Mounting Global Growth Fears   Has The US Equity Market Already Priced In A Recession? One very important question for investors to answer is how much further downside is likely to occur for US equities in the event of a US recession. At its worst point in mid-June, the S&P 500 fell close to 24% from its early January high, and many investors have since questioned whether the US equity market is already priced for a potential contraction in output. Chart I-20The S&P 500 Is Not Currently Priced For A US Recession We disagree with this perspective, and believe that the S&P 500 would fall close to 3100 in a typical recession scenario. Chart I-20 presents a range of estimates for the S&P 500 based on a Monte Carlo approach, using what we believe are feasible ranges for the US equity risk premium, real 10-year government bond yields, and the extent of the decline in 12-month forward earnings per share. The chart shows that the equity market only has a positive return at the 5th percentile, which can be interpreted as just a 5% chance that the US equity market has already priced in the impact of a recession. Charts I-21 and I-22 highlight the range of possible outcomes that we used when modeling the likely decline in stock prices in a recession scenario. We assume that the equity risk premium, defined here as the difference between the S&P 500 12-month forward earnings yield and 10-year TIPS yields, rises on average to its early-March level in the wake of Russia’s invasion of Ukraine. We assume that both 10-year nominal Treasury yields and 10-year breakeven inflation rates fall to 2%, reflecting an expectation that 10-year TIPS yields will not return to negative territory in a recessionary scenario. Finally, we expect that S&P 500 forward EPS will decline by 15% from current levels, which is in line with the historical average decline in 12-month trailing operating EPS during recessions. Chart I-21We Do Not Expect Real Bond Yields To Fall Back Into Negative Territory In A Typical Recession Scenario Chart I-22We Expect Earnings To Decline Between 10-20% In A Recession     One key takeaway from our analysis is that the likely recessionary equity market decline projected by our approach is fairly close to our estimate of the likely decline in earnings. One potential pushback against our view that earnings will fall in line with what usually occurs during recessions is the fact that nominal revenue growth may only mildly contract or may not contract at all in a recession that is occurring due to high rates of inflation (and thus higher prices charged by firms). Chart I-23 highlights that 12-month trailing S&P 500 sales per share growth never turned negative in the 1970s, even following the 1970 and 1974 recessions. Chart I-23Revenue Growth Did Not Contract In The 1970s, And May Not Contract Significantly If A Recession Occurs Today... There are two counterpoints to this argument. First, the current risk of a recession mostly stems from the Fed’s determination not to repeat the mistakes that it made during the 1970s, meaning that inflation expectations are unlikely to rise to the level that they did during that period in advance of a recession. That implies that actual inflation, and thus corporate pricing power, will come down significantly during a recession. Second, even in a scenario in which a recession occurs and S&P 500 revenue growth contracts less aggressively than it has during previous recessions, Chart I-24 highlights that the mean-reversion risks to earnings from falling profit margins are quite high. The chart shows that even if profit margins were merely to return to their pre-pandemic levels during a recession (which would actually be a comparatively mild decline given the historical behavior of margins during recessions), it would imply close to a 20% contraction in earnings if sales per share growth were flat. Given this, we feel that our assumption of a 10-20% decline in earnings per share in a recessionary scenario is reasonable. Chart I-24But Profit Margins Are At Great Risk Of A Significant Decline If The Economy Contracts There is another important takeaway from our analysis, which is that the decline in bond yields that will occur in a recessionary scenario will likely be more than offset by a rise in the equity risk premium. Another potential pushback against our view that the US equity market has already priced in a recession is focused on our assumption that the 10-year US Treasury yield will only fall back to 2%, and that real 10-year yields will not return to negative territory. For some investors, this assumption seems far too high, given the structural decline in long-maturity bond yields over the past decade and the fact that the 10-year yield stood below 2% at the beginning of the year when the odds of a recession were lower than they are today. In response to this, we offer three points for structurally-bullish bond investors to consider. The first is that the decline in the nominal 10-year US Treasury yield to 0.5% in 2020 was extremely irregular and it occurred because of the extent of the essentially unprecedented economic weakness wrought by the pandemic. This is absolutely the wrong yield benchmark to use in a typical recession scenario, because the Fed’s response to the recession will be much less aggressive. The second point is related to the first, in that negative real 10-year government bond yields have been heavily driven by the secular stagnation narrative and the general view that the natural/neutral rate of interest has permanently fallen. We agree that the neutral rate of interest fell for a time following the global financial crisis, but we believe strongly that it rose in the latter half of the last economic expansion as US households aggressively deleveraged their balance sheets. Academic estimates of R-star, such as that derived from the previously popular (but now discontinued) Laubach-Williams model, continued to point to a low neutral rate from 2015-2019 because of the deflationary impact of an energy-driven decline in long-term inflation expectations on actual inflation, a factor that is clearly no longer present. Chart I-25We Doubt That The Fed Will Resort To QE When The Next Recession Occurs Finally, we agree that the existence of the Fed’s asset purchase program has likely had some impact on the 10-year term premium over the past decade. We doubt that the Fed would resort to QE as a monetary policy tool in response to a conventional recession, implying that the term premium will not fall as low as it has over the past decade when growth slowed or contracted. Chart I-25 highlights one important reason for this. Since 2008, the Fed’s use of asset purchases has been part of a strategy to ease monetary policy further when the policy rate had already fallen to zero, to meet its dual mandate of maximum employment and price stability. The chart highlights that even just prior to the pandemic, a persistent gap existed between the headline and core PCE deflator and the level that would have prevailed if both deflators had grown at a 2% annual rate since the onset of the 2008 recession. The chart makes it clear that this gap will completely disappear within the next 12 months for both the headline and core deflator, if the recent pace of change in prices is sustained. In effect, Chart I-25 highlights that the entire post-GFC missed inflation-target era is almost over, which severely undercuts the idea that the Fed will resort to QE as a monetary policy tool in a recession scenario unless the contraction is very severe as it was in 2008 and 2020. We doubt that this will be the case if a recession does occur, implying that both a deeply negative term premium and a significant decline in the 5-year/5-year forward bond yield in a typical recession scenario is unlikely. Investment Conclusions Wayne Gretsky’s famous quotation, that he “skate[s] to where the puck is going, not where it has been” is often invoked by BCA strategists. Successful active investing requires anticipation rather than reaction, and it is legitimate for investors to ask whether downgrading risky assets at the current juncture represents the latter rather than the former. We are cognizant of that risk, but we are also mindful of the importance of capital preservation. When we wrote our annual outlook last year, we believed fairly confidently that inflation would peak and specifically that supply-side inflation would wane. We still believe that pandemic-related effects on consumer prices will eventually dissipate, and it is still possible that inflation is in the process of peaking. Recent evidence, however, about the pace of price advances, the clear impact that high inflation is having on real wage growth, and the Fed’s desire to see consumer prices fall quickly back toward its target, means that the cyclical economic outlook is now highly dependent on the speed at which prices normalize – not just whether it will occur. To us, that implies that investors need to have a high-conviction view that supply-side inflation will normalize soon in order to stay overweight risky assets, and that the Fed will look through elevated housing-related inflation that is likely to persist for several months. At least in the case of supply-side inflation, we think normalization is probable but we no longer have high conviction about the speed of adjustment. As such, we recommend that investors maintain no more than a neutral stance towards stocks versus bonds in a global multi-asset portfolio. We also recommend that investors increase their allocation to government bonds within a global fixed income portfolio (to overweight), at the expense of corporate bonds, as part of an overall shift towards more defensive positions. In terms of other important asset class allocations, we recommend the following: Within a global equity portfolio, maintain a neutral regional allocation, a neutral stance toward cyclicals versus defensives, and a neutral stance towards small-cap stocks versus their large-cap peers. Modestly favor value stocks over growth stocks, as most of the outsized outperformance of growth stocks during the pandemic has already reversed. Within a fixed-income portfolio, a modestly short stance is warranted over the coming 6- to 12-months. Extremely stretched technical and valuation conditions point to a bearish view towards the US dollar over the coming 6- to 12-months, but USD will likely remain well-bid over the nearer-term. We are only likely to upgrade our cyclical USD call in a scenario in which we recommend underweighting global equities within a multi-asset portfolio. As noted above, financial markets rarely trend sideways over 6-to-12 month periods. We regard a neutral global asset allocation stance as a temporary stepping stone to either a further downgrade of risky assets to underweight or an increase in risky asset exposure back to a high-conviction overweight. Thus, additional changes to our recommended cyclical allocation may occur over the coming few months, in response to the incoming data and our assessment of the likely implications for monetary policy. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 30, 2022 Next Report: July 28, 2022 II.  Inflation Whipsaw Ahead Dear Client, This month’s Special Report has been written by Martin Barnes, BCA’s former Chief Economist. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for inflation. The views expressed in this report are his, and may not be consistent with those of the Bank Credit Analyst or other BCA Research services. But Martin’s warning of future stagflation is sobering, and I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Overly stimulative policies meant that inflation was set to rise even before the disruptions caused by the pandemic and Ukraine conflict. Inflation should decline sharply over the coming year in response to weaker economic growth and an easing in supply problems. But it will be a temporary respite. Central banks will not have the stomach to keep policy tight enough for long enough to squeeze inflation out of the system. Price pressures will return as economies bottom and the environment will become one of stagflation. Financial assets will rally strongly when inflation fears subside but subsequent stagflation will not be bullish for markets. Former Federal Reserve Chairman Alan Greenspan once defined price stability as existing when “households and businesses need not factor expectations of changes in the average level of prices into their decisions”. Until recently, that state of affairs was the case for much of the past 30 years and for many, inflation was quiescent during their entire working lives. But inflation is now back as a huge issue and there is massive debate and uncertainty about whether it will be a temporary or lasting problem. I lean toward the latter view. Major changes in the economic and/or financial environment more often are identified in hindsight than in real time. It is easier to attribute large trend deviations to temporary factors than to make bold predictions about structural shifts. Obviously, the pandemic and conflict in Ukraine have had a significant impact on the near-term inflation picture via massive supply-side disruptions and represent temporary events. Thus, inflation will retreat from current elevated levels as those disruptions diminish. But the conditions for higher inflation were already in place before those two unfortunate events occurred. Specifically, central banks have been erring on the side of stimulus for several years and they will find it extremely difficult, if not impossible, to put the inflation genie back into the bottle. Inflation has moved from a non-issue to the most important factor driving markets. Over the next year, the next big surprise might be how fast inflation retreats and investors and policymakers will then breathe a big sigh of relief. However, this will prove to be a temporary respite because it will not take long for inflation to move back up and remain stubbornly above central bank targets. In other words, a whipsaw is in prospect over the next few years as inflation goes from up, to down, and to up again. The Current Inflation Problem The biggest increases in consumer prices have occurred in areas most affected by supply problems, with energy attracting the most attention. Nevertheless, in most countries, inflation has risen across the majority of goods and services. The core inflation rate (i.e. consumer prices excluding food and energy) in the G7 economies climbed from 2% to 4.8% between April 2021 and April 2022 (Chart II-1). Meanwhile, the Cleveland Fed’s trimmed mean measure of US consumer price inflation has spiked dramatically higher, consistent with a broad-based acceleration in inflation.7 The rise in underlying inflation is a bigger problem in the US, UK and Canada than in Japan or the Euro Area. Chart II-2 shows current core inflation rates relative to the target rate of 2% pursued by most central banks. That geographical divergence will be touched on later and in the meantime, the focus will be on the US situation. Chart II-1A Broad-Based Pickup In Inflation Chart II-2The US, UK And Canada Have A Bigger Inflation Problem   The latest US inflation data for a range of goods and services is shown in Table II-1. The table shows the three- and six-month annualized changes in prices because 12-month rates can be affected by a base effect given the impact of pandemic-related shutdowns and disruptions a year ago. Also, a comparison of the three- and six-month rates shows if momentum is building or fading. The trends are not encouraging in that momentum has accelerated, not diminished in many key areas. Table II-1Selected Inflation Rates In The US CPI Even if the data show a moderation in core inflation in the months ahead, it is important to note that rent inflation – the CPI component with the biggest weight – is seriously underestimated. This is one of the few items where prices are collected with a lag and real estate industry reports highlight that rent inflation is running at double-digit rates in the major cities. According to one report, average rents nationally increased by more than 25% in the year to May.8 The CPI data will eventually catch up with reality, providing at least a partial offset to any inflation improvements in other areas. Another problem for inflation is the acceleration in wage growth against the backdrop of an unusually tight labor market. Currently, the number of unfilled vacancies is almost twice the number of unemployed and it is thus no surprise that wage growth has picked up sharply (Chart II-3). The Atlanta Fed’s measure of annual wage inflation has risen above 6%, its highest reading since the data began in 1997. Wage growth is unlikely to suddenly decline absent a marked rise in the unemployment rate. There is much debate about whether the US economy is on the verge of recession, but let’s not get bogged down in semantics. Regardless of whether the technical definition of recession is met (at least two consecutive quarters of negative GDP growth), the pace of activity is set to slow sharply. Plunging consumer and business confidence, contracting real incomes and a peaking in housing activity all point to a significant weakening in growth, even if the labor market stays healthy (Chart II-4). Chart II-3A Very Tight US Labor Market Chart II-4The US Economy Is In Trouble   Softer economic growth eventually will take the edge off inflationary pressures in many goods and services. Combined with an easing in supply-side disruptions, the inflation rate is certain to decline in the coming year, even if oil prices move higher in the short run. Currently, the Fed is talking tough about dealing with inflation and there is little doubt that further rate hikes are on the way. However, policymakers will have little stomach for inflicting enough economic pain to completely squeeze inflation out of the system. Once there are clear signs of a significant economic slowdown, the Fed will back off quickly. What Causes Inflation Anyway? Economics 101 teaches that prices are determined by the interaction of supply and demand. If the demand for a good or service exceeds supply, then prices will rise to bring things back into balance. Seems simple enough but, unfortunately, this leaves many unanswered questions. How much must prices rise and for how long in order to restore balance? What if there are structural impediments to supply? What if there are monopolies in key commodities or services? What if policy interferes with the operation of market-clearing solutions? And, finally, what measure of inflation should we be looking at? Chart II-5Inflation Is A 'Modern' Issue For much of economic history, deflation was just as prevalent as inflation, with the latter only being a problem during periods of war (Chart II-5). As the pre-WWII world pre-dated fiat money, automatic stabilizers (e.g. the welfare state), and counter-cyclical fiscal policy, economies were prone to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. But those days are long gone and free market forces should not be expected to keep inflation under wraps. I rather like the simple explanation of inflation’s roots as being “too much money chasing too few goods”. In that sense, the control of inflation lies firmly at the door of central banks. In the “old days” (i.e. before the 1990s), it was possible to use the growth in the money supply to gauge the stance of policy because there was a fairly stable and predictable relationship between monetary and economic trends. That all ended when financial deregulation and the explosion in non-bank financial activities meant that monetary trends ceased to be a reliable indicator of economic growth and inflation. As a result, the Fed stopped setting monetary growth targets more than 20 years ago and since then, money supply data has rarely been mentioned in FOMC discussions. Chart II-6A Simple Measure Of The Monetary Stance Fortunately, all is not lost. The gap between the federal funds rate and nominal GDP growth is a reasonably good proxy for the stance of monetary policy. Conditions are easy when rates are persistently below GDP growth and vice versa when they are above. As can be seen in Chart II-6, rates were below GDP growth during most of the 1960s and 1970s, a period when inflation rose sharply. And inflation fell steadily in the 1980s into the first half of the 1990s when the Fed kept interest rates above GDP growth. And look at what has happened in the past decade: rates have been significantly below GDP growth, suggesting an aggressively easy monetary stance. It was only a matter of time before inflation picked up, even without the recent supply-side disruptions. The FOMC’s latest projections show long-run growth of 3.8% in nominal GDP while the fed funds rate is expected to average only 2.5%. That implies a continued accommodative stance, yet inflation is forecast to be in line with the 2% target. That all seems very unlikely. Fed policymakers spend a lot of time trying to figure out the level of the equilibrium real interest rate – the level consistent with steady non-inflationary economic growth. It would be very helpful to have this number but coming up with an accurate measure is a largely futile exercise. It cannot be measured empirically and its estimation requires a lot of assumptions, explaining why there is no broad agreement on what the right number is. I think there is a case for the simpler approach of using the nominal growth in GDP as a proxy for where rates should be in normal circumstances. As noted above, that suggests monetary policy was excessively accommodative for an extended period. If US Policy Was Too Easy, Why Was Inflation Low For So Long? The Fed’s preferred measure of underlying inflation is the change in the personal consumption deflator, excluding food and energy. In the 25 years to 2019, inflation by this measure averaged only 1.7%, compared to the Fed’s desired level of 2%. Thus, even though the level of interest rates implied very accommodative policy over that period, inflation remained tame. This leads to an important caveat. The stance of monetary policy plays the key role in driving inflation, but it is not everything. Offsetting forces on inflation (in both directions) can mute or even swamp the impact of policy. There were several disinflationary forces in operation during the past 25 years. Specifically: In the second half of the 1990s, the explosive growth of the internet and accompanying boom in technology spending led to a marked pickup in productivity growth. The entry of China into the World Trade Organization at the end of 2001 unleashed a wave of offshoring and downward pressure on traded goods prices. A series of deflationary shocks hit the US and global economy including the 1998 financial crisis in South-East Asia and Russia, the bursting of the tech bubble after 2000, and of course the global financial meltdown in 2007-09. Unstable economic conditions undermined labor’s bargaining power, keeping a tight lid on wage growth. This was highlighted by the dramatic decline in labor’s share of income after 2000. Importantly, the above forces are no longer in place and in some cases are reversing. The key technological advances of the past decade have not been particularly good for productivity. Indeed, one could argue that the activities of most so-called FANG stocks – especially those involved in social media - have had a negative impact on productivity. Time spent on FaceBook, Twitter and Netflix do not have obvious benefits for increased economic efficiency. Chart II-7Globalization In Retreat Even before the pandemic’s impact on supply chains, there were signs that globalization had peaked (Chart II-7). Indeed, BCA first suggested in 2014 that globalization was running out of steam. More recently, the interruption to supply chains has highlighted the downside of relying excessively on overseas production for key goods such as semi-conductors and pharmaceuticals. Onshoring rather than offshoring will become more common with higher prices being the cost for greater control over supply. Globalization is not dead, but, at the margin, it no longer is a powerful source of disinflation. US import prices from China are back to their highest level in a decade after falling steadily during the eight years to 2020. The inflationary impact of the pandemic and the war in Ukraine via supply-side disruptions are more than offsetting any disinflationary effects of softer economic growth. In other words, they have represented stagflationary rather than deflationary shocks. Finally, with regard to income shares, the pendulum has swung more in favor of labor. Demographic trends (e.g. slow growth in the working-age population) suggest that the labor market will remain relatively tight in the years ahead, notwithstanding short-term weakness as the economy slows. Profit margins are likely to weaken and labor’s share of income will rise. The bottom line is that easy money policies will no longer be offset by a number of powerful external forces that served to keep consumer price inflation under wraps in the pre-pandemic period. And this raises another important point. If monetary policy is too easy, then it will show up somewhere, even if consumer price inflation is under control. There Is More Than One Kind Of Inflation Inflation most commonly refers to the change in the prices of consumer goods and services. That is understandable because consumer spending accounts for more than half of GDP in the major developed economies (and almost 70% in the US). And because consumers are the ones who vote, it is the inflation rate that politicians care most about. However, there are other kinds of inflation. If there are structural impediments to increased consumer prices, then excessively easy monetary policy most likely will show up in higher asset prices. This is a very different kind of inflation because it is welcomed by the owners of assets and by politicians. Nobody is happy to face higher prices for the goods and services they buy, but asset owners love the wealth-boosting effect of higher prices for homes and shares.  Consumer inflation may have been subdued in the pre-pandemic decade, but the same is not true for asset prices. During the period that the Fed ran accommodative policies, there were several periods of rampant asset inflation such as the tech stock bubble of the late 1990s, the housing bubble of the 2000s, and the bond bubble of 2016-2020. And both equity and home prices surged in response to monetary stimulus triggered by the pandemic. Central banks may fret about the potential financial stability implications of surging asset prices, but in practice they do not act to curb them. Policymakers argue that it is hard to determine when an asset bubble exists and even when one is obvious, monetary policy is a crude tool to deal with it. If rising asset prices occur alongside an economy that is characterized by stable growth and moderate inflation, then acting to burst a bubble could inflict unnecessary economic damage. That is an understandable position, but it means ignoring the longer-term problems that occur when bubbles inevitably burst. This was highlighted by the economic and financial chaos after the US housing bubble burst in 2007. The reality is that central banks have been forced to rely more heavily on asset inflation as a source of monetary stimulus. An easing in monetary policy affects economic conditions in three primary ways: boosting credit demand and supply, raising asset prices, and lowering the exchange rate.9 Historically, the credit channel was by far the most important. BCA has written extensively about the Debt Supercycle and the role of monetary policy in fueling ever-rising levels of private sector indebtedness (see the Appendix for a brief description of the Debt Supercycle). Chart II-8No Releveraging Cycle In Household Debt The environment changed dramatically after the 2007-09 financial meltdown. The collapse of the credit-fueled housing bubble drove a stake through the heart of the household sector’s love affair with debt. The ratio of household debt to income peaked in early 2009 and ten years later it was back to the levels of 2001 (Chart II-8). Even an extended period of record low interest rates has failed to trigger a new leveraging cycle. If the Fed can’t persuade consumers and businesses to fall back in love with debt, then it must rely on the other two transmission channels for monetary policy – asset prices and the exchange rate. And the Fed really has limited control over the latter channel given that it also depends on the actions of other central banks. The deleveraging of the household sector in the post-2009 period could have been very bearish for the economy, but the Fed’s easy money policies underpinned the stock market, allowing household net worth to revive. There was an explosive rise in household net worth in 2020-21 as surging house prices added to stock market gains. Between end-2019 and end-2021, the household sector’s direct holdings of equities plus owner’s equity in real estate increased in value by around $20 trillion, equal to more than one year’s personal disposable income. The recent decline in equity prices has reversed some of the gains, but net worth remains elevated by historical standards. The bottom line is that it was wrong to suggest that the Fed’s accommodative stance did not create inflation. Consumer price inflation was tame in the pre-pandemic period, but there was lots of asset inflation and that gathered pace in 2020 and 2021. There was always going to be some leakage of this into more generalized inflation but this was accelerated by the double whammy of the supply disruptions caused by the pandemic and the Ukraine war. The Strange Case Of Japan If higher inflation in the US has seemed inevitable, how can one explain the situation in Japan? In contrast to other developed countries, Japan’s annual core inflation rate was only 0.2% in May. While this was an increase from the average -1.3% rate in the prior six months, it is impressive given the country’s continued highly stimulative monetary policy and the same exposure to supply disruptions as elsewhere. Most importantly, Japan has suffered structural deflation for so long that inflation expectations are totally dormant for both consumers and businesses. In other words, raising prices is seen as a desperate measure and something to be avoided. Japan’s poor demographics may also have played a role. A sharply declining labor force and rapidly aging population are disinflationary rather than inflationary influences and help reinforce the corporate sector’s reluctance to raise prices. While Japan seems an outlier, it is worth noting that core inflation also has remained relatively subdued in many European countries. For the overall Euro area, the latest core inflation rate is 3.8%, well below that of the US and UK. Two common features of the higher inflation countries are that they tended to have more aggressively-easy fiscal policies in recent years and greater asset inflation – especially in real estate. Unfortunately, inflation expectations and business pricing behavior in the US and other Anglo-Saxon economies have not followed Japan’s example. Employees have become more aggressive in demanding higher wages, and most companies have no problem in passing on higher costs to their customers. The UK is facing a wave of public sector strikes over pay the likes of which have not been seen for decades. The Outlook Chart II-9A Peaking In Supply Problems? Inflation may prove sticky over the next few months, but as noted earlier, it should move significantly lower over the coming year. Crude oil prices have risen by around 75% in the past year and that pace of rise cannot be sustained. Meanwhile, while shipping rates remain historically high, they are down sharply from earlier peaks (Chart II-9). Together with a revival in Chinese exports, this suggests some easing in supply chain problems. And as mentioned above, the pace of economic activity is set to slow sharply. But a return to pre-pandemic inflation levels is not in the cards. The Fed currently is talking tough and further rate hikes are on the way. But the tightening will end as soon as it becomes clear that the economy is heading south. A deep recession is not likely because there are not the worrying imbalances such as excessive consumer debt or inventories that typically precede serious downturns. However, policymakers will not take any risks and policy will return quickly to an accommodative stance, even though inflation is unlikely to return to the desired 2% level. On a positive note, inflation may be the highest in 40 years in many countries, but we are not facing a return to the destructive high-inflation environment of the 1970s. Inflation back then was institutionalized and a self-feeding cycle of higher wages and rising prices was deeply embedded. I was working as an economist for BP in London in the 1970s and remember receiving large quarterly pay rises just to compensate for inflation. In the absence of inflation-accounting practices, companies seriously underestimated the destruction that inflation was creating to balance sheets and profitability, making them complacent about the problem. Moreover, there were not the same global competitive pressures that exist today. Inflation in the US likely will form a new base of 3% to 4% over the medium term, with occasional fluctuations to 5% or above. An environment of stagflation is in prospect: growth will not be weak enough to suppress inflation and not strong enough to allow the Fed to maintain a restrictive stance. This puts the Fed in a difficult spot as it will be reluctant to admit defeat by raising the inflation target from its current 2%, even though that level will be out of reach in practical terms. A counter view is that I am too pessimistic by underestimating the disinflationary effects of technological advances. A sustained improvement in productivity would certainly help lower inflation but how likely is this? Technological advances are occurring all the time, but in recent years they largely have been incremental in nature and it is hard to think of any new breakthrough productivity-enhancing technologies. There is a difference between new technologies that simply represent better ways to do existing tasks (3D printing would fall into that category) and general purpose technologies that completely change the way economies operate (e.g. electricity and the internet). While businesses are still exploiting the benefits of the digital world, we await innovations that will trigger a new sustained upsurge in productivity. A game changer would be the development of unlimited cheap energy (cold fusion?) but that does not seem likely any time soon. Nevertheless, I will keep an open mind about the potential for productivity to surprise on the upside, despite my current skepticism. Chart II-10Inflation Expectations Spike Higher What does all this mean for the markets? Not surprisingly, shifts in market expectations for future inflation are highly correlated with the current rate and have thus spiked higher in recent months, hurting both bonds and stocks (Chart II-10). Obvious inflation hedges would be inflation-protected bonds and resources, but neither group currently is attractively priced. The good news is that the current panic about inflation is setting the scene for a buying opportunity in both stocks and bonds. The exact timing is tricky to predict but both stocks and bonds will rally strongly later this year when inflation expectations retreat as it becomes clear that the economy is weakening and the Fed softens its hawkish tones. The bad news is that this bullish phase will not last much more than a year because a re-emergence of inflationary pressures will bring things back to earth. The long-run outlook is one of stagflation and that will be a tough environment for financial assets. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Appendix: A Primer On The Debt Supercycle The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a buildup of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance-sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity. The pain of the Great Depression led governments to intervene to smooth out the business cycle, and their actions were given legitimacy by the economic theories of John Maynard Keynes. Fiscal and monetary reflation, together with the introduction of automatic stabilizers such as unemployment insurance, were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that balance-sheet imbalances and financial excesses built up during each expansion phase were never fully unwound. Periodic "cyclical" corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows. These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance-sheet excesses become, the more painful the corrective process would be. So, the stakes became higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means were available. The Supercycle process was driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation. The Supercycle reached an important inflection point in the recent economic and financial meltdown, with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead, representing the Debt Supercycle's final inning. III. Indicators And Reference Charts BCA’s equity indicators paint a bearish picture for stock prices. Our monetary indicator is now at its weakest in almost three decades and our valuation indicator highlights that stocks are still overvalued, albeit less so than they were last year. Meanwhile, both our sentiment and technical indicators have now broken down very significantly, and are not yet providing a contrarian buy signal. The odds of a US recession over the next 12 months have recently risen, and we now recommend a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being significantly revised up, but bottom-up analysts’ expectations for earnings are still too rosy. Although earnings growth is still likely to be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits. Within a global equity portfolio, we recommend a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. Within a fixed-income portfolio, investors should stay modestly short duration. The increase in commodity prices that followed Russia’s invasion of Ukraine has cooled, and prices are now rolling over significantly on the back of global growth concerns. Our composite technical indicator has dropped meaningfully, indicating that commodities are now no longer overbought. Our base-case view is that oil prices have peaked, but there some risk to that view given the current geopolitical situation. In addition, the recent rise in European natural gas prices suggests that global food inflation could remain elevated, given that natural gas is used in the production of fertilizer. We remain structurally bullish on industrial metals, but metals prices are likely to decline further until recessionary concerns abate. US and global LEIs have rolled over significantly and are now edging towards negative territory. The Conference Board’s LEI has now decreased for three consecutive months, and four consecutive month-over-month declines have historically been associated with a recession. Our global LEI diffusion index has bottomed, but we are not convinced that this heralds a major upturn in the LEI itself. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Content Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning Chart III-28US And Global Macro Backdrop   ECONOMY: Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate Footnotes 1     Please see Global Investment Strategy Special Alert "Hard Or Soft Landing? BCA Strategists Debate The Question," dated June 21, 2022, available at gis.bcaresearch.com 2     Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 3    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com; The Bank Credit Analyst "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com; The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 5    Please see Emerging Markets Strategy "A Conversation With Ms. Mea: Navigating An Inflation Storm," dated June 16, 2022, available at ems.bcaresearch.com 6    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 7     This trimmed mean measure excludes the top 8% of CPI components with the largest monthly price gains and the bottom 8% with the smallest monthly gains. 8     Rent.com, https://www.rent.com/research/average-rent-price-report/, June 2022. 9    A fourth channel can be via a psychological boost to business and consumer confidence, but this can cut both ways if an easing in policy is interpreted as a sign of worsening economic conditions rather than as a reason for optimism.

Executive Summary There has never been a modern era recession or sharp slowdown in which the oil price did not collapse. In a recession, the massive destruction of oil demand always overwhelms a tight supply. Across the last six recessions, the median collapse in the oil price was -60 percent, with the best case being -30 percent, and the worst case being -75 percent. Hence, in the coming recession, the oil price is likely headed to $55, with the best case being $85, and the worst case being $30. Investors should short oil, or short oil versus copper. Equity investors should underweight the oil sector versus basic resources and/or industrials and/or banks, and underweight oil-heavy equity markets such as Norway. Fractal trading watchlist: Oil versus industrials, and oil versus banks. Oil Didn’t Get The ‘Everything Sell-Off’ Memo Bottom Line: There has never been a modern era recession or sharp slowdown in which the oil price did not collapse, and this time will be no different. Feature We have just witnessed a rare star-alignment. The near-perfect line up of Mercury, Venus, Mars, Jupiter and Saturn in the heavens is a spectacular sight for the early birds who can star gaze through clear skies. And it is a rare event, which last happened in 2004. But investors have just witnessed an even rarer star-alignment. The ‘everything sell-off’ in stocks, bonds, inflation-protected bonds, industrial metals, and gold during the second quarter has happened in only one other calendar quarter out of almost 200. Making it a ‘1 in a 100’ event, which last happened way back in 1981 (Chart I-1 and Chart I-2). Chart I-1The ‘Everything Sell-Off’ In 2022… Chart I-2...Last Happened In 1981 As we detailed in our previous reports Markets Echo 1981 When Stagflation Morphed Into Recession and More On 2022-23 = 1981-82 And The Danger Ahead, a once-in-a-generation conjugation connects the ‘1 in a 100’ everything sell-offs in 1981 and 2022. The conjugation is inflation fears, exacerbated by a major war between commodity producing neighbours, and countered by aggressive rate hikes, morph into recession fears. The 1981-82 episode is an excellent blueprint for market action through 2022-23. This makes the 1981-82 episode an excellent blueprint for market action through 2022-23, and we refer readers to the previous reports for the implications for stocks, bonds, equity sectors, and currencies. Oil Didn’t Get The ‘Everything Sell-Off’ Memo But one major investment didn’t get the ‘everything sell-off’ memo. That major investment is crude oil. Even within the commodity space, oil is the outlier. In the second quarter, industrial commodity prices have collapsed: copper, -20 percent; iron ore -25 percent; tin, -40 percent; and lumber, -40 percent. Yet the crude oil price is up, +7 percent, and the obvious explanation is the Russia/Ukraine war (Chart I-3). Chart I-3Oil Didn't Get The 'Everything Sell-Off' Memo The Russia/Ukraine war is an important part of the 2022/1981 once-in-a-generation conjugation. In 1981, just as now, the full-scale invasion-led war between two major commodity producing neighbours – Iraq and Iran – disrupted commodity supplies, and thereby added fuel to an already red-hot inflationary fire. When Russia invaded Ukraine earlier this year, the oil price surged by 25 percent. Remarkably, when Iraq invaded Iran in late 1980, the oil price also surged by 25 percent. But by mid-1981, with the global economy slowing, the oil price had given back those gains. Then, as the economy entered recession in early 1982, the oil price slumped to 15 percent below its pre-war level. If 2022-23 follows this blueprint, it would imply the oil price falling to $85/barrel (Chart I-4). Chart I-4If Oil Follows The 1981-82 Blueprint, It Will Tumble To $85 There Has Never Been A Recession In Which The Oil Price Did Not Collapse Everybody knows the narrative for the oil price surge this year. In what is putatively a very tight market, the embargo of Russian oil has removed enough supply to put significant upward pressure on the price. The trouble with this story is that Russian oil will find a buyer, even if it requires a discount. Moreover, with the major buyers being China and India, it will be politically and physically impossible to police secondary sanctions. The bottom line is that Russian oil will find its way into the market. There has never been a modern era recession or sharp slowdown in which the oil price did not collapse. But the bigger problem will come from the demand side of the equation when the global economy enters, or even just flirts with, a recession. Put simply, because of massive demand destruction, there has never been a modern era recession or sharp slowdown in which the oil price did not collapse (Chart I-5 - Chart I-10). Chart I-5In The Early 80s Recession, Oil Collapsed By -30 Percent Chart I-6In The Early 90s Recession, Oil Collapsed By -60 Percent Chart I-7In The 2000 Dot Com Bust, Oil Collapsed By ##br##-55 Percent Chart I-8In The 2008 Global Financial Crisis, Oil Collapsed By -75 Percent Chart I-9In The 2015 EM Recession, Oil Collapsed By ##br##-60 Percent Chart I-10In The 2020 Pandemic, Oil Collapsed By ##br##-75 Percent Furthermore, as we explained in Oil Is The Accessory To The Murder, a preceding surge in the oil price is a remarkably consistent ‘straw that breaks the camel’s back’, tipping an already fragile economy over the brink into recession. Meaning that the oil price ends up in a symmetrical undershoot to its preceding overshoot. The result being a massive drawdown in the oil price in every modern era recession or sharp slowdown. Specifically: Early 80s recession: -30 percent Early 90s recession: -60 percent 2000 dot com bust: -55 percent 2008 global financial crisis: -75 percent 2015 EM recession: -60 percent 2020 pandemic: -75 percent What about the 1970s episode – isn’t this the counterexample in which the oil price remained stubbornly high despite a recession? No, even in the 1974 recession, the oil price fell by -25 percent.  Moreover, the commonly cited explanation for the elevated nominal price of oil through the 70s is a misreading of history. The popular narrative blames OPEC supply cutbacks related to geopolitical events – especially the US support for Israel in the Arab-Israel war of October 1973.  As neat and popular as this narrative is, it ignores the real culprit: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, OPEC countries were raising the price of crude oil just to play catch up. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. In terms of gold, in which oil was effectively priced before 1971, the oil price was no higher in 1980 than in 1971! (Chart I-11) Chart I-11Priced In Gold, The Oil Price Was No Higher In 1980 Than in 1971! Shorting Oil And Oil Plays Will Be Very Rewarding For Patient Investors The four most dangerous words in investment are ‘this time is different’. Today, the oil bulls insist that this time really is different because of an unprecedented structural underinvestment in fossil fuel extraction. Leaving the precariously tight oil market vulnerable to the slightest uptick in demand, or downtick in supply. Maybe. But to reiterate, in a recession, the massive destruction of oil demand always overwhelms a tight supply. In this important regard, this time will not be different. Taking the median drawdown of the last six recessions of 60 percent, and applying it to the post-invasion peak of $130, it implies that, in the coming recession, oil will plunge to $55. In a recession, the massive destruction of oil demand always overwhelms a tight supply. Of course, this is the average of a range of recession outcomes, with the best case being $85 and the worst case being $30. Still, this means that patient investors who short oil can look forward to substantial gains. Alternatively, those who want a hedged position should short oil versus copper – especially as oil versus copper is now at the top of its 25-year trading channel (Chart I-12). Chart I-12Oil Versus Copper Is At The Top Of Its 25-Year Trading Channel Equity investors should underweight the oil sector versus basic resources (Chart I-13) and/or versus industrials and/or versus banks, and underweight oil-heavy stock markets such as Norway (Chart I-14). Chart I-13Underweight Oil Versus Basic Resources Chart I-14Underweight Oil-Heavy Stock Markets Such As Norway Suffice to say, these are all correlated trades. They will all work, or they will all not work. But to repeat, this time is never different. Fractal Trading Watchlist Confirming the fundamental arguments to underweight oil plays, the spectacular recent outperformance of oil equities versus both industrials and banks has reached the point of fragility on its 260-day fractal structures that has reliably signalled previous turning points (Chart I-15). Chart I-15The Outperformance Of Oil Versus Industrials Is Exhausted We are adding oil versus banks to our watchlist, with this week’s recommendation being to underweight oil versus industrials, setting a profit target and symmetrical stop-loss of 10 percent, with a maximum holding period of 6 months. Fractal Trading Watchlist: New Additions The Outperformance Of Oil Versus Banks Is Exhausted Chart 1BRL/NZD At A Resistance Point   Chart 2Homebuilders Versus Healthcare Services Has Turned Chart 3CNY/USD At A Potential Turning Point Chart 4US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Vulnerable To Reversal Chart 6Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Vulnerable To Reversal Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 18A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Has Ended Chart 23USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Executive Summary High food and fertilizer prices are at risk of morphing into a full-blown food crisis in several developing countries. Some countries were plagued by severe food insecurity even before the Ukraine war broke out. The Ukraine war has upended two crucial aspects of food security: availability of food grains as well as the availability of fertilizers. A few Middle Eastern and African countries, who are dependent on both imported cereals and crude oil, are experiencing the greatest difficulty. The stock-to-use ratio of food grains is alarmingly low in several countries. Some of them also have high twin deficits (i.e., fiscal and current account deficits) – indicating that governments there would be hard-pressed to provide necessary relief. Several Countries Need To Import Over 90% Of Their Cereal Consumption Bottom Line: All aspects considered, we reckon Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka to be the most at risk of experiencing a food crisis, and consequent socio-political upheaval. Feature Food prices have surged in most parts of the world. In some developing countries however, food inflation is threatening to morph into a food crisis. In the year ahead, high food and fertilizer prices could accentuate food insecurity in several poorer countries − with major socio-political ramifications. In this report, we identify the nations most at risk, especially among countries included in the MSCI Emerging and Frontier Equity Indexes. Our research indicates that Lebanon, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are the most vulnerable to a food crisis, and consequent socio-political upheaval. Food Inflation: In The Stratosphere In a few countries such as Lebanon and Venezuela, food inflation is at a mind-boggling 370% and 200%, respectively. It is abnormally high in many other developing countries as well – including Turkey (92%), Argentina (64%), Iran (49%), Sri Lanka (45%), Ghana (30%), and Egypt (28%). In several other countries such as Colombia, Nigeria, Hungary, Bulgaria, and Kazakhstan, food prices are rising at about 20% or more. That is also the case in war-torn Ukraine and Russia (Chart 1). Chart 1Food Inflation Has Become Extremely Painful In Some Countries In a few countries such as Turkey, Pakistan and Sri Lanka, currency depreciation could explain part of the rise in food prices. Chart 2Food Prices Began To Surge Well Before The Ukraine Crisis That said, given that only a minor share of all food consumed is imported by these countries, the sharp rise in overall food prices cannot be explained away by currency depreciation alone. Rather, it points to genuine price pressures in domestically grown food. That is also the case in all other countries where food inflation is higher than currency depreciation. Notably, in many of these countries, food inflation was quite high even before the Ukraine war broke out. Indeed, global food grain prices had begun to surge in mid-2020 – well before Russia’s invasion began (Chart 2). And yet, the onset of the Ukraine war and the resulting sanctions and logistics bottlenecks have worsened the situation dramatically. Even though food prices have eased marginally in the past couple of weeks, they are still extremely elevated compared to pre-pandemic levels. More worryingly, many countries are now at risk of experiencing a full-blown food crisis.  Pre-existing Food Insecurity Some developing countries are more susceptible to a food crisis than others. This is because they were already plagued by food insecurity even before the Ukraine war broke out. The x-axis of Chart 3 shows the extent of “severe food insecurity”1 in various developing nations, as per the United Nations’ Food and Agriculture Organization (FAO). Kenya, Nigeria, South Africa and Peru stand out in this respect among the countries included in the MSCI EM & Frontier market equity indexes: as high as 18 to 26% of the total population in these countries experienced severe food insecurity between 2018 and 2020. Chart 3Countries With Pre-Existing Food Insecurity Are More At Risk Notably, these countries also happen to have high fiscal deficits; and in some cases, high public debt (Chart 3, y-axis). This leaves their governments with less room to provide necessary relief should an acute food crisis hit their population. Not surprisingly, some of the countries plagued by severe food insecurity are highly dependent on grain imports to meet their domestic demand. The x-axis of Chart 4 shows the cereal import dependency of various countries as a percentage of their cereal intake. Most middle eastern countries such as Lebanon, Jordan, Kuwait, Saudi Arabia and Oman need to import nearly all of their cereal consumptions, as per FAO data. That said, what sets the truly vulnerable cereal importers apart from the rest is that some of them do not have much export earnings to pay for their rising food import bills. For instance, in Lebanon, food imports alone cost two-thirds of its total goods export revenues before the pandemic, according to FAO. For Egypt, Jordan and Kenya, food imports used up over 40% of their export earnings (Chart 4, y-axis). Chart 4Several Countries Need To Import Over 90% Of Their Cereal Consumption These figures must have gone up further as food prices have risen significantly in the past two years. If high food prices persist, the balance of payments of these countries will deteriorate further. That, in turn, will negatively affect their currencies and general inflation.  High Oil Prices Adding To The Woes Many oil and gas producers in the Middle East and Africa are also large net importers of food. Current high crude prices, however, are helping them to foot their food bills. But countries who need to import both food and oil and gas are facing a double whammy. Chart 5 shows that several food importers are indeed large net importers of oil and gas too. On this parameter, Lebanon, Pakistan, Jordan and Kenya appear to be facing the most acute pain − their annual food plus net oil import bills are very high, ranging from 60 to 120% of their goods export revenues. Needless to say, if both food and oil prices remain elevated, these nations could face major socio-economic upheavals. Chart 5Countries Which Need To Import Both Food And Fuel Are The Most Distressed Chart 6Industrial Metals And Ore Producers Will Face More Pain Going Forward On a separate note, many producers of industrial metals/raw materials such as Chile and Peru may also soon experience more difficulties. The reason is that industrial metal prices have recently rolled over relative to food prices (Chart 6). Going forward, slowing global growth will likely push down industrial metal prices further, robbing these nations of a major source of income. Falling income amid high food prices would hurt the population even more, as the former will also limit the authorities’ ability to provide relief. The Implications Of The Ukraine War Could Linger The Ukraine war has upended the two most crucial aspects of food security: availability of food grains and fertilizers. Notably, the exportable surplus of food and fertilizers in the world are concentrated in only a handful of countries. Russia and Ukraine are key among them. In the case of wheat, 28% of global exports (in volume terms) in 2021 came from Russia (18%) and Ukraine (10%),  as per the FAO. In the case of barley, their share was 24%, and for corn (maize) 12%. Chart 7Grain Prices Have Surged Across The Board These two countries are dominant in some oilseed exports as well. Ukraine (37%) and Russia (26%) together held about two-thirds of the global sunflower oil export market share. In the case of rapeseed, Ukraine had about 20% of global export share. Much of these supplies now face severe logistical hurdles. That, in turn, has pushed up grain and edible oil prices globally, hurting all countries whether they are dependent on food imports or not (Chart 7). That said, the countries who are heavily dependent on Russian and Ukrainian supplies are particularly hit hard. Chart 8 shows the import dependency of some countries on Russian and Ukrainian wheat. Turkey, Lebanon and Egypt will have to urgently find alternative suppliers as a very large share of their imports now face uncertainty. The same can be said about Eritrea, Somalia and some former Soviet republics.    In the case of fertilizers, Russia was the largest supplier of nitrogen-based fertilizers2 (the kind that is most heavily used) at 17% of global exports in 2021. The country was also the second largest exporter of potassium-based fertilizer (23%), and the third largest in phosphorus-based fertilizers (16%). Ukraine, however, has not been a big exporter of fertilizers. Just like in the case of wheat, several countries had been highly dependent on Russian fertilizers. Among EM countries, Peru procured 42% of its fertilizer needs from Russia last year. Brazil, Mexico, and Colombia each imported about 22% from Russia. That figure was substantially higher for some other developing countries such as Ghana (37%), Cameroon (47%), and Honduras (50%) (Chart 9). Given the numerous sanctions imposed on a multitude of Russian entities, shipments of Russian fertilizers are now at risk. As such, all these countries need to find substitute suppliers urgently.  Chart 8Russia And Ukraine Supplied Over 80% Of Wheat Imports For Many Countries Chart 9Russia Supplied Over 40% Of Fertilizer Imports For Many Countries   Notably, it’s not just the logistics/availability issues that fertilizer users must contend with. Prices of fertilizers have also surged by a massive 200 to 300% compared to pre-pandemic levels. The reason for that is sky-high natural gas prices, which is the primary feedstock of (nitrogen-based) fertilizers (Chart 10). Chart 10High Natural Gas Prices Will Keep Fertilizers Expensive Since Russia is also a major natural gas producer, the current situation does not bode well for the fertilizer price relief outlook. New western sanctions on Russia and countermeasures by Russia are continuing relentlessly. As such, one can expect that natural gas prices will likely stay elevated for the foreseeable future. That will keep fertilizers expensive. Meanwhile, the scarcity and/or high prices of fertilizers would force farmers in many poor countries to curtail their fertilizer use during the ongoing / upcoming crop season. That in turn would imperil their domestic food production, accentuating overall food scarcity. Where Do Countries’ Food Stocks Stand Now? Chart 11 shows various developing countries’ combined stockpile of food grains (wheat, corn and soybean) relative to their yearly usage (i.e., the stock-to-use ratio). Chart 11The Stock Of Foodgrains Is Precariously Low In Many Countries Among the countries who have high cereal import dependency (and, who are not oil producers), the stock-to-use ratio is particularly low for Lebanon, Jordan, Chile, Peru, and Egypt. Since some of the countries with low food stock-to-use ratio are also dependent on imported food and fertilizers, they are even more susceptible to an outright food shortage this year. Lebanon, Egypt and Peru are three such countries among MSCI included ones. If various countries’ stock-to-use figures are juxtaposed with their twin deficits, their wherewithal to provide necessary relief should their food stocks become inadequate can be demonstrated. Chart 12 shows that several countries with a low food stock-to-use ratio are also plagued by high twin deficits, and therefore low capacity to provide relief. Examples are Lebanon, Jordan, Egypt, Nigeria and Venezuela. Chart 12Some Countries With Low Food Stock Have A Low Capacity To Provide Relief Food Price Shock: Is It Inflationary Or Deflationary? High food prices can sometimes lead to higher general inflation. The starting point of that is usually household inflation expectations: facing higher grocery prices every day, consumer expectations of future prices become unmoored. That said, whether the higher inflation ‘expectations’ will evolve into higher ‘realized’ inflation depends on households’ (labor) power to negotiate wages. If they are successful to gain higher wages, core inflation also begins to rise in tandem with food inflation, which might eventually lead to a wage-inflation spiral. In most developing nations, however, that does not look to be the case. Wages are rising sharply in only a handful of countries. Moreover, since a very high share of consumer spending in developing countries is accorded to food (25% to 55%), higher food bills are eating substantially into households’ real discretionary spending. That does not bode well for (non-food) corporate earnings. In addition, the central banks in many developing economies are raising interest rates in response to high inflation. All these will likely push many developing economies on the brink of a recession.   Investment Conclusions Currently, most emerging and frontier market nations are facing a deteriorating growth outlook – thanks to tight fiscal and tightening monetary policies domestically, a very strong US dollar, rising global interest rates, and a subpar Chinese recovery. High food and/or fuel prices are additional ‘taxes’ on their economies, and especially for the import-dependent ones. As a result, their growth will be stymied further. The consequence could well be socio-political volatility. Incidentally, the last time global food prices witnessed a major surge (about 40%) was back in 2010. That was soon followed by social upheavals in much of the Middle East (known as the ‘Arab Spring’) and elsewhere in the developing world. In the present episode, food prices have risen by 70% in two years. As mentioned, some of the countries facing food and fertilizer scarcity are also plagued by low grains stocks (relative to requirement) and have weak fiscal and external accounts. Considering all the aspects, we reckon that Lebanon, Jordan, Egypt, Kenya, Peru, Pakistan, and Sri Lanka are most-at-risk of slipping into a food crisis this year and beyond. Incidentally, the Emerging Markets Strategy team holds a bearish view on the near-term performances of EM stocks and bonds. Investors should stay underweight EM relative to global equities and bonds. Absolute return investors should stay on the sidelines. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Sebastian Rodriguez Research Associate sebastian.rodriguez@bcaresearch.com     Footnotes 1     Severe food insecurity refers to missing meals and/or reduced food intake because of financial constraints 2     The three main type of chemical fertilizers are nitrogen-based (urea and ammonia), potassium-based (potash), and phosphorus-based (phosphates).

Executive Summary Though the BCA House View has downgraded global equities to neutral, US Investment Strategy still recommends overweighting equities in US multi-asset portfolios over the coming twelve months. We believe that financial markets have prematurely discounted a sharp economic downturn. The selloff is an opportunity to get long equities if the recession fails to begin this year and/or turns out to be mild. We were surprised and disappointed by the May CPI report but view it as merely a delay in the flow of evidence confirming our view that inflation is peaking, not a repudiation of it. Inflation expectations will shape the intensity of the Fed’s efforts to lean against the economy, but the University of Michigan consumer survey that placed it on high alert was only preliminary and market-based measures of longer-run inflation expectations remain contained. History, folklore and popular culture all suggest that wage-price spiral fears are overdone. The Bear's Here; Where's The Recession? Bottom Line: Although the odds of an adverse outcome are rising, we maintain a constructive base-case view on the twelve-month prospects for US equities and the US economy, subject to a meaningful decline in inflation over the rest of the year. Feature At our monthly editorial view meeting last Monday, BCA researchers voted to downgrade the 6-to-12-month House View on equities to neutral from overweight. The US Investment Strategy team argued for an overweight recommendation and cast our vote with the minority to maintain it. Though we are on the opposite side of the slight plurality that voted to underweight equities, we acknowledge that the risks to our constructive view have risen. The difference between our view and the BCA consensus is mainly a matter of timing – while we believe the US economy is on its way to a recession, we think the journey will be more winding than expected. The Timing And Severity Of The Gathering Storm Recession was the key economic issue informing our investment strategy decision: When will it begin (if it hasn’t already) and how severe will it be? The domestic economy is clearly slowing, and the Eurozone and China face sizable pressures. As Chief Global Strategist and Director of Research Peter Berezin highlighted, every one-third-percentage-point increase in the three-month moving average of the unemployment rate has been followed by a recession. Mean reversion and the Fed’s campaign to combat inflation by cooling off demand suggest that the unemployment rate will soon be rising, en route to crossing the one-third-of-a-point threshold. Related Report  US Investment StrategyThe Yield Curve As An Indicator Though we noted last week that a return to the pre-pandemic labor force participation rate would allow payrolls to expand despite a rising unemployment rate, the expansion’s days are numbered. A broad range of series, from payroll employment (Chart 1, top panel) to the Leading Economic Index (Chart 1, middle panel) and consumer confidence (Chart 1, bottom panel), echoes the unemployment rate’s message: once the economy begins to move in the wrong direction, a recession eventually follows. Our read is that financial markets have overlooked the eventual aspect in their headlong rush to price in the effects of the Fed’s promised tightening campaign. While no one can pinpoint the equilibrium fed funds rate’s exact position, all agree that it’s nowhere near the current 1.5-1.75% target. Tight monetary policy is a necessary (but not sufficient) precondition for a recession; based on the latest guidance provided by Chair Powell and the dots, it looks like it won’t be met until around the end of the year. Once it is, the start of the recession will be subject to debate (Chart 2, top panel), along with its impact on the economy (Chart 2, middle panel) and equities (Chart 2, bottom panel). Chart 1Recessions Occur Once Key Metrics Roll Over Chart 2Predictions About The Future Are Hard As it dawns on investors that the recession is approaching at a meandering pace, and that it may turn out to be mild, equities will likely retrace some of their losses. The vicious May/June selloff was predicated on forecasts that a Category 4 or 5 hurricane could be arriving soon. If the storm system is downgraded to a Category 2 or 3 event, and the date that it’s due to make landfall is pushed back by two or three quarters, we expect that a playable rally will unfold. 4% Is Easy, 2% Will Be A Bear Our relatively constructive base-case view is predicated on the idea that core inflation has peaked and will soon begin declining toward 4% of its own accord. If inflation shows clear and convincing evidence of trending down over the rest of the year, the Fed will not feel obligated to race to push the fed funds rate to a restrictive level. The longer it takes for monetary policy to become restrictive, the longer it will take for the recession to begin. The further the recession can be pushed out into the future, the harder it will be for restless investors and asset allocators to stay on the sidelines as the dire scenario discounted in equity prices fails to materialize. Conversely, if the Fed has to proceed as rapidly as possible to regain the upper hand over inflation, the recession timetable will be accelerated, and the downturn may be more severe than anticipated. We were therefore relieved to hear our Chief US Bond Strategist, Ryan Swift, reiterate his team’s view that inflation will recede to 4% independent of any policy intervention, provided that pandemic-driven supply constraints unwind. Ryan cites the Atlanta Fed’s decomposition of core inflation into flexible and sticky components to illustrate how pandemic-fueled inflation in flexible categories that tend to experience more pricing variability, like new and used vehicles, hotel room rates and airfares, have pushed up the overall series to double-digit levels. The sticky subset, including rent and medical care, is elevated itself, but if the flexibles undershoot on their way back to the mean, year-over-year core CPI can end the year in the 4% neighborhood (Chart 3, top panel). Chart 3Not As Bad As It Looks An 8% trailing four-quarter increase in unit labor costs – a wage measure that considers compensation per unit of output instead of compensation per unit of time – would suggest on its face that inflation isn’t likely to dip to 4% any time soon. The four-quarter measure has been skewed by wild post-pandemic swings in productivity growth, however. Smoothing out those swings by using the annualized trailing five-year trend in productivity to deflate the 12-month growth rate in average hourly earnings yields a much easier to stomach 3.8% rate of compensation growth (Chart 3, bottom panel). With reference to other more nuanced measures of the underlying inflation trend and a deeper dive into the outlook for automobile prices, which will fall as demand wanes and supply increases, our bond strategists expect core CPI to move toward 4% across the rest of this year while the expansion continues, albeit at a slower pace. Unfortunately, sticky shelter is the largest component of core CPI, and labor market strength will keep residential rents growing at an elevated level consistent with 4% inflation. The Fed will have to lean heavily on the economy to get inflation from 4% back down to its 2% long-run target, and that should induce the recession markets have discounted. Our position is that the recession won’t begin until the second half of 2023 or the first half of 2024. Expectations Are Still Well Anchored Chart 4Still Anchored Chair Powell repeatedly cited increasing household inflation expectations as a driver of this month’s 75-basis-point rate hike following the preliminary June University of Michigan consumer sentiment survey’s sharp move higher (Chart 4, bottom panel). The Michigan survey is not the last word on inflation expectations, however, and 5-year-on-5-year TIPS breakeven rates are in line with the Fed’s 2% target (Chart 4, top panel). 5-year-on-5-year CPI swap rates have also remained well behaved (Chart 4, middle panel) despite the volatility in reported inflation and near-term expectations measures. We have been watching the evolution of inflation expectations carefully and will continue to do so; if they remain well anchored, and measured inflation comes down in line with our expectations, we are likely to remain constructive. A Half Century Of Bear Markets The fact that the S&P 500 has entered a bear market despite rising earnings estimates has stimulated a lot of discussion within BCA. More bearish observers’ general take has been, “If stocks are down almost 25% while earnings are up 8% since the start of the year, they’re in real trouble once the inevitable earnings declines arrive.” We have countered that a 30% valuation haircut on inchoate recession expectations could be considered extreme. A review of the empirical record might advance the discussion. Table 1 lists the ten bear markets of the last 60 years, defined as a peak-to-trough decline in closing prices of at least 20% (1990's 19.9% decline has been rounded up). Half of the bear markets lasted between one-and-a-half and two years, while the remainder, excepting the current unfinished one, have been relatively sudden events, persisting for less than six months. Table 1US Equity Bear Markets, 1968 -2022 Drawdowns have ranged from 20 to 57%, with average and median losses of 36% and 34%, respectively. The mean and median duration of the bear markets have been 12 and 17 months. Bear markets and recessions tend to coincide, as we’ve frequently noted, with only the first leg of the Volcker double dip in 1980 lacking ursine company and the Black Monday bear market of late 1987 occurring outside of a recession (Chart 5). The magnitude of the 1987 bear market was no different from the 50-year average, however, though it did end swiftly. Chart 5The Bear Arrived Ahead Of Its Escort Even though the specter of restrictive monetary settings triggered the current bear, Chart 2 demonstrated that there is not a clear parallel between the intensity or duration of rate hiking cycles and the severity of the economic or market declines. Mild recessions can produce mild drawdowns, as in 1990, or severe ones, as at the turn of the millennium. Bad recessions may occur alongside terrible stock market declines (1973-74 and 2007-09) or comparatively modest ones (1980-82). All we can say now is that equities and many other public assets were priced dearly at the start of the selloff and were therefore more vulnerable while the lack of glaring imbalances suggests the economy is reasonably well insulated. The bear markets only begin to show some resemblance to one another in terms of the relative share of the declines accounted for by earnings and multiple contractions. Valuations absorb the full force of the decline during bear markets, falling 30%, while forward earnings estimates are barely revised lower. The pattern is consistent no matter where starting multiples began, though the dot-com bust produced the biggest valuation haircut of the forward earnings era (Table 2). Table 2Bear Market Earnings And Multiple Changes ​​​​​​​ The multiple/earnings breakout is mostly a function of the fact that analysts do not adjust their forward estimates in real time while prices can change from moment to moment while markets are open. The result is that the numerator of the price-earnings ratio immediately resets, while the earnings denominator adjusts only after an extended lag. Considering the peak-to-trough changes in earnings estimates, which typically play out beyond the bounds of the strictly defined bear phases, the pain is nearly equally shared. The takeaway for today is that the nearly 30% forward multiple decline is partially a placeholder for future earnings revisions and downward revisions should not be viewed as an add-on to the valuation haircut that’s already occurred. John Henry And The Wage-Price Spiral Many of our colleagues and clients are concerned about rising wages. Nominal compensation is already growing at its fastest pace in decades. Though none of the major wage series has managed to keep pace with inflation, the labor market remains undeniably tight. Rising wages threaten to squeeze corporate profits, exacerbate demand-over-supply imbalances, and act as the linchpin of a vicious circle in which rising prices beget rising prices. The wage-price spiral of the seventies and early eighties lurks at the edge of all our inflation discussions, and nearly all investors seem to view the seventies as something of a baseline. A careful read of history highlights that the spiral took hold near the end of organized labor’s 50-year heyday, however, and challenges the received wisdom that the subsequent 40-year Reagan era is an anomaly at risk of being overturned. Those waiting for labor to be delivered from the depredations of the last 40 years might do well to consider the legend of John Henry, a nineteenth-century railroad laborer in West Virginia or Virginia who drove steel drill bits into mountain rockfaces to create openings for tunnel-blasting explosives. Henry competed against the newly invented steam shovel to see if a man could hew his way through the rock faster than a machine. Henry won the race but succumbed to exertion while doing so. Songwriter Jason Isbell’s take on the legend deftly links the pre-New Deal days with today. Labor may have the numbers, but management has the capital and the incentive to automate every process it can. We contend that wages will rise less than expected over the rest of this expansion and in the early stages of the coming recession, as labor faces a steeper climb than is widely recognized. A few years of cyclical labor market tightness will not be enough to overcome the structural advantages that employers have obtained over the last four decades and guarded jealously in John Henry’s time, before New Deal legislation temporarily leveled the playing field.   It didn’t matter if he’d won/ If he’d lived or if he’d run/ They’d changed the way his job was done/ Labor costs were high   That new machine was cheap as hell/ Only John would work as well/ So they left him layin’ where he fell/ The day John Henry died   “The Day John Henry Died” (Isbell)   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com​​​​​​​

Executive Summary Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked​​​​​​ Chart 5Hong Kong Faces More Troubles​​​​​​ Chart 6Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia​​​​​​ Chart 11Russia Squeezes EU's Natural Gas​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration​​​​​​ Chart 16Internal Sources Of Nationalism​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades​​​​​​ Chart 21Favor Semiconductors But Not Taiwan​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks​​​​​ Chart 23Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Special Report

Listen to a short summary of this report.       Executive Summary Gold Has Established A Double-Top Formation Gold has done quite well amidst the turmoil in global financial markets. BCA is neutral global equities, which bodes well for gold as a hedge. The shiny metal is a great inflation hedge. Investors betting on non-transitory inflation should be overweight gold in their portfolios. Historically, gold has held up relatively well during equity market downturns. Most of our fair-value models are pinning gold at neutral valuations. This suggests that positioning should be tactical rather than strategic.   Bottom Line: Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance. Feature Gold has held up remarkably well, amidst very poor returns for traditional asset classes. The bellwether S&P 500 index is down 20% year to date. US 10-year treasury prices are down 14%. Even copper, a barometer for commodity prices is off 20% from its peak, despite a supply-driven bull market in many resources from grains to energy. Investors who decided to park their wealth in gold are flat year-to-date, not a desirable result, but a much better outcome compared to a 60/40 equity-bond portfolio, which is down 18% year-to-date. What is remarkable about gold’s resilience is that traditional tailwinds for the yellow metal are now opposing forces. For example, gold trends with falling real rates, but the 10-year TIPS yield has rebounded violently as the Federal Reserve has turned more hawkish. Gold also moves inversely to the dollar, but the DXY dollar index hit fresh cycle highs this year. In fact, we are witnessing the rare occurrence where both gold and the dollar are up this year (Chart 1). Gold’s resilience comes at an important time since, from a technical standpoint, a classic double-top formation has been established. For chartists, this means either a major downturn is in the cards, or some consolidation is due before new highs are established (Chart 2). In this report, we try to gauge the outlook for gold from the lens of the current macroeconomic paradigm, valuations, and shifts in investors’ perception of what defines a safe-haven asset. Chart 1Gold Has Held Up Remarkably Well Chart 2Gold Has Established A Double-Top Formation Gold As An Inflation Hedge Chart 3Gold Prices Track US Inflation Gold prices have historically been a good inflation hedge. Chart 3 shows that gold has done an excellent job at tracking consumer prices in the US. According to this chart, gold has lagged the overshoot in inflation. This suggests that bullion prices could be poised for a coiled spring rebound. Gold’s link to inflation dates back many centuries, given that it has historically been a monetary standard. The pre-war period in the early 1900s saw tremendously undervaluation in gold, as an economic boom was met with a rigid money supply. It was not until the 1929 stock market crash, and the ensuing Great Depression, that Western governments had to debase fiat money vis-à-vis gold to stop price deflation. Under the post-WW2 Bretton Woods system, the widespread implementation of social welfare schemes in the late 1960s, excessive government spending, and the Vietnam war all created a huge fiscal burden for the US government. This caused the current-account deficit to widen, leading to a sharp fall in confidence in the dollar. Inflationary pressures began to fester. As a result, the Nixon administration was forced to shut the gold window in 1971 and delink the US dollar from gold. The dollar collapsed and gold soared as a result. Today, most currencies are freely floating, adjusting to price differentials in a timely manner, but rising inflation once again is a global problem. This is an environment where gold usually does well. Proponents of the gold standard generally point out that since 2020, the US monetary base has expanded by 71%, but gold output has risen only by 4%. Ergo, monetary policy would have been extremely tight under a gold-exchange standard, helping curtail inflation. The bottom line is that inflation risks are here to stay, as outlined in various Commodity & Energy Strategy reports. This will be a tailwind for bullion. Gold And The Dollar It has become clear in recent weeks that the Fed (and most other central banks) are behind the curve on inflation. As an anti-fiat currency, gold typically does well in this environment. Chart 4 highlights that the real Fed fund’s rate is below a variety of reasonable estimates of neutral. Gold typically moves inversely to the dollar so the question becomes how fast the Fed can tighten financial conditions, while engineering a soft landing in the US. In our view, it is possible but not probable. The Fed’s hawkish shift has triggered a tremendous outflow from long-duration US equities (Chart 5). Bonds remain the overarching driver of US portfolio flows, but rising inflation volatility is keeping big buyers such as Japan on the sidelines. This raises the likelihood that the Fed will pivot in a dovish fashion, as financial conditions tighten. Chart 4Real Rates In The US Are Very Low Chart 5Higher Rates Are A Threat To US Equity Inflows Even if the US avoids a recession, it is likely that countries that were starved of growth during the pandemic will increasingly benefit, including China. It is noteworthy that currency strength has been bifurcated. Commodity-producing currencies have done relatively well (BRL, CAD, AUD), while commodity importers’ currencies have been hammered (EUR, JPY, SEK). Excluding the supply side of the commodity picture, the dollar would be marginally weaker. Gold And Commodities Most of gold’s demand comes from investment, but there is some industrial and jewelry use as well. As such, gold remains very highly correlated to overall commodity prices. The prices of many commodities are in a supply-side bull market. This has helped keep gold prices elevated. Gold’s industrial demand is likely to be a bane in the near term, even if it would support prices longer term. Most industrial powers are seeing a slowdown in their economies, notably China. This puts a lot of industrial commodities, including gold, at risk of a price reversal. Looking ahead, commodity demand is expected to remain firm especially in the face of supply-side bottlenecks. This will put a floor on how low gold prices can fall. Consumer demand could become a key source of support for gold prices. Chinese and Indian gold imports have surged this year, amidst soft prices. Gold coin and bar investment demand is also above its 5-year average. There is high seasonality to India’s demand for gold, so upcoming festival and wedding seasons, many of which were postponed due to Covid-19 restrictions, will provide a boost to gold purchases. In the US, gold coin sales in May were at the highest level in over a decade. Even Russia, which recently removed the VAT tax on gold purchases, saw a 54% year-on-year rise in gold coin sales. Gold And Central Banks The one profound change in the gold market has been the behavior of global central banks. Global allocations of foreign-exchange reserves have drifted away from the dollar and towards gold and other currencies (Chart 6). This helps underpin the gold bull market. This diversification away from the USD has been particularly acute among countries with a geopolitical incentive to increase non-dollar holdings. China has seen its gold reserves rise from 1.9% to 3.6% since 2016. Russia, which presently is at war with the West, has little Treasury holdings with 21% of its reserves in gold. With every country having an implicit geopolitical imperative to diversify its reserve holdings, gold sits as a neutral monetary standard. As such, the allocation of global FX reserves towards gold will continue to rise (Chart 7). Chart 6A Stealth Diversification From US Dollars Chart 7Central Banks Have Become Gold Buyers Gold And Financial Markets The biggest demand for gold is likely to come from hedging against equity volatility. Historically, gold has done relatively well during equity market drawdowns (Chart 8). This has been the case so far this year. As outlined above, if inflation continues to surprise to the upside, then gold should be a core holding in investor portfolios. That said, TIPS yields are rising; as such, should global central banks contain the risk of a wage-inflation spiral, gold will underperform other asset classes. Chart 8Gold Does Well During Crises The gold/commodity ratio has an eery correlation with the VIX (Chart 9). This cements gold’s role as a safe-haven asset. Given rising political and economic uncertainty, a gold hedge is practical. Chart 9Higher Volatility Will Benefit Gold How To Value Gold Valuing gold is an extremely difficult exercise. As an inflation hedge, gold is trading at a 210% premium relative to its purchasingpower (Chart 10). However, shorter-term models are more sanguine. Our in-house models using a combination of monetary and financial variables suggest gold is much closer to fair value at current levels (Chart 11). From a holistic sense, gold is a hedge against geopolitical uncertainty, overly abundant liquidity, and inflation risk, as well as a source of capital preservation. Putting all these together, the gold price is fair. Chart 10Gold Is Expensive In Real Terms Chart 11Gold At Fair Value According To Our Models From a commodity standpoint, gold is trading at a hefty premium to cash costs (Chart 12). This has always been the case during gold bull markets. Should the current paradigm shift to one of low inflation and little geopolitical risk, investors need to be cognizant of the safety premium currently embedded in gold prices. Chart 12Gold Is Trading Well Above Cash Costs From a technical standpoint, our indicators suggest gold is oversold but not yet at a nadir (Chart 13). This implies some consolidation is due before the next leg of the gold trend is established. Chart 13Sentiment On Gold Is Not Yet At A Nadir From a valuation standpoint, we will be buyers of gold today, but will not hold it for the long term. Investment Conclusions Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance is appropriate.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary  

    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 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 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 Chart 3The 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) Chart 4BLabor 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 Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment   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 Chart 8Even The Rich Spend The Majority Of Their Income     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 Chart 10Tight 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 Chart 12Euro Area Fiscal Policy Is Expected To Be More Expansionary In The Years To Come Than Before The Pandemic   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 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 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 Special Trade Recommendations Current MacroQuant Model Scores