Inflation/Deflation

Listen to a short summary of this report.       Executive Summary Second Fastest Hiking Cycle Ever? Can the Fed achieve a soft landing, bringing inflation back to its 2% target without causing growth to slow significantly below trend? It has managed this only once in the past (in 2004). Every other cycle triggered a recession or, at best, a fall in the PMI to below 50. Recession is not a certainty. A higher neutral rate than in the past – partly due to the build-up of household savings – means the economy may be unusually robust this time. But the risk is high. We recommend a neutral weighting in equities, with a tilt to more defensive positioning: Overweight the US, and a focus on quality and defensive growth sectors. China’s slowdown is particularly worrying. We expect the RMB to fall, which will put downward pressure on other Emerging Markets. Bottom Line: Investors should maintain low-risk portfolio positioning until the outcome of the sharp tightening of financial conditions is clearer.     Recommended Allocation The key to the performance of financial markets over the next year is whether the Fed and other central banks can kill inflation without killing economic growth. This is not impossible. But the risk that aggressive tightening of monetary policy triggers a recession – or at best a sharp slowdown – is high. Investors should maintain relatively low-risk portfolio positioning. If the Fed raises rates in line with what the futures market is projecting – by 286 basis points over the next 12 months – it will be the second fastest tightening on record, after only the “full Volcker” of 1980-1981 (Chart 1). Other central banks, even in countries and regions with much weaker growth than the US, are predicted to tighten almost as aggressively (Table 1). At the same time, the Fed will start to run down its balance-sheet rapidly; we estimate its holdings of US Treasurys will fall by more than $1 trillion by end-2023 (Chart 2). What was the impact on the economy of previous Fed hiking cycles? It varied, but on only one occasion in the past 50 years (2004) was there neither a recession nor a fall of the Manufacturing ISM to below 50 in the two years or so following the first hike (Table 2).1 The ISM (and other global PMIs) falling to below 50 is important because that is typically the dividing line between equities outperforming bonds and vice versa (Chart 3). Chart 1Second Fastest Hiking Cycle Ever? Table 1Futures Projected Interest Rate Hikes Chart 2Fed Balance-Sheet Will Shrink Rapidly Too Table 2What Happened To The Economy In Fed Hiking Cycles Chart 3Will PMIs Fall Below 50?  A recent paper by Alex Domash and Larry Summers showed that, since 1955, when US inflation was above 4% and unemployment below 5%, there was a 73% probability of recession over the next four quarters, and 100% over the next eight quarters (Table 3). On each of the three occasions when inflation was above 5% and unemployment below 4% (as is the case now), recession followed within a year. How could the Fed avoid a hard landing? Inflation could come down quickly, which would allow the Fed to ease back on tightening. As consumption switches back to services from durables, and the supply side succeeds in increasing production, the price of manufactured goods could fall (Chart 4). There were signs of this happening already in March, when US durables prices fell by 0.9% month-on-month. The problem, however, is that because of rising energy costs and lockdowns in China, the supply-side response has been delayed. The fall in semiconductor and shipping costs, which we previously argued would happen this year, is not yet clearly coming through (Chart 5). There are also signs of a price-wage spiral, with US wages rising (with a lag) in line with prices (Chart 6). Table 3This Level of Inflation And Unemployment Usually Leads To Recession Chart 4Can The Price Of Durables Now Fall? Chart 5Supply-Side Recovery Delayed? The economy could be more robust than in the past, leaving it unscathed by higher rates. Our model of the equilibrium level of short-term rates is 3.2%, well above the Fed’s estimate of 2.4% (Chart 7). Our colleague Peter Berezin has argued that the neutral rate could be as high as 4%.2 In particular, the $2 trillion-plus of excess US household savings (equal to 10% of GDP) could support consumption for some years even if real wage growth is negative (Chart 8). However, there are already signs that higher rates are hurting the housing market, the most interest-rate sensitive part of the economy. The average US 30-year fixed-rate mortgage rate has risen to 5.1% from 3.2% since the start of the year. This is negatively impacting home sales and mortgage applications (Chart 9). Moreover, even if the Fed can succeed in raising rates without killing the expansion, the markets – for a while – will worry that it cannot. Chart 6A Price-Wage Spiral? Chart 7Rates Are Still A Long Way Below Neutral Chart 8Excess Savings Could Support The Economy Chart 9Higher Rates Already Impacting Home Sales There are clear signs of a slowdown in the global economy. Europe may already be in recession, with sentiment indicators collapsing to recessionary levels (Chart 10). More esoteric indicators, which have historically signaled slowing growth ahead, such as the Swedish new orders/inventories ratio, are also flashing a warning signal (Chart 11). Global financial conditions have tightened at the fastest pace since 2008 (Chart 12). Corporate earnings forecasts have started to be revised down for the first time in this cycle (Chart 13). Chart 10Is Europe Already In Recession? Chart 1111. Signs Of Trouble Ahead Chart 12Financial Conditions Have Tightened Significantly Chart 13Corporate Earnings Forecasts Being Revised Down But what of the argument that investors have already turned ultra-pessimistic and that all the bad news is in the price? Global equities are down only 14% from their historic peak, barely in correction territory. It is true that sentiment (historically a contrarian indicator) is very poor, with twice as many respondents to the American Association of Individual Investors’ weekly survey expecting the stock market to fall over the next six months as expect it to rise (Chart 14). But, despite investor pessimism, there are few signs that investors have made their portfolios more defensive. The same AAII survey shows little decline in equity weightings, and no big shift into cash (Chart 15). Chart 14Investors Are Very Pessimistic... Chart 15...But Haven't Moved More Defensive Equities: The US is the best house on a tough street. Growth is likely to remain more robust than in the euro area or Japan. The US stock market has a lower beta (Chart 16). And, while the US is more expensive, valuations do not drive the 12-month relative performance of stocks and, anyway, the US premium valuation can be justified by higher ROE and the lower volatility of profits (Chart 17). Emerging markets continue to look vulnerable to the slowdown in China and tighter US financial conditions (Chart 18). We remain underweight. Chart 16US Stocks Are Lower Risk Chart 17US Premium Valuation Is Justified Chart 18Tightening Financial Conditions Are Bad For EM Chart 19Consumer Staples Are Defensive Chart 20IT Earnings Will Continue To Grow Strongly Within sectors, our preference remains for quality and defensive growth. Consumer staples tend to outperform when PMIs are falling (Chart 19) and are supported by attractive dividend yields. Information Technology is a more controversial overweight, given that it is expensive and sensitive to rising rates. Nevertheless, investment in tech hardware and software is likely to continue, giving the sector strong structural earnings growth in coming years (Chart 20). Currencies: The dollar has risen by 7.3% year-to-date driven by interest-rate differentials and the Fed being expected to be more aggressive than other central banks. But we are only neutral, since the Fed will probably not raise rates by as much as the market is pricing in, and because the dollar looks very overvalued (Chart 21). We lower our recommendation on the Chinese yuan to underweight. Interest-rate differentials with the US clearly point to it falling further – also the outcome desired by the authorities to help bolster growth (Chart 22). The likely CNY weakness will put further downward pressure on other EM currencies, particularly in Asia, given their high correlation to the Chinese currency (Chart 23). Chart 21The Dollar Is Very Overvalued Chart 22Rate Differentials Point To A Weaker RMB... Chart 23...Which Is Bad News For Other EM Currencies Fixed Income: With the 10-year US Treasury yield at 2.9% and that in Germany at 0.9%, there is a stronger argument for marginally raising weightings in government bonds. We are neutral on government bonds within the (underweight) fixed-income category. Remember, though, that real yields are still negative: -0.1% in the US and -2.1% in Germany. We do not expect long-term rates to rise much over the next 6-9 months, and so remain neutral on duration. The “golden rule of bond investing” says that government bond returns are driven by whether the central bank is more or less hawkish than expected over the next 12 months (Chart 24). We would expect the Fed to be slightly less hawkish than currently forecast. US high-yield bonds offer an attractive yield pick-up – as long as US growth does not collapse. In a way, HY bonds are like defensive equities, given their high correlation with equities but beta only one-third that of equities (Chart 25). Chart 24Will The Fed Be More Or Less Hawkish Than Expected? Chart 25High Yield Bonds Are Like MinVol Equities Chart 26Russian Oil Is Going Cheap Commodities: Oil prices are likely to fall back to around $90 a barrel by year-end, as demand softens and increased supply (from Saudi Arabia, UAE, and North American shale, and maybe from Venezuela and Iran) enters the market. But the risk is to the upside if this extra supply does not emerge. In particular, possible bans on Russian oil and gas into the European Union (or Russia blocking sales) could disturb the market. It will take time for Russia’s 11 million b/d of oil production, which used to go mainly to Europe, to be rerouted to Asia. This is why the Urals benchmark is at a 30% discount to Brent (Chart 26). The long-term story for industrial commodities remains good, but there is downside risk – especially for iron ore and steel – from China’s slowdown (Chart 27). Gold is an obvious hedge against geopolitical risks and high inflation. But over the past 20 years, it has been negatively correlated to real interest rates and the US dollar, suggesting upside is capped. There is a chance, however, that the relationship between rates and gold breaks down, as it did in the 1970s and 1980s (Chart 28). We, therefore, remain neutral on gold, believing that a moderate holding is a good diversifier for portfolios. Chart 27Chinese Slowdown Is Negative For Commodities Chart 28Will Gold Start To Behave As It Did Before 1990? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1         In 2015, the ISM was already below 50 when the Fed hiked in December. 2         Please see Global Investment Strategy Report, “Is A Higher Neutral Rate Good Or Bad For Stocks?” dated March  18, 2022. Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary China's Demand Was Very Weak before Lockdowns The selloff in risk assets is not over. Stay defensive. Stagflation fears will continue gripping financial markets. Global trade volumes are set to contract, but the Fed has little maneuvering room as US core inflation is well above its target. Commodity prices are at an important juncture. The plunge in Chinese material stock prices is a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. The rally in EM commodity plays like Latin America and South Africa is at risk of a major reversal. Bottom Line: Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will be considerable, and the greenback will likely overshoot. A buying opportunity in EM local currency bonds will present itself after EM currencies hit a bottom versus the US dollar. Feature Global and EM risk assets will remain under selling pressure. This Charts That Matter report contains charts that will help investors navigate treacherous financial markets by shedding light on the following key issues: How much more downside in stocks? Chart 1 displays EM share prices in USD terms alongside their long-term moving averages. If EM equities break below the current technical support line, the next one implies that there is 20-25% further downside in EM stocks. For the S&P500, the next technical support is at 3650-3750. Our Equity Capitulation Indicators for both the S&P500 and EM stocks remain above their previous (2010-2020) lows (Charts 5 and 6 below). In addition, equity market breadth is deteriorating. Fundamental problems with financial markets are linked to mounting stagflation fears. Global trade volumes are set to contract in H2 due to a decline in US and European household spending on goods ex-autos and a delayed recovery in China as we discussed in last week’s report. In turn, US wage growth is accelerating, which will push up unit labor costs. US core inflation will likely drop due to base effects, but will remain above 3.5-4%, which far exceeds the Fed’s 2-2.25% target. Chart 1EM Share Prices: Their Long-Term Moving Averages Served As A Support In Bear Markets Chart 2 illustrates that stagflation fears have already gripped financial markets. Global defensive equity sectors have recently been outperforming global non-TMT stocks despite rising US and global bond yields (Chart 2). This is a major departure from the historical relationship between the two and likely foreshadows a period of continuous Fed tightening despite slower global growth. Global equity managers should favor defensive stocks as they will continue to outperform under the two most likely scenarios: (1) either these stagflation dynamics continue; or (2) a growth scare will dominate, during which US bond yields could drop. Chart 2Does This Divergence From A Historic Correlation Signify Stagflation? The US dollar continues to climb, and its strength has recently become very broad-based – extending to commodity currencies and Asian currencies. As we show in Charts 46-48 below, the US dollar has more upside.   Commodity prices are at an important juncture. On the one hand, supply shortages and risks to further supply disruptions could continue to support resource prices. On the other hand, demand will disappoint. Shrinking US and European consumer spending on goods ex-autos, contracting Chinese commodity intake and weakness in EM ex-China demand all suggest that global commodity consumption will decline in the months ahead. In our March 10 report, we noted that commodity prices would be volatile and this view has been validated: commodity prices swings have been extreme over the past two months. More recent evidence points to lower resource prices. Chart 3 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed them to two standard deviations above their time-trend. Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 3 does not include energy, gold and semi-precious metals (the footnote of Chart 3 lists commodities included in this aggregate). Chart 3Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Finally, Chart 4 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding oil), accounting for about 50-55% of global industrial metal demand. Chart 4Chinese Material Stocks Are Signaling Trouble For Global Materials Investment Recommendations Stay defensive. Global equity and credit portfolios should underweight EM equities and credit, respectively. The rally in the US dollar might be the final upleg before a major downtrend sets in. However, this final rally will likely be considerable, i.e., the greenback will likely overshoot. The CNY has broken down versus the US dollar and our target is 6.70-6.75 for now. A depreciating yuan is bearish for Asian and EM currencies. We continue to recommend short positions in the following EM currencies versus the US dollar: ZAR, COP, PEN, HUF, IDR, PHP and PLN. A buying opportunity in EM local currency bonds will present itself when EM currencies hit a bottom versus the US dollar.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   US And EM Equity Capitulation Indicators These indicators have not reached their lows of 2010, 2011, 2018 and 2020. The magnitude of the S&P500 selloffs in 2011 and 2018, were 19.5% and 19.8%, respectively. Hence, our best guess for the size of a S&P500 drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3800-3850. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 5, top panel).  Chart 5 Chart 6 Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Odds are that US share prices will drop further. US equity valuations are still expensive, geopolitical risks are elevated, and inflation and inflation expectations are extremely high, which will limit the Fed’s maneuvering room. Chart 7 Chart 8 Components Of Our EM Equity Capitulation Indicator Similarly, the components of our EM Equity Capitulation Indicator have not reached their previous lows. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above prior troughs. Further downside in EM share prices is likely.  Chart 9 Chart 10 S&P500 Overlays With Previous Geopolitical Crises The most recent examples of geopolitical shocks include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War and the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. Today, the S&P 500 is down only 12.8% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer.  Chart 11 Chart 12 Chart 13 Table 1 Various EM Equity Indexes: Deteriorating Breadth Various EM equity indexes have been in a bear market. The deterioration has been broadening as recent leaders such as commodity producers and Taiwanese stocks have been gapping down. Yet, not all bourses are very oversold. We published a Special Report on semiconductors on April 14 arguing that semi stocks face more downside. Share prices of commodity producers have recently corrected, and, as we argue above, odds of a further drop are non-trivial. What are the odds that the overall EM equity index undershoots? See the next section.  Chart 14 Chart 15 Chart 16 Chart 17 EM Undershoot Is Likely Sentiment towards EM equities has fallen significantly, but it is not yet at previous lows. Similarly, there is still room for EM net EPS revisions by bottom-up analysts to fall further. Finally, platinum prices point to more downside in EM non-TMT share prices.  Chart 18 Chart 19 Chart 20 EM Bond Yields And Share Prices Historically, rising EM corporate USD bond yields and EM local currency bond yields led to a selloff in EM share prices. Unless EM USD and local currency bond yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 21 Chart 22 Rising US Corporate Bond Yields Are Bearish For US Stocks Rising US corporate borrowing costs point to lower US share prices. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Furthermore, bearish US equity market technicals are presently reinforcing this downbeat outlook for US stocks.  Chart 23 Chart 24 Chart 25 The S&P500 EPS Can Contract Outside Of A Recession Let’s recall what happened in 2000-2001 in the US. Real GDP contracted only slightly, household spending in real terms did not contract at all, and the housing market was booming. Yet, the S&P 500 operating EPS plunged by 30% and the stock index was down by 50%. In 1966, even though real and nominal GDP did not contract, the S&P500 operating EPS shrank by about 5% and share prices fell by 22%. This episode is the best analogy for US economic and financial market dynamics over the near term.  Chart 26 Chart 27 US Stagflation Scare US wage growth is accelerating, and unit labor costs are surging. The latter will make inflation sticky and hurt corporate profit margins. Besides, US consumer demand for goods ex-autos will shrink following a two-year period of overspending. This combination will produce a stagflation scare – a period when corporate profits are weak, but the Fed has little maneuvering room as core inflation is well above its target.  Chart 28 Chart 29 Chart 30 Chart 31 Global Trade Volumes Will Shrink Taiwanese shipments to China – which lead global exports – have started to contract. Korea’s business survey of exporting companies reveals that business conditions deteriorated substantially in April. Global cyclicals have been underperforming global defensives. Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives. This also points to a slowdown in US growth. Chart 32 Chart 33 Chart 34 Chart 35 China’s Economy Requires Much More Aggressive Stimulus In China, monetary and fiscal stimulus have so far been insufficient to produce a major economic recovery given the headwinds from the property sector and the harsh lockdowns. The enacted fiscal stimulus has mainly been for infrastructure spending, and it does not include direct fiscal transfers to households who are losing income due to the lockdown. On the monetary front, the credit impulse – excluding local government bond issuance (which is counted in our fiscal spending impulse) – has barely bottomed.  Chart 36 Chart 37 Chart 38 Chart 39 China Has Been A Drag On Global Trade Chinese domestic demand was extremely weak even prior to the recent lockdowns in Shanghai. Chinese import volumes of various commodities, machinery, industrials goods and semiconductors were contracting as of March. Lockdowns and associated income/profit losses will further depress domestic demand. Chart 40 Chart 41 Chinese Property Woes Are Worsening Housing floor space sold in April is down by 50% from a year ago. Households are reluctant to borrow and buy, and property developers’ financing has dried up. All these point to shrinking construction activity. Chart 42 Chart 43 Chart 44 Chart 45 The US Dollar Has More Upside Our view on the greenback has played out well, and more upside is likely. The CNY has broken down against the dollar and it will reach at least 6.70-6.75. One exception to a strong US dollar might be the yen, as the trade-weighted yen has fallen to its previous lows. However, a rebound in the yen from current levels requires  a stabilization of US bond yields.  Chart 46 Chart 47 Chart 48 Chart 49 EM Currencies: Do Not Catch A Falling Knife EM currencies remain at risk. They are not cheap, and the recent rebound has faltered with many EM exchange rates unable to break above their technical resistance vis-à-vis the USD. However, we expect the US dollar to top and EM currencies to bottom later this year. Stay tuned.  Chart 50 Chart 51 EM Credit Markets: More Spread Widening Ahead EM and US credit spreads are not particularly wide and will likely widen further. China’s corporate USD bonds remain in a bear market. The two key drivers of EM credit spreads are the business cycle and exchange rates. EM growth will continue to disappoint, and EM currencies will relapse versus the US dollar. Hence, investors should be patient before buying/overweighting EM credit.  Chart 52 Chart 53 Chart 54 Chart 55 EM Domestic Bonds: A Buying Opportunity Down The Road The EM GBI domestic bonds total return index in USD terms has broken down and near-term weakness is likely. Meanwhile, EM local currency bond yields have risen significantly, and they offer good value. That said, a buying opportunity in local currency bonds will transpire only after their currencies bottom. Chart 56 Chart 57 Footnotes    

Highlights Several factors point to both an improvement and a deterioration in economic and financial market conditions, underscoring that the 6- to 12-month investment outlook is unavoidably uncertain. On the one hand, the US will likely avoid a recession over the coming year, slowing headline inflation will boost real wages and lower the equity risk premium, bond yields will not move much higher this year, and US services spending will support consumption as the pandemic continues to recede in importance. These are positive factors that will work to support economic activity and risky asset prices. On the other hand, the US will likely experience a recession scare focused on the housing market, the European economy may contract, Omicron’s spread in China threatens a further rise in shipping costs and a trade shock for Europe, and US inflation expectations may unanchor despite a falling inflation rate. For now, investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional stance. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. The US dollar is likely to strengthen over the near term, but we expect it to be lower a year from today. The Scourge Of Harry Truman US President Truman famously lamented the need for “one-handed” economists. His complaint reflected how essential it is for economic policymakers to receive clear advice about the best path forward. Investors understandably have even less tolerance for ambiguity than Truman did about the macro landscape and the attendant investment implications. However, there are times when the economic and financial market outlook is unavoidably uncertain. The current economic and geopolitical environment easily qualifies as one of those instances. Several factors point to both an improvement and a deterioration in economic and financial market conditions, which we review in detail below. The likely avoidance of a recession in the US over the coming year suggests that investors should remain minimally-overweight stocks over a 6- to 12-month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. What Could Go Right The US Will Likely Avoid A Recession Over The Coming Year Chart I-1The Odds Of A US Recession Are Currently Low We downgraded our odds of an above-trend 2022 growth scenario in last month’s report,1 but noted that a stagflation-lite environment of below-trend growth and above-target inflation was a more likely outcome than recession. We based this assessment on our view that the US neutral rate of interest is likely higher than the Fed and investors expect, which we discussed at length in past reports.2 Chart I-1 highlights that our recession probability indicator also supports this view, as it does not yet signal that a recession is on the horizon.3 Table I-1 highlights the components of the model (which is significantly influenced by the Conference Board’s LEI), and shows that the model is not providing a meaningful warning signal. The Fed funds rate component of the model will likely flash red next month following the FOMC meeting, and we have listed it as providing a warning signal in Table I-1. But rising rates themselves have not proven to be a particularly timely indicator of a recession; this is similarly true with rising inflation expectations and oil prices. We noted in last month’s report that a surge in oil prices has not been an especially consistent indicator of a recession since 2000. Table I-1The Components Of Our Recession Model Are Not Yet Flashing A Warning Sign The yield curve component of the model is based on the spread between the 10-year Treasury yield and the 3-month T-bill yield in order to minimize false recession signals, and we agree that the 10-year / 2-year spread has better leading properties. But even the latter curve measure has recently moved back into positive territory (Chart I-2), which will certainly qualify as a false yield curve signal if a recession is avoided over the coming 18 months. Within the components of the Conference Board’s LEI, Table I-1 highlights that there have been signs of weakness from the manufacturing sector, consumer expectations, and the credit market. Chart I-3 aggregates the deviation of six of these components from their trend, and shows that they have indeed been consistent with a significant slowdown in economic activity. Chart I-2The 2/10 Yield Curve Is No Longer Inverted Chart I-3The Weakest Components Of The Conference Board's LEI Are Not Yet Signaling A Recession However, two caveats are warranted. First, part of this weakness reflects the ongoing shift from goods to services spending, unraveling the massive surge in goods spending that occurred during the pandemic (Chart I-4). Second, Chart I-3 highlights that similar weaknesses occurred in the past outside of the context of a recession, most notably in 1995/1996, in the aftermath of the 1994 bond market crisis; in 1998/1999, following the Long-Term Capital Management (LTCM) crisis; in 2015, following the collapse in oil prices; and, finally, in 2018/2019, in response to the Trump administration’s trade war. None of these instances resulted in a contraction in output. Headline Inflation Is Likely To Come Down Headline consumer price inflation is currently extremely high in the US. Rising prices do not just reflect energy, food, or pandemic-related effects. Chart I-5 highlights that trimmed mean CPI and PCE inflation rates have accelerated significantly since last summer, and are currently running at 6% and 3.6% year-over-year rates, respectively. Chart I-4Part Of The Weakness In Manufacturing Activity Indicators Reflects A Shift In Spending From Goods To Services Chart I-5There Is More To High Inflation Than Food, Energy, And Pandemic-Related Effects... However, it seems likely that inflation has peaked in the US (or is about to do so), even abstracting from base effects.Chart I-6 highlights that the one-month rate of change in trimmed mean measures seemingly peaked in October and January, and shows that the level of used car prices also appears to be trending lower (panel 2). The ongoing shift away from goods to services spending noted above will also push core ex-COVID-related consumer prices lower. Finally, BCA’s Commodity & Energy strategy service is forecasting that Brent crude oil prices will average roughly $90/bbl for the remainder of the year, which would likely bring US gasoline prices back toward $3.50/gallon and will lower both headline inflation and energy passthrough effects to core prices (Chart I-7). Chart I-6... But The Rate Of Headline Inflation Has Likely Peaked Chart I-7Our Forecast For Oil Implies US Gasoline Prices Will Fall     A meaningful deceleration in inflation will help reverse some of the recent decline in real wage growth that has occurred, and will likely lower the equity risk premium (see Section 2 of this month’s report).   Long-Maturity Bond Yields Will Not Move Much Higher This Year Chart I-8Our Inflation Probability Model Is Signaling Core Inflation That Is Roughly In Line With The Fed's Latest Forecast Chart I-8 highlights that our inflation probability model is currently signaling core PCE inflation of roughly 4.3% over the coming year. This is only moderately above the Fed’s forecast for this year, suggesting that a moderation in the rate of inflation makes it more likely that the Fed will raise rates in line with, or only moderately above, what was projected in the March Summary of Economic Projections (1.9% by the end of this year, and 2.8% by the end of 2023). By contrast, Chart I-9 highlights that the OIS curve is pricing the Fed funds rate at 80 basis points higher by the end of this year than what the Fed projected in March, suggesting that the bar for further hawkish surprises is quite high. We agree that the Fed will likely front-load a good portion of its planned tightening this year, and we agree that a 50 basis point hike is likely next month and also possibly in June. However, it is quite possible that the Fed will ultimately raise rates over the coming year at a slower pace than investors currently anticipate, which would lower yields at the front end of the curve. Chart I-9The Bar For Further Hawkish Surprises From The Fed Is Quite High If short-maturity yields are flat or trend modestly lower over the coming year, then a significant further rise in long-maturity yields would likely necessitate a major shift in neutral rate expectations on the part of investors or the Fed. We believe that such a shift will eventually occur, as the economic justification for long-maturity bond yields well below trend rates of economic growth disappeared in the latter half of the last economic expansion. However, we noted in last month’s Special Report that a low neutral rate outlook has become entrenched in the minds of investors and the Fed, and is only likely to change once the Fed funds rate rises meaningfully and a recession does not materialize.4 BCA’s fixed-income team currently recommends that investors maintain a neutral duration stance; the Bank Credit Analyst service is more inclined to recommend a modestly short stance. However, the key point for investors is that another significant rise in long-maturity bond yields is unlikely over the coming year, which is positive for economic activity and investor sentiment. The Pandemic Will Recede In Importance, Supporting Services Spending Chart I-10COVID Hospitalizations And Deaths Remain Low In The DM World While the pandemic is clearly not over in China (discussed below), it is likely to continue to recede in importance in the US and other highly vaccinated, and relatively highly exposed DM economies. Despite the fact that confirmed cases of COVID-19 have risen in the DM world in March and April, Chart I-10 highlights that there has been very little increase in ICU patients or deaths. A recent study from the US CDC suggests that 58% of the US population overall and more than 75% of younger children have been infected with the SARS-COV-2 virus since the start of the pandemic.5 When combined with a vaccination rate close to 70%, that signals an extraordinarily high national immunity to severe illness from the disease. Chart I-11 also highlights that deliveries of Pfizer’s Paxlovid continue to climb in the US, a drug that seemingly works against all known variants and has been found to reduce hospitalizations from COVID significantly if taken within the first five days of symptoms. Given that the decline in services spending that we showed in Chart I-4 has been clearly linked to the pandemic, we expect that a slowing pandemic will continue to support services spending. Goods spending is normally a more forceful driver of economic activity than is the case for services spending, but the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-World War II economic environment (Chart I-12). This underscores that a continued recovery in services spending relative to its pre-pandemic trend will provide a ballast to overall consumer spending as goods spending continues to normalize. Chart I-11Paxlovid To The Rescue! Chart I-12Real Services Spending Will Continue To Be A Forceful Driver Of US Economic Activity What Could Go Wrong The US Will Likely Experience A Recession Scare Chart I-13US Housing Affordability Has Cratered, In Large Part Due To Surging House Prices Despite our view that the US economy will avoid a recession over the coming year, it seems likely that investors will experience a recession scare at some point over the coming 6 to 12 months. Even though it has recently moved back into positive territory, the inversion of the 2-10 yield curve has set the scene for a recessionary overtone to any visible weakness in the US macro data over the coming months. We noted above that the manufacturing and goods-producing sectors of the US economy are likely to slow as spending returns to services. More importantly, the extremely sharp increase in mortgage rates will likely cause at least a temporary slowdown in US housing activity, even if that slowdown does not ultimately prove to be contractionary.Chart I-13 highlights that the recent increase in mortgage rates will cause US housing affordability to deteriorate back to 2007 levels. While rising mortgage rates will be the proximate cause of this deterioration in affordability, panel 2 highlights that the real culprit has been a significant increase in house prices relative to income. There is strong evidence pointing to the fact that US real residential investment has been too weak since the global financial crisis (GFC).6 We agree that high prices will likely spur additional housing construction (which will support growth). But over the nearer-term, the sharp deterioration in affordability may imply that house price appreciation will have to fall below the rate of income growth, which would represent a very sharp correction in house price gains that would almost assuredly appear recessionary for a time. The European Economy May Contract We have discussed the risk of a European recession in past reports, and noted that it would be almost certain to occur in a scenario in which Russia’s energy exports to Europe were to be completely cut off. We continue to see this as an unlikely scenario, although the odds have increased significantly of late in light of Russia’s halt of gas supplies to Bulgaria and Poland and Germany’s apparent acceptance of an oil embargo against Russia. However, Chart I-14 highlights that a recession, at least a technical one, may occur in Germany even if its imports of Russian natural gas are not interrupted. The chart shows that the German IFO business climate indicator for manufacturing has deteriorated more than the Markit PMI has, and panel 2 highlights that IFO-reported service sector sentiment is considerably worse than what was suggested by the Markit services PMI. Chart I-15 highlights that European stocks are not fully priced for a European recession, either in relative or absolute terms. This underscores the risk to global equities if real euro area growth falls meaningfully below current consensus expectations of 1.9% this year. Chart I-14German Business Sentiment Suggests A Possible Recession Chart I-15Euro Area Stocks Are Not Fully Priced For A European Recession Omicron Will Continue To Spread In China Table I-2The Ports Of Shanghai and Ningbo Are Quite Important To Chinese Trade Flows Confirmed cases of COVID-19 have surged in China over the past two months, and it is now clear that the country’s zero-tolerance policy will fail to contain the spread of the disease. We initially downgraded the odds of our above-trend growth scenario in our January report specifically in response to the risk that the Omicron variant of the virus posed to China.7 That risk that is now manifesting itself most acutely in Shanghai, but also increasingly in other coastal and northeastern provinces. Chart I-16COVID Restrictions In China Are Causing Significant Delays In Suppliers' Delivery Times China’s COVID surge has two implications for the global economic and financial market outlook. The first is that the surge has led to increased port congestion and shipping delays, which clearly threaten to cause a further rise in global shipping costs. We have noted in past reports that shipping costs from China to the West Coast of the US surged following the one month shutdown of the port of Yantian last year. Table I-2 highlights that the ports of Shanghai and nearby Ningbo handle nearly 30% of China’s total ocean shipping volume. Chart I-16 highlights that road traffic restrictions in the Yangtze River Delta have caused significant delays in suppliers’ delivery times, further raising the risk of bottlenecks that may take months to clear. Chart I-17China's Battle With Omicron Further Raises The Risk Of A Euro Area Recession The second implication of China’s COVID surge is that China’s contribution to global growth is at risk of declining significantly further, at least for a time. If Chinese economic activity slows sharply in response to the lockdowns and a further spread of the disease, we fully expect Chinese policymakers to provide further stimulus to support household income in line with what occurred in DM countries two years ago. In addition, some investors have argued that reduced commodity demand from China is actually desirable in the current environment, as it would further reduce inflationary pressure in the US and other developed economies. However, Chart I-17 highlights that Chinese import growth has already slowed very significantly, which has clearly impacted euro area exports. European exports to China are not predominantly commodity-based, and it is yet unclear whether the form of stimulus that Chinese policymakers will introduce will be particularly import-intensive. As such, China’s failure to contain Omicron further adds to the risk of the European recession we noted above, and threatens our view that US headline inflation will trend lower this year. Inflation Expectations May Unanchor Despite Slowing Inflation We discussed above that US inflation will decelerate this year and that this may allow the Fed to raise interest rates at a slower pace than currently expected by market participants. One risk to this view is the possibility that inflation expectations may unanchor to the upside, despite an easing in inflation. Even though inflation expectations have not trended in a different direction than actual inflation since the GFC, Chart I-18 highlights that this has occurred in the past (from 2001-2006). In our view, the level of inflation that is likely to prevail over the coming two years will be an extremely important determinant of whether inflation expectations break above their post-2000 range. For now, Chart I-18 highlights that the Fed’s expectation for core inflation this year is reasonable, but it remains an open question whether core inflation will decelerate below 3% next year as the Fed is forecasting. This is notable, because US core PCE inflation peaked at a rate of 2.6% during the 2002-2007 economic expansion, which is the period when stable long-dated inflation expectations were prevalent. Chart I-19 highlights that market-based inflation expectations are currently challenging or have risen above their 2004-2014 average. We noted in last month’s report that long-dated household inflation expectations will be historically low, even if inflation decelerates in line with what near-dated CPI swaps are forecasting. Chart I-18Inflation Expectations May Still Unanchor Even If The Inflation Rate Comes Down Chart I-19Market-Based Inflation Expectations May Soon Rise Above Pre-GFC Range   The bottom line for investors is that a slowing of inflation over the coming several months may not be enough to prevent long-term inflation expectations from rising. That raises the risk of an even more aggressive pace of interest rates than currently expected by investors, because the Fed is determined to avoid repeating the mistakes of the 1970s when rising inflation expectations led to a wage-price spiral that required years of comparatively tight monetary policy to correct. By contrast, the Fed will view a temporary income-statement recession stemming from a sharp rise in interest rates as the lesser of two evils. A recession to prevent a long-lasting wage-price spiral would also probably be better for investors over the longer run, but a recession would clearly imply a significant decline in risky asset prices at some point over the coming two years were it to occur. Investment Conclusions Chart I-20Despite The Risks Facing Europe, Euro Area Stocks Are Not A Clear Underweight Candidate From the perspective of allocating to risky assets, the most important question for investors to answer is whether the US is likely to experience a recession over the coming year. As we noted above, in our view the answer is “no”, which implies that US earnings growth will remain positive and that investors should not be underweight stocks within a global multi-asset portfolio. It is true that earnings can decline outside of the context of a recession, but we discuss in Section 2 of our report that this has almost always been associated with a significant contraction in profit margins. The factors that have historically been associated with a nonrecessionary decline in profit margins may occur later this year, but our indicators so far point more to flat margins rather than a significant decline. For now, investors should remain minimally-overweight stocks over a 6 to 12 month time horizon, although that assessment may change in either a bullish or bearish direction over the coming several months. Within a global equity allocation, we recommend that investors maintain a neutral regional allocation. The larger risk of a recession in Europe than in the US would normally imply that investors should be overweight US stocks, but euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine. Chart I-15 highlighted that they will underperform further if euro area growth turns negative. It is not clear, however, if that risk warrants an underweight stance today, especially considering the enormous valuation advantage offered by euro area stocks versus their US counterparts and the fact that the euro has already fallen to a five-year low (Chart I-20). Chart I-21Favor A Neutral Stance Towards Cyclical Stocks Versus Defensives Within the dimensions of the equity market, Chart I-21 highlights that the outperformance of cyclicals versus defensives was already late at the onset of Russia’s invasion of Ukraine, and that the uptrend in relative performance has seemingly ended. Still, a moderately overweight stance toward stocks overall does not especially support an underweight stance toward cyclicals; therefore, we recommend a neutral stance over the coming year. We continue to recommend that investors (modestly) favor value stocks over growth stocks on the basis of better value and as a hedge against potentially higher long-maturity yields, although we acknowledge that most of the outsized outperformance of growth stocks during the pandemic has already reversed. Despite their recent underperformance, we continue to favor global small-cap stocks over their large-cap peers, as they are now unequivocally inexpensive and have seemingly already priced in a likely recession scare in the US later this year (Chart I-22). Within a fixed-income portfolio, we recommend that investors maintain a modestly short duration stance despite our forecast that long-maturity bond yields will not increase much this year. We are wary of recommending a neutral duration stance given the possibility that investors or the Fed may upwardly revise their neutral rate expectations earlier than we anticipate; however, investors are also likely to see long-maturity yields come down for a time in response to a housing market slowdown over the coming several months. More nimble investors should be neutral duration, and should test a long stance if US data releases begin to exhibit meaningfully negative surprises. Finally, while we are bearish toward the dollar on a 6- to 12-month time horizon, it is likely to strengthen over the near term. Chart I-23 highlights that our composite technical indicator for the US dollar is now clearly in overbought territory. We expect that a downtrend will begin once the war in Ukraine reaches a durable conclusion and clarity about the economic impact of the spread of Omicron in China – and the likely policy response – emerges. Chart I-22The Selloff In Small Caps Seems Overdone Chart I-23US Dollar And Indicator The Dollar Is Ripe For A Major Pullback Beyond Likely Near-Term Strength   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 28, 2022 Next Report: May 26, 2022 II. The US Equity Market: A Fundamental, Technical, And Value-Based Review All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.8 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.9 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts As discussed in this month’s Section 2, BCA’s equity indicators do not paint an optimistic picture for stock prices. Our monetary indicator is at its weakest point in almost three decades, our valuation indicator continues to highlight that stocks are overvalued, and both our sentiment and technical indicators have broken down. An eventual easing in the latter two measures will ultimately prove positive for equities, but this will likely happen only once they reach extremes. Investors should be at most modestly overweight stocks versus bonds over the coming year. Forward equity earnings are likely pricing in too much of an increase in earnings per share over the coming year. Net earnings revisions and net positive earnings surprises have rolled over considerably, although there is no meaningful sign yet of a decline in the level of forward earnings. Earnings growth is more likely than not to be positive over the coming year, but will be modest. Within a global equity portfolio, we recommend a neutral stance towards cyclicals versus defensives, as well as a neutral regional equity stance. Euro area stocks are not a clear underweight candidate despite the risk of a European recession. Within a fixed-income portfolio, the 10-Year Treasury Yield has very little further upside over the coming year, arguing for a modestly short duration stance. We do not believe that the Fed will end up raising rates to a level higher than investors are forecasting over the coming year. Commodity prices continue to rise in a broad-based fashion following Russia’s invasion of Ukraine, and our composite technical indicator highlights that they remain significantly overbought. We expect oil and food prices to come down over the coming year, but there is a risk to that assessment. Russia aggression has very likely sped up Europe’s decarbonization timeline, suggesting that investors should be tactically, cyclically, and structurally bullish on industrial metals prices. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Leading and coincident indicators remain decently strong, and we do not expect a recession in the US over the coming year. However, the odds of a stagflationary-lite outcome of above-target inflation and at-or-below-trend growth have increased because of the war. 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 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 ECONOMY: Chart III-28US And Global Macro Backdrop 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 The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 2     Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, and "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3  Please see US Investment Strategy/ US Bond Strategy Special Report "Gauging The Risk Of Recession: Slowdown Or Double-Dip?" dated August 16, 2010, available at usbs.bcaresearch.com 4    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 5    Clarke, KE, JM Jones, Y Deng, et al. Seroprevalence of Infection-Induced SARS-CoV-2 Antibodies — United States. September 2021–February 2022. 6    Please see The Bank Credit Analyst "Global House Prices: A New Threat For Policymakers," dated May 27, 2021, available at bca.bcaresearch.com 7     Please see The Bank Credit Analyst "January 2022," dated December 23, 2021, available at bca.bcaresearch.com 8    Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 9    Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com

Executive Summary Using the real yield on inflation protected bonds as a gauge of the long-term real interest rate is possibly the biggest mistake in finance. The ultra-low real yield on inflation protected bonds captures nothing more than a stampede for inflation protection overwhelming a tiny supply of inflation protected bonds. The long-term real interest rate embedded in the US bond and US stock markets is likely to be significantly higher than the -0.2 percent real yield on US inflation protected bonds. Long-term investors should overweight conventional bonds and stocks versus inflation protected bonds. On a 6-12 month horizon, overweight both US bonds and US stocks. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-offs both in long duration bonds and in the stock market. Fractal trading watchlist: High dividend stocks, and MSCI Hong Kong versus MSCI China. The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection Bottom Line: The end is in sight for the sell-offs both in long duration bonds and in the stock market. Feature “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so” One of my favourite quotes, ostensibly attributed to Mark Twain, warns us that trouble doesn’t come from what you don’t know. Rather, trouble comes from what you think you know for certain but turns out to be wrong. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. The long-term real interest rate is arguably the most fundamental concept in economics and finance. It encapsulates the risk-free real return on savings, and it is embedded in the returns offered by all assets such as bonds and equities. The trouble is, the way that most people quantify the long-term real interest rate turns out to be wrong. Specifically, most people define the long-term real interest rate as the real yield on (10-year) inflation protected bonds, which now stands at -0.2 percent in the US and -2.3 percent in the UK. US and UK inflation protected bonds will of course deliver the negative long-term real returns that their yields offer. So, most people believe that the long-term real interest rate is still depressed, permitting many rate hikes from the Federal Reserve and Bank of England before monetary policy becomes ‘restrictive’, and providing a massive cushion to asset valuations before they become expensive.This commonly held belief is arguably the biggest mistake in finance. The Long-Term Real Interest Rate Is Not What You Think The biggest mistake in finance stems from the confluence of two factors: first, the inflation protected bond market is the only true hedge against inflation; and second, it is tiny. Compared with the $45 trillion US equity market and the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion. Many other economies do not even have an inflation protected bond market! The ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. When the price level surges, as it has recently, stock and bond investors have a fiduciary duty to seek an inflation hedge, even if they are shutting the stable door after the horse has bolted (Chart I-1). With at least $70 trillion worth of investors all wanting a piece of the $1.5 trillion TIPS market, the demand for TIPS surges, meaning that their real yield collapses. Therefore, the ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. Chart I-1When The Price Level Surges, Investors Flood Into Inflation Protected Bonds The proof comes from the perfect positive correlation between the oil price and so-called ‘inflation expectations.’ As a surging oil price drives down the 10-year TIPS yield relative to the 10-year T-bond yield, this difference in yields – which is the commonly accepted definition of expected inflation through 2022-32 – also surges (Chart I-2and Chart I-3). This perfect positive correlation also applies to the so-called ‘5-year, 5-year forward’ inflation rate, the expected inflation rate through 2027-32 (Chart I-4). Chart I-2Inflation Expectations Just Track The Oil Price Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price Chart I-4Even The ‘5-Year, 5-Year Forward’ Inflation Expectation Just Tracks The Oil Price Yet this observed positive correlation between the oil price and inflation expectations is nonsensical, because the reality is the exact opposite! The higher the price level at a given moment, the lower will be the subsequent inflation rate. This is just basic maths. The subsequent inflation rate is the future price divided by the current price, so dividing by a higher price results in a lower number. The empirical evidence over the last 50 years confirms this. The higher the oil price, the lower the subsequent inflation rate (Chart I-5). Chart I-5But A Higher Oil Price Means Lower Subsequent Inflation As the price level surges, subsequent inflation declines, both in theory and in practice. Hence, we should subtract a smaller number from the nominal bond yield to get a higher long-term real interest rate. In other words, all else being equal, the impact of a higher price level is to lift the long-term real interest rate. To repeat, the very low real yield on inflation protected bonds just captures the stampede of inflation hedging demand overwhelming a tiny supply (Chart I-6). Given this distortion, the real yield on inflation protected bonds is likely not the long-term real interest rate embedded in the much larger bond and stock markets. Right now, the long-term real interest rate embedded in the bond and stock markets is likely to be significantly higher than the -0.2 percent real yield on TIPS. Chart I-6The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection To which the obvious rejoinder is: if the real yield embedded in conventional bonds and stocks is much higher than in inflation protected bonds, why does the market not arbitrage it away? The simple answer is that the market will arbitrage it away, but in slow motion. This is because the mispricing between expected and realised inflation will crystallise in real time, and not ahead of it. Nevertheless, this slow motion arbitrage provides a compelling opportunity for patient long-term investors. Overweight conventional bonds and stocks versus inflation protected bonds. The Best Way To Value The Stock Market Given that we cannot use the yield on inflation protected bonds as a reliable measure of the long-term real interest rate embedded in stock prices, it is also a big mistake to value equities versus the real bond yield. In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities. The basic idea is that the cashflows of any investment can be condensed into one future ‘lump sum payment’. So, we just need to know the size of this lump sum payment, and then to calculate its present value. The US stock market tracks (the 30-year T-bond price) multiplied by (profits expected in the year ahead). For a stock market, the size of the payment just tracks current profits multiplied by ‘a structural growth constant’, and the present value just tracks the value of an equal duration bond. For example, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years.1  It follows that the US stock market price should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a structural growth constant) To the extent that the structural growth outlook for profits does not change, we can simplify the expression to: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) This approach might seem simplistic, yet it perfectly explains the US stock market’s evolution both over the past 40 years (Chart I-7) and over the past year (Chart I-8). Specifically, in 2022 to date, the major drag on the US stock market has been the sell-off in the 30-year T-bond. Chart I-7The US Stock Market = The 30-Year T-Bond Price Times Profits (40 Year Chart) Chart I-8The US Stock Market = The 30-Year T-Bond Price Times Profits (1 Year Chart) For the foreseeable future, we expect profit growth to be lacklustre, keeping the 30-year T-bond price as the dominant driver of the US stock market. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-off in long duration bonds and therefore for the sell-off in the stock market. On a 6-12 month horizon, overweight both US bonds and US stocks. Fractal Trading Watchlist This week, we note that the MSCI index outperformance of Hong Kong versus Chinese has reached a point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2015, 2016, 2018, 2019, and 2020. Therefore, we have added this to our watchlist of investments that are at or approaching turning points, which is available in full on our website: cpt.bcaresearch.com We also highlight that the strong rally in high dividend stocks (the ETF is HDV) is vulnerable to correction if, as we expect, bond yields stabilise or reverse (Chart I-9). Accordingly, the recommended trade is to short high dividend stocks (HDV) versus the 10-year T-bond, setting the profit target and symmetrical stop-loss at 6 percent. Chart I-9The Outperformance Of High Dividend Stocks Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile   Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 19Switzerland's Outperformance Vs. Germany Has Started To End Chart 20The Rally In USD/EUR Could End Chart 21The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. Defined mathematically, it is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield. 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  

Executive Summary Economic Growth in Q2 Will Be Much Softer China’s GDP headline growth in Q1 was better than consensus, but it does not capture the full economic impact of ongoing city lockdowns. Other than infrastructure investment, business activity data from March shows a broad-based slowing in growth momentum. Manufacturing investment decelerated, while both real estate investment and retail sales contracted from a year ago. Exports in value terms continued to grow rapidly through March. However, the resilient rate of expansion is unsustainable given a weakening global manufacturing cycle and softening external demand for goods. China’s domestic supply-chain disruptions will also weigh on its export sector’s activity. Home sales contracted sharply in the first three weeks of April, particularly in larger cities. The lockdowns, coupled with poor funding dynamics among real estate developers, suggest that the real estate sector will remain a huge drag on China’s economy this year. Bottom Line: Even though business activities will resume after the lockdown restrictions are lifted, we do not expect China’s economy to rebound quickly and strongly as it did in 2H20. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio.   A slew of economic data released during the past two weeks suggests that the negative effects from the COVID-induced lockdowns in China’s largest and most prosperous cities are starting to emerge. The closings, which will likely continue through the end of April, are causing disruptions in both production and demand just as the economy was already in a business downcycle. Other than infrastructure spending, business activity data from March illustrates a broad-based slowing in growth momentum. The longer-term impact of the citywide shutdowns is still to come. Related Report  China Investment StrategyThe Cost Of China’s Zero-COVID Strategy The economic benefits of Beijing’s enhanced stimulus measures will be delayed to 2H22 at the earliest. Moreover, as we discussed in our last week’s report, the post-lockdown recovery in the second half of this year will be much more muted than in H2 2020 . The external environment is less reflationary than in 2H20; China’s domestic demand and sentiment among corporates and households were already declining prior to the latest lockdowns. The deteriorating economic outlook will continue to depress the absolute performance of Chinese onshore stocks in the coming months (Chart 1). Furthermore, against a backdrop of rising US Treasury yields, the interest rate differentials between China and US have become negative for the first time in a decade. A yield disadvantage, coupled with risk-averse sentiment across global financial markets, has discouraged portfolio flows into China. We expect foreign investment outflows to continue in the near term before China’s economy stabilizes sometime in 2H22 (Chart 2). Chart 1Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Chart 2...And Have Triggered Substantial Foreign Investment Outflows From a cyclical perspective, we maintain our neutral position on Chinese onshore stocks in a global portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com China’s Credit Conditions: Amble Supply Versus Lack Of Demand Although broad credit growth accelerated in March from the previous month, the improvement mainly reflects a sharp increase in local government bond issuance. Bank loan growth on a year-over-year basis has not improved yet. Loan demand for infrastructure investments escalated, supported by front-loaded fiscal supports in Q1 (Chart 3). However, private-sector credit demand remains very weak. The acceleration in the credit impulse –calculated as a 12-month difference in the annual change in credit as a percentage of nominal GDP –is much more muted when excluding local government bond issuance (Chart 4). Chart 3Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Chart 4The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Sentiment among the corporate and household sectors has plunged to a multi-year low, following two years of stringent COVID-containment measures and last year’s regulatory clampdowns (Chart 5). Furthermore, the corporate sector’s propensity to invest weakened sharply in Q1, despite much looser monetary conditions (Chart 6). A worsening private sector’s sentiment suggests that demand for credit is unlikely to pick up imminently. Chart 5Private-Sector Demand For Credit Remains in The Doldrums... Chart 6...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions Chart 7Significant Foreign Investment Outflows In China's Onshore Bond Market The PBoC announced a 25bps cut in its reserve requirement ratio (RRR) rate on April 15, but has kept its policy rate unchanged. The move was below the market’s expectation of a 50bps RRR cut and/or a policy rate cut. While we still expect that the PBoC will trim the loan prime rate (LPR) in Q2, the recent acceleration in the RMB’s devaluation may make the central bank more cautious in reducing rates and further diverging from the hawkish US Fed and other major central banks  (Chart 7). China GDP: Above-Expectation Growth In Q1, Mounting Concerns In Q2 China’s year-over-year GDP growth in Q1 accelerated to 4.8% from 4.0% in Q4 last year, beating the market expectation of a 4.2% increase. The Q1 growth was mainly supported by strong infrastructure investments and exports (Chart 8). On a sequential basis, however, seasonally adjusted GDP growth in Q1 was 1.3% (non-annualized), slower than Q4’s reading of 1.6% and below its historical mean (Chart 9). Meanwhile, private- sector investment and household consumption remain subdued and activity in the housing sector worsened. Chart 8Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Chart 9Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean The negative effect from broadening city-wide lockdowns and more supply-chain disruptions in Shanghai and surrounding cities in the Yangtze River Delta region will be much larger in Q2 than in Q1. We expect that year-over-year GDP growth in Q2 will drop well below 4%, sharply down from the 4.8% growth recorded in Q1. Furthermore, the aggregate economic impact from the lockdowns could reduce China’s real GDP growth in 2022 by 1ppt, which poses substantial risks to the country’s 5.5% annual growth target for this year. Exports Growth Set To Decelerate Although the growth of exports in value terms remained resilient in March, China’s exports will be challenged this year by the softening global demand for goods and domestic COVID-induced disruptions in the supply chain. A recent PBoC survey of 5,000 industrial enterprises shows that overseas orders dived sharply (Chart 10). In addition, global cyclical stocks have underperformed defensives. The underperformance has historically been a good leading indicator of a global manufacturing downturn, which will likely lead to a decline in demand for Chinese exports (Chart 11). The weakening external demand is also reflected in softening US demand and falling personal consumption expenditures on goods ex-autos (Chart 12).   Chart 10Overseas Orders For Chinese Industrial Enterprises Dived Sharply Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Furthermore, China’s imports for processing trade, which historically has been highly correlated with China’s total exports growth, decelerated sharply in March. The drop heralds a slowdown in the growth of Chinese exports in the coming months (Chart 13). Chart 12External Demand For Chinese Export Goods Will Likely Dwindle Chart 13Slowing Processing Imports Point To A Deceleration In Chinese Export Growth   Port congestions and supply-chain disruptions worsened in April after the Shanghai lockdown began on March 28. COVID-related supply-chain disruptions in China’s key ocean ports and reduced shipping volumes will curtail activity of the country’s export sector in the short term. Real Estate Sector Will Remain A Drag On China’s Economy March’s data reflects a broad-based deterioration in housing market activities (Chart 14). The growth in real estate investment rolled over, and all floor space indicators contracted further in March. Moreover, households’ sentiment in the property market remains lackluster (Chart 15). Funding among real estate developers has plummeted to an all-time low, which will continue to dampen housing construction activities (Chart 16). Chart 14A Broad-based Deterioration In Housing Market Indicators In March Chart 15Housing Market Sentiment Shows Little Signs Of Revival Chart 16Housing Construction Activities Are Set To Slow Further Chart 17Home Sales Worsened In April Amid COVID Flareups In Major Cities The March housing transaction data only captures some early indications from the recent round of lockdowns. The negative upshot on home sales will be greater in April. Figures for high-frequency floor space sold show a substantial weakening in home sales, particularly in tier-one and tier-two cities, through the first three weeks of April (Chart 17). The shrinkage in home sales will likely continue through Q2 and poses a significant risk for property investment and construction activities in H2. Regional governments are allowed to initiate their own housing policies, therefore, an increasing number of regional cities have slashed mortgage rates and/or down payment thresholds (Chart 18). However, the easing measures have failed to shore up demand for housing. In addition, pledged supplementary lending, which the government used to monetize massively excess inventories in the 2015/16 market, resumed its downtrend in March after a short-lived rebound earlier this year (Chart 19). Chart 18More Regional Cities Have Eased Local Housing Policies Chart 19PSL Injections Resumed Downward Trend In March Subdued Domestic Demand And Household Consumption Chart 20Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments China’s domestic demand remained weak in March and will likely worsen in the next few months when more negative fallout from the recent lockdowns spill over to the aggregate economy.   Infrastructure investments picked up strongly in March. However, robust infrastructure investments were insufficient to fully offset the weakness in capital spending in the real estate and manufacturing sectors (Chart 20). The sluggish housing market and a deceleration in exports growth will likely slow China’s capital spending further in Q2. Growth in China’s imports in value terms contracted slightly in March; this was the first time since September 2020. Meanwhile, import growth in volume terms contracted sharply amid weak domestic demand and the early effects of supply-chain disruptions (Chart 21). Moreover, imports of major commodities in volume shrank deeper in March (Chart 22).  Chart 21Chinese Imports Value Growth Fell Into Contraction In March Chart 22The Volume Of China's Key Commodity Imports Contracted Further In March Household consumption has been a laggard in China’s economy in the past two years and the wave of city lockdowns are taking a heavy toll on consumption. Retail sales growth contracted in March, for the first time since August 2020 (Chart 23). Notably, online sales of goods also slowed to a multi-year low, highlighting not only subdued demand but also COVID-related logistic interruptions. Chart 23Retail Sales Growth Slipped Below Zero Chart 24Tame Core And Service CPIs Also Reflect Sluggish Household Demand Weakening core and service CPI readings also reflect a lackluster demand from consumers (Chart 24). We expect that the ongoing lockdowns will continue to weigh on service sector activity and household consumption, at least for the next couple of months (Chart 25). In addition, labor market dynamics are worsening rapidly and the nationwide urban unemployment rate rose to its highest level since mid-2020. The employment situation will also curb household consumption in the medium-term (Chart 26). Chart 26Labor Market Situation Is Deteriorating Sharply Chart 25Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes Strategic Themes Cyclical Recommendations

Executive Summary Summarizing Our Main Investment Themes In One Chart Our current strategic recommendations are centered around four key themes: global inflation will slow over the rest of 2022, Europe remains too weak to handle significantly higher interest rates, corporate default risk in the US and Europe is relatively low, and the fundamental backdrop for emerging markets is poor. If we are going to be proven wrong on any of those themes, it will most likely be because global inflation remains high for longer due to resilient commodity prices and lingering supply chain disruptions. A sluggish economy will handcuff the ECB’s ability to raise rates as fast as markets are discounting over the next year. The state of corporate balance sheet health in the developed world is not problematic, on average, even with some sectors taking on more leverage in response to the 2020 COVID downturn. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. Bottom Line: We remain comfortable with our main fixed income investment recommendations: maintaining neutral global portfolio duration, overweighting core European bonds versus US Treasuries, favoring high-yield corporates over investment grade (both in the US and Europe), and underweighting EM hard currency debt. Feature One of the foundations of a sound medium-term investment process is to allocate capital towards highest conviction views, while constantly assessing - and reassessing - if those views are unfolding as expected. Trades that are not going according to plan may need to be reconstructed, if not exited entirely, to avoid losses. We feel the same way about the investment recommendations highlighted in the pages of our reports, which represent our portfolio, as it were. With this in mind, in this report we identify the four most critical themes underpinning our current main investment recommendations and evaluate the potential risks that our views will not turn out as expected. Theme #1: Global Inflation Will Decline In The Latter Half Of 2022 Our biggest theme for the rest of this year is that global inflation will cool off after the massive acceleration over the past year. Many of our current fixed income investment recommendations across the developed markets – maintaining neutral overall global duration exposure, underweighting global inflation-linked bonds versus nominal government debt, betting against additional yield curve flattening (especially in the US) – are predicated on reduced inflationary pressure on interest rates. Related Report  Global Fixed Income StrategyA Crude Awakening For Bond Investors The expectation of lower inflation is based on some easing of the forces that first caused the current inflationary overshoot – booming commodity prices and rapidly accelerating goods prices due to supply-chain disruptions. Already, the commodity price factor is starting to fade, on an annual rate-of-change basis that matters for overall inflation, thanks to more favorable comparisons to the commodity surge in 2021 (Chart 1). The year-over-year growth rate of the CRB index has decelerated from a peak of 54.4% in June 2021 to 19.3% today, even with many commodity prices seeing big increases in response to the Russia/Ukraine war. This is because the increases in commodity prices were even larger one year ago when much of the global economy reopened from COVID-related economic restrictions. Favorable base effect comparisons are not the only reason why commodity inflation has slowed. Commodities are priced in US dollars, and the steady appreciation of the greenback, with the trade-weighted dollar up 5% on an year-over-year basis, has also helped to slow commodity price momentum (Chart 2). Slower global growth, coming off the overheated pace of 2021, has also acted as a drag on overall commodity price inflation (middle panel). Beyond the commodity space, some easing of global supply chain tensions has resulted in indicators of shipping costs seeing meaningful declines even with supplier delivery times still elevated (bottom panel). Chart 1Our Main Strategic Theme: Decelerating Global Inflation​​​​​​ Chart 2Disinflationary Momentum From Commodities Already Underway​​​​​ A more fundamental factor that should help moderate global inflation momentum this year beyond the commodity/supply chain effects relates to a lack of broad-based global "excess demand", even as the world economy continues to recover from the massive pandemic shock in 2020. The IMF’s latest projections on output gaps – estimates of the amount of spare economic capacity – show that few major developed or emerging market economies are expected to have positive output gaps over 2022 and 2023 (Chart 3). The US is the most notable exception, with an output gap projected to average +1.6% this year and next. Most other developed market countries are projected to have an output gap close to zero. This suggests that the US is facing the most inflationary pressure from an overheating economy, which is why we continue to see the Fed as being the most hawkish major developed market central bank over the next couple of years. Chart 3Few Countries Expected To Have Inflationary Output Gaps In 2022/23 Yet even with so much of the macro backdrop supporting our call for slower global inflation in the coming months, there are several potential risks to that view. Chart 4A Risk To Our Lower Inflation View: Resilient Oil Prices Another war-related upleg in global oil prices Our commodity strategists continue to see oil prices settling down to the low $90s by year-end. Yet oil has seen tremendous volatility since the Ukraine war began as prices had to factor in the potential loss of Russian oil supplies in an already tight crude market. The benchmark Brent oil price briefly hit $140 in the immediate aftermath of the Russian invasion. A similar move sustained over the latter half of 2022 would trigger a reacceleration of oil momentum, putting upward pressure on overall global inflation rates. A renewed bout of energy-induced inflation would push global interest rate expectations, and bond yields, even higher from current levels – a challenge to both our neutral duration stance and underweight bias on global inflation-linked bonds (Chart 4). More supply-chain disruption from China Chinese authorities are clamping down hard on the current COVID wave sweeping across China. The current lockdowns in major cities like Shanghai could shave as much as one percentage point off Chinese real GDP growth for 2022, according to our China strategists. Those same lockdowns in a major transportation and shipping hub like Shanghai are already causing supply chain disruption within China. Supplier delivery times saw big increases in the March PMI data (Chart 5), while the number of cargo ships stuck outside Shanghai has soared. The longer this lasts, the greater the risk that supply chains beyond China would be disrupted, erasing the improvements in global supplier delivery times seen over the past few months. That could keep goods price inflation elevated for longer. Stubbornly resilient services inflation A big part of our lower inflation view is related to a rebalancing of consumer demand in the developed world away from goods towards services as economies move away from COVID restrictions. This implies an easing of the excess demand pressures that have triggered supply shortages for cars and other big-ticket consumer goods. The result would be a sharp slowing of goods price inflation, with the result that overall inflation rates in the major economies would gravitate towards the slower rate of services inflation. The latter, however, is accelerating in the US, UK and Europe (Chart 6) – largely because of soaring housing costs – which raises the risk that overall inflation will fall to a higher floor in 2022 as goods inflation slows. Chart 5Another Risk To Our Lower Inflation View: China Lockdowns​​​​​ Chart 6One More Risk To Our Lower Inflation View: Sticky Service Prices In the end, we see the balance of risks still tilted towards much slower global inflation this year. However, if we are going to be proven wrong on any of our major investment themes in 2022, it will most likely be because global inflation remains resilient for longer. Theme #2: Europe’s Economy Is Too Fragile To Handle Higher Interest Rates Beyond the global inflation call, our next highest conviction view right now is that markets are overestimating the ECB’s ability to tighten euro area monetary policy. Markets are now pricing in 85bps of ECB rate hikes by the end of 2022, according to the euro area overnight index swap (OIS) curve, which would take policy rates back to levels last seen before the 2008 financial crisis. The war has put the ECB in a difficult spot vis-à-vis its next policy move. High euro area inflation, with annual headline HICP inflation climbing to 7.4% in March and core HICP inflation reaching 2.9%, the highest level of the ECB era dating back to 1996, would justify a move to begin hiking policy interest rates as soon as possible.   However, European growth momentum has slowed significantly so far in 2022. Initially this was due to the spread of the Omicron COVID variant that resulted in a wave of economic restrictions. That was followed by the shock of the Russian invasion of Ukraine, that has hit European economic confidence and raised fears that Europe would lose access to Russian energy supplies. Our diffusion indices of individual country leading economic indicators and inflation rates within the euro area highlight the pickle the ECB finds itself in (Chart 7). All countries have headline and core inflation rates above the ECB’s 2% target, yet only 60% of euro area countries have an OECD leading economic indicator that is higher than year ago levels. In the three previous tightening cycles of the “ECB era” since the inception of the euro in 1998, the diffusion indices for both growth and inflation reached 100% - in other words, every euro area economy was seeing faster growth and above-target inflation. Chart 7The ECB Will Have Difficulty Hiking As Much As Expected Chart 8Warning Signs On European Growth Other economic data are also sending worrying messages. The euro area manufacturing PMI fell to the lowest level since January 2021 in March, while the European Commission consumer confidence index and the ZEW expectations index have plunged to levels last seen during the depths of the 2020 COVID recession (Chart 8). Euro area export growth has also decelerated sharply, with exports to China contracting on a year-over-year basis. Simply put, these are not the kind of growth data consistent with a central bank that needs to begin tightening policy aggressively. The inflation data also does not paint a clean picture for the ECB. ECB President Christine Lagarde has repeatedly noted that the central bank is on the lookout for any “second round effects” from the current commodity-fueled surge in European inflation on more lasting inflationary measures like wages. On that front, European wage growth remains stunningly subdued. European annual wage growth was only 1.6% in Q4/2021, despite the unemployment rate for the whole euro area falling below the OECD’s full employment NAIRU estimate of 7.7% (Chart 9). Unit labor costs only grew at an 1.5% annual rate at the end of 2021, suggesting little underlying pressure on European inflation from wages. Chart 9No Inflationary Pressures From Wages In Europe​​​​​ Chart 10European Bond Yields Discount Too Much ECB Hawkishness Without a bigger inflation boost from labor costs, the ECB will feel less pressured to begin tightening monetary policy as rapidly and aggressively as markets are discounting – especially if global goods/commodity inflation slows as we expect. We remain comfortable with our overweight recommendation on core European government bonds (Germany and France), both within a global bond portfolio but especially versus the US. The Fed is far more likely to deliver the aggressive rate hikes discounted in money markets compared to the ECB (Chart 10). Theme #3: Corporate Default Risk In The US And Europe Is Relatively Low Another of our main investment themes relates to corporate credit risk. Specifically, we see high-yield debt in the US and Europe as being relatively more attractive than investment grade credit, even in a typically credit-unfriendly environment of tightening global monetary policy and slowing global growth momentum. Our Corporate Health Monitors are highlighting that corporate finances are in relatively good shape on either side of the Atlantic (Chart 11). This is primarily related to strong readings on interest coverage, free cash flow generation and profit margins, all of which are helping to service higher levels of corporate leverage. Defaults are expected to rise over the next year in response to slowing growth momentum, but the increase is projected to be moderate. Moody’s is forecasting the US and European high-yield default rates to be virtually identical, climbing to 3.1% and 2.6%, respectively, by February 2023. Those relatively low default rates, however, are for the aggregate of all high-yield borrowers. Default risks may be higher for some companies and industries that were more severely impacted by the pandemic. Chart 11US/Europe Default Risk Remains Relatively Modest​​​​​ Chart 12The IMF Sees Fewer Financially Vulnerable Firms​​​​​​ Chart 13Default-Adjusted HY Spreads Still Offer Some Value An analysis of global private sector debt included in the latest IMF World Economic Report highlighted that companies that suffered the most significant declines in revenues in 2020 also took on greater amounts of debt than companies whose businesses were least impacted by the 2020 growth shock (Chart 12). Industries that were “worst-hit” by COVID also saw significant worsening of debt servicing capability, described by the IMF analysts as the percentage of firms among the “worst-hit” that had interest coverage ratios less than one (middle panel). Importantly, the IMF report noted that the “worst-hit” industries have seen significant improvements in interest coverage since 2020, reducing the number of financially vulnerable firms (those with high debt-to-assets ratios and interest coverage less than one). The IMF analysis uses corporate data from a whopping 71 countries, but the conclusions are like those from our Corporate Health Monitors for the US and Europe – corporate credit quality has improved, on the margin, since the dark days of the 2020 COVID recession for an increasing number of borrowers. Default-adjusted spreads for high-yield bonds in the US and Europe, which subtract expected default losses from high-yield index spread levels, show that high-yield bonds currently offer decent compensation for expected credit losses (Chart 13). This is especially true for European high-yield, where the default-adjusted spread is just below the average level since 2000. This fits with our current recommendation to maintain neutral allocations to both US and European high-yield. We have a bias to favor the latter, however, due to better valuation metrics and a more dovish outlook on ECB monetary policy compared to the Fed. Theme #4: The Fundamental Backdrop For Emerging Markets Is Poor Chart 14The Backdrop Remains Challenging For EM We have been negative on emerging market (EM) credit dating back to the latter months of 2021. Specifically, we are now underweight EM USD-denominated debt, both sovereigns and corporates. This is a high-conviction view and one that remains fundamentally supported. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China policy stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. While we expect the latter to occur in the coming months, there are meaningful risks to that view, as described earlier. Meanwhile, the situation in Ukraine appears to be worsening with Russia pushing the offensive and showing no desire for reengaging talks with Ukraine. Chinese policymakers are starting to respond to slowing Chinese growth, made worse by the COVID lockdowns, with some easing measures on monetary policy. Credit growth has also started to pick up, but the credit impulse remains too weak to warrant a more positive view on Chinese growth and import demand from EM countries (Chart 14). Finally, the US dollar remains well supported by a hawkish Fed and widening US/non-US interest rate differentials. This may be the most critical variable to watch before turning more positive on EM credit, given the strong historical correlation between the US dollar and EM hard currency spreads (bottom panel). For now, the trend of the US dollar remains EM-negative. Concluding Thoughts Chart 15Summarizing Our Main Investment Themes In One Chart Our four main investment themes, and associated recommendations, are summarized in Chart 15. The credit-related themes – underweighting high-yield bonds in the US and Europe versus investment grade equivalents, and underweighting EM USD-denominated debt – are already performing as expected. The interest rate related themes – slower global inflation and fading European rate hike expectations – should unfold in favor of our recommendations over the balance of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Chart 2Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Chart 6The Clogged-Up Port Of Shanghai Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   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 Brent Stable As Demand + Supply Fall Oil demand growth will slow this year and next by 1.6mm b/d and 1mm b/d, respectively. These expectations are in line with sharp downgrades in World Bank and IMF economic forecasts, which cite pressures from the Ukraine War, COVID-19-induced lockdowns in China, and central-bank policy efforts to contain rising inflation. Lower oil demand will be offset by lower supply from Russia and OPEC 2.0, which now are ~ 1.5mm b/d behind on pledges to restore production taken from the market during the pandemic. In 2022, US production will increase ~750k b/d year-on-year. The strategic relationship between the US and core OPEC 2.0 producers Saudi Arabia and the UAE is fraying. The Core's unwillingness to increase production despite pleas from the Biden administration likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian storage to fill, and lead to production shut-ins. Oil prices would surge to destroy enough demand to cover this loss. Our base-case Brent forecast is at $94/bbl this year and $88/bbl in 2023, leaving our forecast over the period mostly unchanged. Bottom Line: Despite major shifts in global oil supply and demand over the past month, oil markets have remained mostly balanced. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs. Feature Related Report  Commodity & Energy StrategyDesperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma Oil demand and supply growth are weakening on the back of the Ukraine War, COVID-19-induced lockdowns in China, and central-bank efforts to contain rising inflation. We expect global demand growth to slow this year and next by 1.6mm b/d and 1mm b/d, respectively, in line with downgrades in IMF and World Bank global growth forecasts.1 Demand will fall to 100mm b/d on average this year, down from our earlier expectation of 101.5mm b/d published in March. For next year, we expect global oil consumption to come in at 102.2mm b/d, down from our March estimate of 103.2mm b/d (Chart 1). EM consumption, the engine of oil-demand growth, falls to 54.2mm b/d vs. 55.8mm b/d in last month's forecast for 2022 demand. We have been steadily lowering our estimate for 2022 Chinese demand this year due to its zero-tolerance COVID policy and its associated lockdowns, and again take it down 250k b/d in this month's balances to 15.7mm b/d on average. In our estimates, Chinese oil demand grows 2.6% from its 2021 level of 15.3mm b/d. We have been expecting DM oil consumption to flatten out this year, following massive fiscal and monetary stimulus fueling oil demand during and after the pandemic, and continue to expect it to come in at ~ 45.7mm b/d this year. Chart 1Sharply Lower Oil Demand Expected Oil Supply Gets Complicated Oil supply will continue to weaken along with demand this year, primarily due to sanctions imposed on Russia by Western buyers following its invasion of Ukraine. Russia's production reportedly was just above 10mm b/d. Estimates of Russian production losses over 2022-23 range from 1mm b/d to as much as 1.7mm b/d over at the US EIA. The outlier here is the IEA, which warns Russian production will fall 1.5mm b/d this month, then accelerate to 3mm b/d beginning in May. In our base-case modeling, we expect Russian output to average 9.8mm b/d in 2022 and 9.9mm b/d next year (Chart 2). Tracking Russia's production became more complicated, as the government this week announced it no longer would be reporting these data. Prices and satellite services will be needed to impute Russia's output in the future. Russia and the Kingdom of Saudi Arabia (KSA) are the putative leaders of OPEC 2.0 (otherwise known as OPEC+). In the wake of Russia's invasion of Ukraine, OPEC, the original cartel led by KSA, continues to maintain solidarity with Russia, referring in its Monthly Oil Market Report (MOMR), for example, to the "conflict between Russian and Ukraine," or the "conflict in Eastern Europe" – not the war in Ukraine. This would suggest KSA and its allies continue to place a high value in maintaining the OPEC 2.0 structure, which has shown itself to be an extremely useful organization for managing production and production declines among non-Core states – i.e., those states outside the Gulf that cannot increase output, or are managing declining production due to lack of capital, labor or both (Chart 3). Chart 2Brent Stable As Demand + Supply Fall Chart 3OPEC 2.0 Remains Useful To KSA And Russia The strategic relationship between core OPEC 2.0 producers capable of maintaining higher production – KSA and the UAE – and the US is fraying. Both states showed no interest in increasing production despite pleas from the Biden administration following Russia's invasion of Ukraine, and have shown a propensity to expand their diplomatic and financial relationships, e.g., exploring oil sales denominated in Chinese RMB, beyond their US relationships.2 This likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. Outside the OPEC 2.0 coalition, we continue to expect higher output from the US, led by shale oil production. According to Rystad Energy, horizontal drilling permits in the Permian basin hit an all-time high in March.3 If these permits are converted into new projects, oil supply growth will be boosted starting 2023. The US government’s recent announcement to lease around 144,000 acres of land to oil and gas companies – in a bid to bring down high US oil prices – also will spur supply growth towards the beginning of next year.4 These bullish factors are balanced out by nearer-term headwinds. Bottlenecks resulting from pent-up demand released following global lockdowns, the Russia-Ukraine crisis, and investor-induced capital austerity means US oil producers will not be able to turn on the taps as quickly this year as they've been able to do in days gone by. Given the near-term bearish factors and longer-term bullish factors, we expect total US crude production to grow slower this year and ramp up at a faster pace the next. US shale output (i.e., Lower 48 states (L48) ex Gulf of Mexico) is expected to average 9.73mm b/d in 2022 and 10.53mm b/d in 2023 (Chart 4). Total US crude supply is expected to average 11.92mm b/d and 12.74mm b/d, respectively, over this period. Additional production increases are expected from Canada, Brazil and Norway. Chart 4Shales Continue To Pace US Onshore Output Increases Upside Risk Remains KSA's and the UAE's strategy to hold off on production increases despite US entreaties upends one of our expectations – i.e., that these state would increase production as the deficit in OPEC 2.0 output being returned to the market widened. We are coming around to the idea this could represent a desire to diversify their exposure to USD payments and assets, which, as Russia's invasion of Ukraine demonstrated, can become liabilities in an economic war. This also would begin to reduce the heavy reliance KSA and the UAE place on the US vis-à-vis defending its interests.5 Lastly, we would observe KSA's and the UAE's spare capacity is being husbanded closely, given it constitutes most, if not all, of OPEC 2.0's 3.4mm b/d of spare capacity (Chart 5). There are multiple scenarios in which this spare capacity would be needed by global markets to address production outages. One of the most imposing is an EU embargo on Russian oil imports floated by France this week, which triggers a cut-off of natural gas supplies by Russia to the EU.6 An embargo of Russian oil imports by the EU is a very low-probability event, but it is not vanishingly small. The EU imports about 2.5mm b/d of Russia's crude oil exports. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian pipelines and storage to fill, and would lead to production shut-ins. Oil prices would have to surge to destroy enough demand to cover this loss of supply, even after OPEC's spare capacity was released into the market. If realized, such an event also would throw the world into recession, in our view. The prospect of a cut-off of Russian oil imports by the EU was addressed last month by Energy Minister Alexander Novak, who said such an act would prompt Russia to shut down natural gas exports to the EU.7 If Russia follows through on such a threat, it would shut down much of the EU's industrial and manufacturing activity. The experience of this past winter – when aluminum and zinc smelters were forced to shut as natural gas prices surged and made electricity from gas-fired generation too expensive for their operations – remains fresh in the mind of the market. An oil-import ban by the EU followed by a cut-off of natgas exports by Russia almost surely would spike volatility in these markets (Chart 6). In addition, a global recession would be a foregone conclusion, in our view. Chart 5OPEC Spare Capacity Concentrated In KSA, UAE Chart 6Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Markets Remain Roughly Balanced … For Now Our supply-demand modeling indicates production losses are roughly balanced by consumption losses at present (Chart 7). If anything, the lost demand slightly outweighs the loss of production, when we run our econometric models. However, we are maintaining a $10/bbl risk premium in our estimates for 2022-23 Brent prices, which keeps our current forecast close to last month's levels. Persistent strength in the USD, particularly in the USD real effective exchange rate, acts as a headwind on prices by making oil more expensive ex-US (Chart 8). We expect this to continue, given the Fed's avowed commitment to raise policy rates to choke off inflation, which, all else equal, will make USD-denominated returns attractive. Chart 7Markets Remain Mostly Balanced Chart 8Strong USD Restrains Oil Prices Investment Implications Despite the major shifts in oil supply and demand over the past month, markets have remained mostly balanced (Table 1). Falling Russian output and weak OPEC 2.0 production – where most states are managing production declines – is being exacerbated by falling Chinese demand and SPR releases from the US and IEA. The market does not yet need the 1.3mm b/d of Iranian output that is being held at bay due to a diplomatic impasse between the US and Iran, which we believe will persist. With overall economic output growth slowing – per the forecasts of the major supranational agencies (WTO, IMF, World Bank) – weaker demand can be expected to persist. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This is not to say upside risk is non-existent. A move by the EU to ban Russian oil imports could set in motion sharply higher oil and gas prices and a deep EU recession, as discussed above. This could trigger an immediate need for OPEC spare capacity and those Iranian barrels waiting to return to export markets. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish Russia's concentration of exposure to OECD Europe – as customers for its energy exports – exceeds the latter's concentration of imports from Russia by a wide margin. Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this Russia exported last year, OECD Europe was its largest customer, accounting for 50% of total oil exports, according to the US EIA (Chart 9). On the natgas side, more than one-third of the ~ 25 Tcf of natgas produced by Russia last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 84% – was exported via pipeline to the OECD Europe, with the biggest customers being Germany, Turkey, Italy and France. As is the case with crude oil and liquids, OECD Europe is Russia's biggest natgas customer, accounting for ~ 75% of exports in either gaseous or liquid form. There is an argument to be made Russia needs OECD Europe as much or more than the latter needs Russia. Ags/Softs: Neutral Grains and vegetable oils are at multi-year or all-time highs, as a result of the war in Ukraine. This week, corn futures hit the highest since 2012, while wheat futures surged amid the ongoing war and unfavorable weather in U.S. growing areas. The U.N. Food and Agriculture Organization's Food Price Index rose 12.6% from February, its highest level since 1990. According to the FAO, the war in Ukraine was largely responsible for the 17.1% rise in the price of grains, including wheat and corn. Together, Russia and Ukraine account for around 30% and 20% of global wheat and corn exports. The cost of fertilizers has increased by almost 30% in many places due to the supply disruptions caused by the war and the tightening of natural gas markets, which is being driven by EU efforts to diversify away from Russian imports of the commodity.8 Planting is expected to be very irregular in the upcoming grain-sowing months, navigate through much higher prices for fuel and fertilizers (Chart 10). Chart 9 Chart 10     Footnotes 1     Please see the IMF's April 2022 World Economic Outlook report entitled War Sets Back the Global Recovery, and the World Bank's Spring Meetings 2022 Media Roundtable Opening Remarks by World Bank Group President David Malpass, posted on April 18, 2022. 2     Please see, e.g., Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales published by wsj.com on March 15, 2022.   3    Please see Permian drilling permits hit all-time high in March, signaling production surge on the horizon, published by Rystad Energy on April 13, 2022. 4    Please see Joe Biden resumes oil and gas leases on federal land, published by the Financial Times on April 15, 2022. 5    Please see Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma, which we published on January 14, 2014. In that report, we noted, "… the U.S. has decided to stop micromanaging the Middle East. The latter policy sucked in too much of Washington's material resources, blood and treasure, at a time when regional powers like China and Russia were looking to establish their own spheres of influence in East Asia and Eurasia respectively." Building deeper commercial relationships with China also would bind both states together in terms of addressing KSA's security concerns, given China's existing relationships with Iran. This is a longer-term strategy, in our view. 6    Please see An EU embargo on Russian oil in the works - French minister, published by reuters.com on April 19, 2022. 7     Please see War in Ukraine: Russia says it may cut gas supplies if oil ban goes ahead, published by bbc.co.uk on March 8, 2022. 8    Please refer to Food prices soar to record levels on Ukraine war disruptions, published by abcNEWS on April 8, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary After having overspent on goods ex-autos over the past two years and experiencing contracting incomes in real terms, US and European households will reduce their purchases of goods ex-autos. Risks to global growth stemming from China remain to the downside. Leading indicators from Asia and global financial markets are signaling a contraction in global trade. Yet, US core inflation will not drop below 4% for the rest of this year. Consequently, the Fed will likely end up hiking rates and sounding hawkish amidst a major global trade slump. This will give rise to stagflation anxiety among investors and will be negative for global risk assets in general and EM equities, currencies and credit markets in particular. The yuan is breaking down versus the US dollar. A weaker RMB will pull down Emerging Asian as well as other EM currencies. Does This Divergence From A Historic Correlation Signify Stagflation? Bottom Line: Global equity and credit portfolios should remain defensive and continue underweighting EM. Currency investors should be positioned for another upleg in the US dollar and a downleg in EM currencies. Feature The volume of global trade is about to contract. Meantime, US inflation will remain well above the Fed’s target. This combination will produce stagflation anxiety among investors. It is impossible to know whether stagflation will be a long-lasting phenomenon in the real economy. In our view, the stagflation narrative will dominate global financial markets in the coming months. This heralds a cautious stance on global and EM risk assets. The slowdown in global manufacturing and trade will be pervasive and broad-based but will exclude auto production. The latter will in fact recover as chip/input shortages ease. The main drivers of the slowdown are (1) a mean reversion in US and European demand for goods ex-autos; (2) China’s economic woes and (3) moribund domestic demand in mainstream EM. Shrinking DM Household Demand For Goods ex-Autos Chart 1DM Household Demand For Goods ex-Autos Will Experience Mean Reversion After having overspent on goods ex-autos over the past two years and experiencing contracting income in real terms (after adjusting for inflation), US and European households will reduce their purchases of goods ex-autos. US and European consumption of goods ex-autos exploded at the onset of the pandemic two years ago and has stayed robust until now. Chart 1 illustrates that since mid-2020, the consumption of goods ex-autos was running well above its trend, which signifies excessive demand over the past two years. Such excessive demand has led to bottlenecks and shortages, giving producers an opportunity to hike prices. In a nutshell, inflation in tradable goods in the past 18 months was primarily driven by demand, not supply constraints. A portion of future goods consumption has been pulled forward, which implies that household demand for these goods has become saturated. Moreover, as the pandemic subsides, consumers are shifting their spending from goods to services. These dynamics could create an air pocket in the demand for certain goods. Chart 2DM Household Real Incomes Are Contracting Critically, US and European household income is contracting in real terms (Chart 2). Wage growth has not kept up with the surge in inflation. Due to shrinking disposable real income, consumers in advanced economies will curtail their consumption of discretionary items, primarily goods ex autos on which they have overspent during the past two years. Bottom Line: Demand for goods ex-autos will shrink in advanced economies in the next 6-12 months. This will weigh on global merchandise trade. China’s Trilemma Chinese authorities are facing an “impossible trinity” in their attempts to simultaneously achieve three objectives: (1) pursuing the dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. We do not think all three objectives can be achieved. China’s economy was struggling prior to the recent lockdowns. The COVID-related restrictions have only made matters worse and have weighed heavily on economic activities and household income. Domestic orders for industrial enterprises plunged below 50, i.e., they are in contraction territory (Chart 3). These surveys, released on March 30-31, were not affected by the Shanghai lockdowns, which have proliferated since March 28. Exports orders are also contracting (Chart 4). Chart 3China: Domestic Orders Were Plunging Prior To Lockdowns Chart 4China: Exports Are Set To Contract   Further, China’s import and export volumes were contracting in January – prior to the Ukraine war and the recent lockdowns. Notably, Chart 5 highlights that prior to the recent lockdowns, import weakness was broad-based, including commodities, machinery and semiconductors. In particular, total imports in USD are flat in March compared to a year ago. With commodity prices up significantly, it is clear that import volumes in March have shrunken substantially. National disposable income per capita was growing at about 6% in nominal terms before the lockdowns (Chart 6, top panel). Household mortgage growth had decelerated considerably before lockdowns became widespread (Chart 6, bottom panel). Chart 5Chinese Imports Were Shrinking Before Lockdowns Chart 6China: Household Income And Mortgage Borrowing ​​​​​​​​​​​​​​​​​​​​​   As the lockdowns wreak havoc on the economy and household income, and with the government not providing direct transfers to the population, household consumption will be severely affected in the months ahead. The property market remains in the doldrums and is unlikely to recover soon. As we have highlighted in previous reports, structural headwinds, continue to weigh down on the property market. Since 2009, there has been no business cycle recovery in China without the real estate market playing the leading role. Residential floor space sold was down by 20% in Q1 from a year ago (Chart 7, top panel). House prices have begun deflating in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Critically, the plunge in property developers’ financing entails shrinkage in housing completion (construction work) (Chart 7, bottom panel). The latter has so far held up as authorities have been forcing developers to use their limited financing to complete projects that they had already started. The massive issuance of local government bonds will spur an acceleration in infrastructure spending. China’s government gave the green light already this year to infrastructure projects worth nearly 70% of what was allowed for the whole of last year. Yet, this might be insufficient to produce a rapid business cycle recovery in an environment of rolling lockdowns and with other segments of the economy facing challenges. Related Report  Emerging Markets StrategyGlobal Semi Stocks: More Downside Given these negative forces, the Chinese economy requires massive government stimulus in the form of direct transfers to households and SMEs – as the US offered in the spring of 2020. Yet, it does not seem that the government is rushing to provide such direct and significant stimulus. In our opinion, the policy stimulus measures announced so far by the government fall short of what is required to lift the economy. Policymakers are neither ready to abandon the dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. With these two constraints, economic growth in China is set to underwhelm. Bottom Line: Risks to global growth stemming from China remain to the downside. In EM ex-China, ongoing fiscal tightening, monetary tightening in LATAM and feeble household income growth in India and ASEAN will all cap consumer spending and business investment (Chart 8). Chart 7China: Property Construction Is Set To Shrink Chart 8EM ex-China: Domestic Demand Will Remain Sluggish Signs Of A Global Trade Contraction There is already evidence to suggest that a major relapse in global manufacturing and trade is beginning: Taiwanese shipments to China are dipping into negative territory, and they lead global exports (Chart 9). Taiwanese exports to China are a good leading indicator of global trade dynamics because mainland producers order inputs from Taiwan first before they produce final goods for export. When producers located in China order less inputs, they evidently expect less in the way of production and shipments. Korea’s business survey of exporting companies indicates a substantial deterioration in their business conditions in April (Chart 10). This points to a major slump in the nation’s exports and, hence, global trade. Chart 9Global Trade Is Set To Contract Chart 10Korean Exporters Are Downgrading Their Expectations Korean and Japanese non-financial share prices have plunged despite considerable currency depreciation, which is typically positive for their competitiveness. As many of these non-financial companies are major exporters, this development points to a major downtrend in global trade. Global cyclicals have been underperforming global defensives. This dynamic has historically been a good leading indicator for the global industrial downturn (Chart 11). Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives (Chart 12). This also points to a slowdown in US growth. Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Chart 12Beware Of A Relapse in US Early Cyclical Stocks   Bottom Line: Leading indicators from Asian economies and global financial markets are signaling that global trade will experience a contraction and global growth will slow. Inflation Amid A Global Trade Contraction? Chart 13US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms A natural question is why worry about inflation when global trade volumes will be contracting? The primary source of anxiety in this context is US inflation and the Fed’s tightening. A decline in global trade will not be enough to bring down US core inflation substantially. By contrast, China and Asia do not face an inflation problem. US inflation worries will persist, and the Fed will likely continue to hike rates and sound hawkish for the following reasons: First, US capital expenditures by companies and household spending on services will remain robust. US services make up a larger share of the American economy and employment than do goods-producing sectors. Hence, we do not expect a broad-based recession in the US this year. Second, as we have previously noted, the US has a genuine inflation problem. American wages are accelerating, and a tight labor market will push up wage growth above 5-6% (Chart 13, top panel). Importantly, real wages in the US have contracted (Chart 13, bottom panel). Faced with a decline in purchasing power, employees will demand higher wages. The tight labor market raises the odds that companies will likely accommodate higher wages. Chart 14Unit Labor Costs Are The Key To Core Inflation Given that US productivity growth is no more than 1.5-2%, wage growth over 5-6% means that unit labor costs will be rising by more than 3-4%. This will prevent core inflation from falling a lot. Unit labor costs have historically been the main driver of core inflation in the US (Chart 14). Finally, inflation is a lagging and inert phenomenon. It takes a long time (more than six to nine months) of sub-par growth for inflation to subside. Odds are that even though global trade volumes will be contracting, the Fed will continue hiking rates and sounding hawkish because US inflationary pressures will remain acute. Bottom Line: Annual core CPI inflation will drop in the US due to the base effect and a drop in some goods prices. Yet, we expect core CPI and PCE to remain above 4% for the rest of this year. Underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be reduced meaningfully without bringing economic growth down below potential growth and weakening the labor market for a few quarters. Investment Implications Shrinking global trade volumes and a hawkish Fed are bearish for global risk assets in general and EM equities, currencies and credit markets in particular. Contracting exports and a hawkish Fed are negative for the Chinese yuan and other Asian currencies. The CNY/USD exchange rate has broken below its 200-day moving average and odds are that it will depreciate further (Chart 15). Our target for CNY/USD is 6.7. The broad trade-weighted US dollar has more upside and EM currencies will depreciate. Chart 16 illustrates that investors’ net long positions in ZAR, BRL and MXN are high. Chart 15The RMB Is Breaking Down Chart 16Investors Are Long EM Commodity Currencies   Our recommended currency shorts for now are ZAR, PHP, IDR, COP, HUF, PEN and PLN. Global equity and credit portfolios should continue underweighting EM. Notably, global defensive equity sectors have been outperforming non-TMT stocks despite rising US/global bond yields (Chart 17). This is a major departure from the historical relationship and likely signifies a period of slower global growth ahead but continuous Fed tightening. Global equity managers should favor defensive stocks. Chart 17Does This Divergence From A Historic Correlation Signify Stagflation? For EM equity managers, we also recommend favoring defensive sectors like consumer staples. Presently, our country overweights are Korea, Singapore, Chinese A-shares, Mexico and Brazil. Our underweights are India, Central Europe, Indonesia, Turkey, South Africa, Colombia and Peru. In local rates, we continue recommending receiving Chinese and Malaysian 10-year swap rates, a long position in Brazilian 10-year bonds, betting on yield curve flattening in Mexico and paying Polish 10-year swap rates while receiving Czech 10-year swap rates. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com​​​​​​​