Policy

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Figure 2The Net Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph.  Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph!  The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Inflation Surprise Reinforces Gridlock And Fiscal Drag A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks A US recession is increasingly likely as the Fed will have to hike rates more aggressively in the short run to contain inflation. Recession would exacerbate US policy uncertainty during a period of peak polarization in the 2022-24 election cycle. The Fed’s struggle with inflation will become entangled in extreme US politics. The Fed will come under immense pressure to pause rate hikes earlier than warranted in 2023. The Fed could get blamed for both over-tightening and politicization. Investors should fade the risk of another Democratic sweep in the midterm elections. Republicans are still highly likely to gain control of the House, resulting in gridlock and a freeze to fiscal policy.   If Democrats lose the House, their odds of retaining the White House will decline. A recession would greatly reduce their odds. In this context the US faces another tumultuous political cycle, as Republicans will stage a comeback. However, reform of the Electoral Count Act could reduce the risk of a catastrophic breakdown in the electoral system. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 12.6% Bottom Line: Stay long US dollar for now but prepare to downgrade to neutral. Feature BCA Research hosted our annual conference at the Plaza Hotel in New York last week. Clients heard a range of views on various topics, including US politics and policy. In this report we touch on some of the insights from the conference while providing our own views on what to expect going forward. A Politicized Federal Reserve? The real Fed funds rate stands at -2.2% today despite the Federal Reserve’s decision to hike rates by 225 basis points this year. The last time the real Fed funds rate was this low was in 1975, under the chairmanship of Arthur Burns – i.e. the epitome of a politicized Fed (Chart 1). Chart 1A Politicized Federal Reserve? A Politicized Federal Reserve? A Politicized Federal Reserve? Is the Fed already politicized or will it become politicized in the coming years? What would that mean for monetary policy, the economy, and financial markets? The Fed waded into political territory when it began pursuing unorthodox policies in the wake of the 2008 financial crisis and again during the Covid-19 pandemic. Ideally monetary policy sets interest rates across the economy and applies equally to all economic actors. But once the Fed began quantitative easing (bond buying) and coordinating its actions with the fiscal authorities (which had bailed out major banks), it entered the game of income and wealth redistribution. Not least because asset price inflation favors asset owners over others. Now that the Fed and other central banks have pioneered these unorthodox policies, they will continue to use them in the face of future economic and political turmoil. They will also innovate new tools to deal with each crisis. As the pandemic response highlighted, the Fed will continue down the path of redistribution, which will continue to provoke political backlash from legislators and the public. At the same time, the Fed’s policy parameters today have been reined in and disciplined by the post-pandemic inflation overshoot. For example, there is not so much excited talk today about implementing Modern Monetary Theory – debt monetization – as there was in the heady days of 2019. Instead the Fed today is focused almost exclusively on fulfilling its price stability mandate, at least until inflation gets down into the 2%-3% range. The market appears over-eager for interest rate cuts in 2023 when the Fed is expecting to continue hiking rates throughout 2023 (Chart 2). The surprise in core and headline inflation in August reinforces this point. If the Fed cannot bring inflation below 3%, what will it do? Could it accept reality and modify the inflation target to 3%? A higher inflation target has long been discussed – it would enable the Fed to stimulate more effectively in the next recession. But Chairman Jerome Powell and his monetary policy strategy review rejected the idea of raising the long-term inflation target from 2% to 3% or above – and that rejection is likely to be sustained at least until the next review in 2024. Even then a higher inflation target seems unlikely as it would be very hard to achieve politically in the wake of the inflation overshoot. Chart 2Will Fed Cut Rates Next Year? Will Fed Cut Rates Next Year? Will Fed Cut Rates Next Year? Of course, a lot can happen by 2024 and new deflationary shocks could conceivably force a change to the inflation target. What is clear to us is that the Fed still has a dovish bias that took a long time to develop and has not yet been entirely overturned by the inflation overshoot (Chart 3).  Chart 3Dovish Consensus Built Up Over Time And Remains In Place For Now A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Meanwhile the Fed’s single-minded focus on restoring price stability will bring an entirely different set of political problems – and accusations of politicization. For example, the Fed wants tighter financial conditions – since that will help to cool the economy and bring down inflation – but cannot well speak openly about deliberately driving down stock market prices and home values. The Fed also believes that a recession with unemployment ranging from 4%-5% would not be the end of the world but it cannot well speak openly about deliberately increasing unemployment. Especially because unemployment rarely stays so low in recessions. The Fed acknowledges that it will need to pause hiking interest rates at some point, hopefully before it tightens monetary conditions so much as to trigger a recession, but it does not want to call it a “pause” since financial markets will take that as a hard stop. It could cause a premature loosening of financial conditions and be blamed for a lack of vigilance when inflation revives. Will the Fed ultimately be prevented from tightening monetary policy enough because of the pressure that higher interest rates will put on the government’s fiscal sustainability? It is entirely possible. Sustaining social programs is more popular than paying bond holders. Since the Fed pays market interest rates on reserve balances, it will stop making a profit if it hikes rates to 3.25% or above (which is slated to happen this month). Very soon the Fed will be turning a loss on its holdings, rather than remitting profits to the Department of Treasury, and it will be amply criticized for spending taxpayer money. In that case there will be plenty of ammunition from critics on all sides. When it comes to the Fed’s specific predicament in 2022-24, Chairman Powell does not want to be the next Arthur Burns, i.e. he does not want to go down in history as the chairman who made a historic mistake by not forcing inflation back into an acceptable and containable range of say 2%-3.5%. Neither he nor the Fed can afford to lose control of price stability, which would damage the US economy and the Fed’s credibility. The implication is that Powell will need to hike rates until price stability is obtained. Yet even a conservative estimate would suggest that hiking rates until inflation falls beneath 3% will require the unemployment rate to rise by more than the estimated 0.5-1.0 percentage points, likely considerably more than this, which historically implies a recession in 2023-24. Recession odds have already risen sharply as priced by the bond market, according to Jonathan LaBerge at our Bank Credit Analyst flagship service (Chart 4). Of course, recession odds have an important implication for the 2022-24 political cycle, implying that the Fed’s handling of the economy will become entangled once again in America’s extreme political polarization. Chart 4Recession Odds Rising Recession Odds Rising Recession Odds Rising Our past research has shown that the Fed does not pay close attention to midterm elections. The Fed is more likely to hike rates than cut rates during a midterm election year – and more likely to hike rates during a president’s first midterm election as opposed to his second. Whereas the Fed is about equally likely to cut rates as to hike them during a presidential election year. Most importantly, the Fed is more likely to hike rates during a non-election year than otherwise (Table 1). Table 1The Fed Doesn’t Care About Midterms … But Prefers To Hike In Off-Years A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks While the Fed had no choice but to hike in 2022, supporting these data, a critical decision will emerge in 2023, when the Fed is still expected to hike but the risk of recession grows. Recessions sharply reduce the odds of the incumbent political party staying in the White House (Table 2). Moreover a recession could bring back President Trump or a Trumpist Republican candidate bent on revenge against the political establishment. The result is that the FOMC will be under immense political pressure not to overtighten monetary policy in 2023-24. In normal times, a Fed chair appointed by a Republican president could conceivably have the license to hike rates aggressively to whip inflation, knowing that if a recession occurs and a Republican comes to power, he would be likely to be reappointed. But Powell can have no such assurance from the erratic President Trump, who is still favored for the Republican nomination as things stand. Even aside from Trump, Powell and the FOMC will fear that a populist Republican Party would seek to audit the Fed or curtail its powers. Table 2Biden’s Odds Fall If Recession Occurs A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks In sum, the Washington political establishment believes it is under attack from right-wing insurrectionists and will put immense pressure on the FOMC to avoid triggering a recession in 2023-24. This could produce an inflationary surprise. Bottom Line: A recession is likely to occur as the Fed continues hiking rates to bring inflation below 3%. This increases political uncertainty for the 2022-24 cycle. But a politicized Fed may compromise when inflation is closer to 4% for fear of a populist win in 2024. That would likely prove to be a historic monetary policy mistake, enabling long-term inflation expectations to rise substantially.   Midterm Elections: Fade The “Blue Sweep” Risk  While the Fed ignores midterm elections, investors are increasingly uncertain over fiscal policy and the outcome of the midterms. Will Congress become gridlocked, as we expect, or will Democrats retain control of Congress and continue the federal spending splurge that has played a large role in the inflation overshoot? Clearly the midterm races have tightened since President Biden changed his tone and started prioritizing the fight against inflation back in June. As inflation has abated, online betting markets have discounted Republican odds of victory, particularly in the Senate where they are now 36% (Chart 5). We anticipated that Biden’s approval ratings would stabilize on the passage of legislation and that the election would tighten in the final months, particularly on the back of women voters turning out to support Democrats in the wake of the Supreme Court’s decision to reduce abortion access. However, we also argued that gridlock would still be the most likely result based on the high odds that the House would flip to Republican control regardless of Roe. This is a consensus view that should be challenged and reassessed as November approaches. Chart 5Bookies Still Expect Gridlock In Midterms A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Senate elections are held statewide and are therefore more susceptible to a shift in suburban and women voters. State-level polls leave much to be desired but the overall picture is that the races are closer than they were earlier this year – and closer than the Republicans would want them to be (Charts 6A & 6B). Persistent high inflation should be the clincher in favor of Republicans but the Senate is simply too close to call at this stage. Chart 6ANeck-And-Neck Races In Senate A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Chart 6BNeck-And-Neck Races In Senate A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Yet the Senate is overrated in this election because if Democrats lose either chamber, gridlock will be the result. Gridlock is what matters most for fiscal policy and hence for investors. The gridlock view rests on the House of Representatives. While the president’s party almost always loses seats in the midterm election, losing seats is not the same as losing control. In fact, over the past 120 years, a party that controls the House and/or Senate is more likely than not to retain control in a midterm election (Chart 7). But in the post-WWII era, the president’s party is slightly more likely to lose control of the House. And in almost all midterms, the president’s party loses seats in the House.  Chart 7Presidents Do Not Always Lose Control, But Dems Have Small Cushion In 2022 A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks The key point about 2022 is that the Democrats only have a six-seat buffer in the House. In other words, losing seats is very likely to be equivalent to losing control this year. To save the House, Biden’s Democrats would have to perform as well as John F. Kennedy’s Democrats in 1962, when they only lost four House seats. Our House model predicts they will lose 21 seats (Appendix). While Democrats could beat this prediction, they would be hard pressed to lose fewer than six seats on a net basis: inflation is high and sticky, real wages and incomes have fallen, consumer confidence has fallen, the president’s approval rating is low, and approval of Congress is low. If a president’s party loses control of the House, its odds of keeping the White House in 2024 also fall (Chart 8). This is another reason for investors to expect that fiscal policy will freeze, policy uncertainty will remain high, and the Fed will be under political pressure not to hike rates aggressively in 2023-24. Chart 8Biden’s 2024 Odds Fall If He Loses The House A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Bottom Line: Fade the “Blue Sweep” risk in 2022. The midterm election is tightening but Republicans are still likely to win the House. Fiscal policy will remain a drag on growth and the 2024 election will become even more uncertain, putting political pressure on the Fed to avoid overtightening. Limited Big Government Another Democratic sweep would greatly reinforce the new US policy trajectory of Big Government: a trajectory that points away from the Washington Consensus and Reagan revolution toward a future of higher taxes, larger budget deficits, higher tariffs, and more extensive regulation (Chart 9).1  But Democrats will be forced to share power. This is why we call the new policy paradigm “Limited Big Government.” It is still a shift in the direction of a larger government role in the economy and society, but it is taking place within the context of the US constitutional system of checks and balances and two-party politics. We do not expect the latter two factors to disappear. Looking at the Obama, Trump, and Biden administrations together we can see that the turn toward Big Government is also compromised by vested interests: Democrats failed to increase corporate taxes, though they did put a floor under the effective tax rate by imposing a new 15% minimum tax on corporate book income. The budget deficit is normalizing after the gargantuan pandemic stimulus. But Democratic legislation will not reduce the deficit substantially over time, contrary to Biden administration propaganda. But Republicans are fiscally profligate themselves, which is clear from Trump’s term in office as well as previous periods of single-party GOP rule. Republicans joined Democrats in passing the infrastructure bill and the Chips and Science Act, which revives US industrial policy in an era of great power competition. Biden has now accepted Trump’s tariff hikes on China. While Republican leadership may push deregulation in future, they may also believe that government regulation will be required to fight back against “woke” or socially left-wing corporations. Chart 9Buenos Aires Consensus equal Spending, Taxes, Tariffs, Regulations A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Thus the US’s new policy paradigm is bipartisan in nature. Of course, if Republicans take the House they will turn fiscally conservative for tactical reasons. That will put a halt to the spending splurge of 2020-22. But it will not signal a new fiscally austere paradigm since full Republican control in 2025 would be highly likely to lead to another fiscal blowout. This is even more likely to be the case now that Republicans have adopted a populist and pro-working class approach. Bottom Line: The US shift away from limited government toward Big Government is entrenched even if it suffers a setback due to gridlock from 2022-24. Given that partisan checks will prevent the US from moving too radically in any direction, we dub this paradigm “Limited Big Government.” It is marginally inflationary due to the rise in taxes, spending, regulations, and tariffs. US Electoral System: A Possible Positive Surprise Our expectation that the Fed will be politicized and that populist policies will persist stems from the underlying inequality and political polarization in the United States. Yet these same factors serve to increase overall political instability and threaten to cause a fundamental breakdown in political order. Will US institutions be able to handle the strain in the coming election cycle? There can be no doubt that polarization is reaching dangerous extremes. The US has suffered two out of five contested elections in the past 22 years. The last two Republican presidential victories have occurred without gaining the popular vote. The Biden administration’s low approval creates the risk of another tight election in 2024, implying controversy over the vote count and procedure (see Appendix). Another tight election could lead to a single state’s controversy determining the outcome of the entire election. Or it could lead to an electoral college tie in which Congress would decide the election result and could decide against the popular verdict.    It is not hard to think of scenarios where contested elections and social unrest get out of hand. For example, one important consequence of the January 6 rebellion is that future governments will suppress protests with force if they attempt to interfere with the electoral process or the workings of the legislature. But imagine if a Republican administration comes to power through a contested election in Congress and then suppresses the resulting protests against it? Or imagine if Democrats retain power and push their “domestic war on terrorism” far enough to provoke a low-level militant insurgency from disaffected nationalists? It is easy to think of scenarios on either side that could lead to a much greater breakdown in public order than what occurred in 2020.   It is unlikely that an institutional fix will occur in time for the 2024 election. However, there is one exception on the congressional agenda: a possible revision of the Electoral Count Act of 1887. This law was designed to prevent a failure of the electoral system in the wake of the “Stolen Election” of 1876. Its main achievement was to have the governor of each state certify the electoral votes of that state before sending them to Washington. However, the law also leaves open the door for state legislatures, secretaries of state, and governors to influence their state’s electoral votes. Democrats have written a revised version of the law that would close some of the loopholes and ambiguities. So far 10 Senate Republicans have co-sponsored the bill, making it very likely they will vote for it (Table 3). If these Republicans do not change their minds in the critical hour, and if all Democrats can be brought to vote for the measure, then a 60-vote, filibuster-proof majority will exist to pass the law. Table 3Republican Senators Who Support Revising The Electoral Count Act A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks The original Electoral Count Act took ten years to pass, so there is no reason to be overly optimistic. But if 60 votes can be found in the Senate, then the electoral system will be fortified ahead of the 2024 election and structural US political risks will be at least somewhat reduced. Bottom Line: The US faces serious social and political instability in the coming years and remains at “peak polarization.” But a bipartisan law could help solidify the electoral system prior to 2024, which would reduce some of the risk of election controversies spiraling out of control. Investment Takeaways Headline consumer price inflation for August came in at 8.3% year-on-year versus an expected 8.1%, while core inflation accelerated from 5.9% to 6.3%. Financial markets took it on the chin, with the S&P500 falling by 4.3%, due to the disappointed expectation that inflation had already peaked. This disappointment is the second of its kind this year: investors have been over-eager to call the peak in inflation. Market volatility is likely to continue through the fall as investors now expect that the Fed will hike interest rates by another 75-100 basis points in September and continue hiking until inflation falls more convincingly. Twice-bitten investors will be hesitant to endorse a third rally until they are certain that inflation is coming down – but by then a recession may already be upon them. A significant increase in unemployment is likely necessary to cool inflation, which implies recession. Higher inflation will drive real wages further into the red, which is negative for the Biden administration’s midterm campaign. Otherwise the economy looked to be improving just in time for the vote. Manufacturing and non-manufacturing employment is perking up, labor force participation is reaching pre-Covid levels, and consumer confidence ticked up in the latest data, albeit still much lower than in 2021 (Chart 10). Now the tightening of financial conditions will cool the economy and sentiment in the advance of the election, reinforcing the opposition party and the expected gridlock. Inflation may indeed be peaking but not in time for the election.  Throughout this year we bet on the US dollar index. This trade is getting very toppy and net speculative positions have rolled over (Chart 11). The dollar is overvalued but its momentum remains strong given extreme macroeconomic and geopolitical uncertainty. We have put this trade on watch for a downgrade to neutral but we expect the momentum to be sustained at least through the US election and Chinese party congress this fall. Chart 10Small Bounce In Economy Will Not Save Democrats Small Bounce In Economy Will Not Save Democrats Small Bounce In Economy Will Not Save Democrats Chart 11Dollar Is Overvalued But Has Momentum Dollar Is Overvalued But Has Momentum Dollar Is Overvalued But Has Momentum     Matt Gertken Senior Vice President Chief US Political Strategy mattg@bcaresearch.com       Footnotes 1     This trajectory is the opposite of the Washington Consensus. As such, Marko Papic, the founder of BCA’s Geopolitical Strategy, has dubbed it the “Buenos Aires Consensus,” as it resembles Argentine economic policy more so than the Thatcher/Reagan policy mix.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Table A3US Political Capital Index A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Chart A1Presidential Election Model A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Chart A2Senate Election Model A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks  Table A4House Election Model A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Table A5APolitical Capital: White House And Congress A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Table A5BPolitical Capital: Household And Business Sentiment A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks Table A5CPolitical Capital: The Economy And Markets A Politicized Fed? Another Blue Sweep? And Other Risks A Politicized Fed? Another Blue Sweep? And Other Risks  

Executive Summary This report looks back at seven recent Fed tightening cycles and summarizes evidence concerning how the US Treasury curve behaves relative to the length and magnitude of the tightening cycle. We document a few consistent relationships. For example, the 10-year Treasury yield tends to peak 1-2 months before the last rate hike of the tightening cycle. We also notice that the Treasury slope is usually inverted by the time it troughs and that the 5-year/30-year slope tends to trough before the 2-year/5-year slope. Given our view that the peak fed funds rate may not occur until the second half of 2023, we expect another leg higher in bond yields before we reach the cyclical peak. We also anticipate further flattening of the 5-year/30-year Treasury curve.   Timing Fed Tightening Cycles A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles Bottom Line: Investors should keep portfolio duration close to benchmark for the time being and should position in 5-year/30-year curve flatteners by selling the 10-year bullet versus a duration-matched 5/30 barbell. While we maintain neutral portfolio duration for now, our bias is to be short duration on a medium-to-long run horizon and we may re-evaluate our recommended duration positioning after this month’s important CPI release and September FOMC meeting. Feature BCA’s Annual Investment Conference was held last week, and we heard a wide variety of views about the outlook for US bonds. Unsurprisingly, the main difference between those with bond-bullish and bond-bearish views was that the bullish panelists anticipated a much quicker end to the Fed’s tightening cycle prompted by a US recession starting late this year or early next year. This week’s report takes a more formal look at the historical linkages between Fed tightening cycles and trends in US Treasury yields. Our goal is to provide some firm evidence that investors can use to translate their views about the length and magnitude of the Fed tightening cycle into concrete positions across the US Treasury curve. Specifically, we look at seven Fed tightening cycles – the five most recent cycles and the two periods of tightening that occurred during the inflationary surge of the early-1980s. The 1977-80 Cycle Chart 1The 1977-80 Cycle The 1977-80 Cycle The 1977-80 Cycle The Fed raised the funds rate by 11.75% between August 1977 and March 1980 in response to sky-high inflation. Then, despite core CPI inflation still running at 12%, it cut rates by 5.5% in 1980 in response to an unemployment rate that had climbed above 6%. This proved to be only a brief reprieve from monetary tightening. With inflation still a problem, the Fed pivoted back to rate hikes later in 1980 even as the unemployment rate continued its ascent. Turning to markets, we see that the Treasury index lost 22% versus a position in cash during the 1977-80 tightening cycle and that index returns troughed in March 1980, around the same time as the last rate hike. The 10-year Treasury yield peaked one month before the last rate hike at 12.72%, 378 bps below the peak fed funds rate that would be attained one month later (Chart 1). As for the shape of the yield curve, the 2-year/10-year Treasury slope troughed at -201 bps one month before the last rate hike of the cycle (panel 4). The 2-year/5-year Treasury slope troughed at -132 bps in the same month as the peak in the funds rate and the 5-year/30-year slope troughed at -123 bps, one month before the last hike (bottom panel). The 1980-81 Cycle After a brief period of cuts in mid-1980, having still not conquered inflation the Fed changed course and lifted the funds rate to a new high in 1981. It did this even with the unemployment rate above 7%. One interesting aspect of this tightening cycle is that the bond market continued to sell off even after the Fed delivered its last rate increase. While the period of Fed tightening spanned from October 1980 until May 1981, excess Treasury index returns versus cash continued to fall until September 1981, losing 20% in the process (Chart 2). The 10-year Treasury yield also peaked four months after the last rate hike at 15.84%, 316 bps below the peak funds rate that was attained four months earlier. Chart 2The 1980-81 Cycle The 1980-81 Cycle The 1980-81 Cycle Looking at the Treasury curve, the 2-year/10-year slope troughed at -132 bps three months after the last rate hike (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed three months after the last rate hike, at -62 bps and -133 bps, respectively (bottom panel). The 1988-89 Cycle The Fed lifted rates from 6.5% in March 1988 to 9.8% in May 1989. Peak-to-trough, the Treasury index lost 7.7% versus cash during this period but returns did trough two months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 9.32%, 48 bps below the peak fed funds rate (Chart 3). Chart 3The 1988-89 Cycle The 1988-89 Cycle The 1988-89 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -43 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at -20 bps and -42 bps, respectively (bottom panel). The 1994-95 Cycle The Fed doubled the funds rate from 3% in February 1994 to 6% in February 1995. Peak-to-trough, the Treasury index lost 9.4% versus cash during this period but returns did trough three months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 7.91%, 191 bps above the peak fed funds rate (Chart 4). Chart 4The 1994-95 Cycle The 1994-95 Cycle The 1994-95 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at +15 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at +14 bps and +6 bps, respectively (bottom panel). In contrast to earlier cycles, it’s notable that the yield curve never inverted during the 1994-95 tightening cycle and that the 10-year Treasury yield peaked at a level significantly above the fed funds rate. The most likely reason for this is that the Fed’s pivot from rate hikes to cuts in early 1995 occurred abruptly and came as a surprise to market participants. A quick look at the economic data makes it easy to see why. The core PCE and core CPI inflation rates were elevated at the time, at 2.3% and 3.0% respectively, and the unemployment rate was significantly down from a year earlier. The 1999-2000 Cycle The Fed lifted rates from 4.75% in June 1999 to 6.5% in May 2000. Peak-to-trough, the Treasury index lost 8.2% versus cash during this period but returns did trough four months before the last rate hike. The 10-year Treasury yield also peaked four months before the last rate hike at 6.68%, 18 bps above the peak fed funds rate (Chart 5). Chart 5The 1999-2000 Cycle The 1999-2000 Cycle The 1999-2000 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -47 bps (panel 4). The 5-year/30-year slope troughed one month before the last rate hike at -59 bps but the 2-year/5-year slope didn’t trough until three months after the last rate hike at -15 bps (bottom panel). The 2004-06 Cycle The Fed lifted rates in steady increments of 25 bps per meeting from 1% in June 2004 to 5.25% in June 2006. Peak-to-trough, the Treasury index lost 5.3% versus cash during this period and returns troughed around the same time as the funds rate reached its peak. The peak in the 10-year Treasury yield also occurred at the same time as the peak in the funds rate, though the peak 10-year was 10 bps below the peak funds rate (Chart 6). Chart 6The 2004-06 Cycle The 2004-06 Cycle The 2004-06 Cycle On the Treasury curve, the 2-year/10-year slope troughed five months after the last rate hike of the cycle at -16 bps (panel 4). The 2-year/5-year slope also troughed five months after the last rate hike at -20 bps, while the 5-year/30-year slope troughed much earlier, four months before the last rate hike at -10 bps (bottom panel). The 2015-18 Cycle Finally, in the most recent tightening cycle before the current one, the Fed lifted rates off the zero-lower-bound in December 2015, went on hold for 12 months and then delivered a string of rate hikes bringing the funds rate up to 2.5% by December 2018. Peak-to-trough, the Treasury index lost 6.7% versus cash during this period and returns troughed two months before the peak in the fed funds rate. The peak in the 10-year Treasury yield also occurred two months before the last rate hike at 3.15%, 65 bps above the peak funds rate (Chart 7). Chart 7The 2015-18 Cycle The 2015-18 Cycle The 2015-18 Cycle On the Treasury curve, the 2-year/10-year slope troughed eight months after the last rate hike of the cycle at 0 bps (panel 4). The 2-year/5-year slope also troughed eight months after the last rate hike at -17 bps, while the 5-year/30-year slope troughed much earlier, five months before the last rate hike at +23 bps (bottom panel). Summarizing The Evidence Tables 1 and 2 summarize the data from the seven tightening cycles that we examined. Four main points jump out. Table 1Timing Fed Tightening Cycles A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles Table 2Fed Tightening Cycles: Peak And Trough Levels A Brief History Of Fed Tightening Cycles A Brief History Of Fed Tightening Cycles First, both the level of the 10-year Treasury yield and the Bloomberg Barclays Treasury Excess Return Index tend to hit inflection points around the time of the last rate hike of the cycle. On average, the 10-year Treasury yield peaks 1.3 months before the last rate hike of the cycle, and it has always hit its peak within a window spanning four months before the last hike and four months after. The timing of the trough in index excess returns versus cash looks similar. Second, the 2-year/10-year Treasury slope also tends to trough near the end of the Fed tightening cycle, but the timing of this inflection point varies a lot more than the timing of the peak in yields. In fact, during the last two cycles the 2-year/10-year slope didn’t trough until well after the last rate hike. Third, the 5-year/30-year Treasury slope always troughs at the same time or earlier than the 2-year/5-year Treasury slope. This is consistent with our intuition that the long end of the yield curve will respond more quickly to changes in the economic outlook than the front end of the curve, which remains more tied to the current policy rate. Fourth, there isn’t much consistency in where the 10-year Treasury yield peaks relative to the peak fed funds rate. On average, the 10-year yield tops out 120 bps below the peak fed funds rate, but there is a wide range of outcomes. The 10-year yield peaked 378 bps below the peak fed funds rate in the 1977-80 tightening cycle and it peaked 65 bps above the peak fed funds rate in the 2015-18 cycle. The same holds true for the slope of the Treasury curve. The trough in the slope exhibits a wide range of outcomes, though it is fair to say that we typically expect the slope to be negative when it bottoms. The 2-year/10-year Treasury slope only failed to invert in two tightening cycles (1994-95 and 2015-18) and in both of those cases the Fed was not expected to deliver a large number of rate cuts. In fact, it could have easily been argued that rate cuts were unnecessary based on the inflation and employment data at the time. Investment Implications In applying the lessons from this analysis to the current environment, the first conclusion we reach is that we should only look to extend portfolio duration to above-benchmark when we think that the last rate hike of the cycle will occur in 1-2 months. Currently, the market is priced for the fed funds rate to peak in June 2023 and we expect that peak could occur even later (Chart 8). For this reason, we anticipate another significant leg higher in Treasury yields before the cyclical peak is reached. Chart 8Rate Expectations Rate Expectations Rate Expectations Our historical analysis of past tightening cycles also supports our recommended short 10-year bullet, long 5-year/30-year barbell positioning along the Treasury curve.1 Given that the 5-year/30-year Treasury slope has always troughed within a window spanning five months before the last rate hike and three months after, it makes sense to position for another leg down. This is a particularly attractive trade on the 5-year/30-year portion of the curve because that slope remains in positive territory.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Central banks are aggressively tightening policy around the world. Their ability to rein in inflation without causing a recession depends upon the level of the real neutral rates. Australia, Canada, New Zealand, and Sweden have elevated r-stars, but the picture changes drastically when their large debt loads are factored in. While real policy rates remain below r-star across DM economies for now, a more rapid decline in supply-driven inflation would correct this situation. Consequently, a global recession does not constitute our base case for the next six months, although it is a growing threat. The ECB is front-loading interest rate increases while it can, but the destination of travel is not changing significantly. Global R-Star Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The global r-star varies greatly around the world and debt sustainability concerns weigh on the real neutral rates of Australia, Canada, New Zealand, and Sweden. The US economy remains best capable of handling higher interest rates.   Chart 1Rising Global Inflation Rising Global Inflation Rising Global Inflation Inflation around G10 economies has been very strong and much more durable than originally hoped. As a result, inflation now averages 7.1% on a headline CPI basis and 4.6% based on core CPI across among G10 economies (Chart 1). Central banks are tightening policy aggressively to prevent this elevated inflation from becoming entrenched. Essentially, they are aiming to avert the emergence of the kind of inflationary mentality that prevailed in the 1970s, which caused stubborn inflation during that decade. This exercise is fraught with difficulty. The objective is to achieve a policy setting that is slightly above the neutral rate of interest, but not too much so. On the one hand, keeping policy too accommodative will increase the chances that an inflationary mentality will emerge; on the other hand, if policy is tightened too much, a recession will become unavoidable and deflationary risks will escalate. A sense of where the neutral rate for major economies lies is therefore necessary to draw that line in the sand. To do so, we estimate the real neutral rate of interest for major DM economies using the methodology we introduced seven weeks ago, when we evaluated the neutral rates for the major Eurozone economies. This exercise shows that, at the current level of interest rates and inflation, policy among major economies remains accommodative. However, if inflation decelerates sharply in the coming months in response to declining global supply constraints and lower commodity prices, the recent increase in policy rates will have already gone a long way to normalizing monetary policy around the world. A Simple Approach The methodology we use is based on the approach developed by Holston, Laubach, and Williams (HLW)  to estimate the neutral real interest rate – or “r-star.” Specifically, we run regressions between the real interest rates in the US, Japan, the UK, New Zealand, Canada, Australia, Sweden, and Switzerland versus trend GDP growth and current account balances, which approximate the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average of core CPI.1  Table 1Unadjusted R-Stars Neutral Rates Around The World Neutral Rates Around The World The results are shown in Table 1. New Zealand, Australia, and Canada have the highest real-neutral rate of the major economies. They have had stronger growth over the past 20 years because of their rapid population growth caused by high immigration rates. Moreover, their commodity-based economies and their booming construction sectors pushed up investment rates, which requires high interest rates to attract sufficient savings to finance. Sweden and the US follow. These two economies have lower population growth rates than the commodity producers; nonetheless, they outperform Japan and the other European nations in the survey on that dimension. Moreover, they fare comparatively well in terms of productivity growth, which implies that their trend growth – a key driver of the neutral rate – is also higher than that of the UK, Japan, Switzerland, or the Euro Area. The US’s r-star shows up as being slightly below what would be expected based on its potential GDP growth. This surprising outcome most likely reflects the role of the dollar in global FX reserves and its standing at the core of the global financial system. These two characteristics of the greenback create an important demand for dollar-denominated assets that is dissociated from US domestic economic fundamentals. This additional demand biases downward the US real neutral rate and suggests that weak trend growth abroad and global excess savings remain important forces for US financial markets. Chart 2Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan displays a surprisingly elevated real neutral rate of 0.1%. This result reflects the limitation of the approach. Japanese interest rates have been at zero since the late 1990s and real rates have been negatively correlated with inflation because of this nominal rigidity (Chart 2). However, while Japanese inflation has averaged a paltry 0.2% since 1997, it has nonetheless fluctuated with commodity prices and global economic activity. As a result, real rates have been essentially dissociated from Japanese domestic drivers. Hence, an empirical approach based on the evolution of domestic economic variables yields poor results for Japan. Instead, the lack of inflation when public debt has increased by 200% of GDP over the past 32 years and Japan’s large net international investment position imply that its r-star is inferior to that of the other countries in the sample, and thus should lie below -1%. For the Eurozone, we use the average result of our July study, which estimated the neutral rates of Germany, France, Italy, and Spain independently. Germany flatters this estimate since its real neutral rate stands near 0%. An average, excluding Germany, would be closer to -0.5%, or well below the US r-star. Meanwhile, the Swiss r-star is depressed by both a low population growth and the Swiss exceptional savings generation, as highlighted by its current account surplus that has averaged 8% of GDP over the past 20 years. Finally, the UK’s r-star stands at the bottom of the pack. The UK’s productivity growth has been very poor over the past ten years, averaging 0.7% per annum. This points to a weak potential GDP for that economy. Moreover, the hurdles to UK growth have only increased in recent years with the implementation of Brexit, which is hurting the availability of labor in the country, while putting the UK at an even greater disadvantage in European markets, its largest export destination. What About Debt? This approach to estimating r-star ignores a key dimension: debt sustainability. If we factor in this crucial variable, the level of interest rates causing economic activity to decelerate changes drastically for many countries. Chart 3Massive Real Estates Bubbles Massive Real Estates Bubbles Massive Real Estates Bubbles Since 2000, real estate prices have surged by 280%, 220%, 170%, and 200% in New Zealand, Canada, Australia, and Sweden, respectively. These gains dwarf the house price appreciation observed in the US, the UK, Japan, or Germany (Chart 3, top panel). This outperformance of house prices is particularly problematic because it does not reflect more rapid underlying cash-flow growth from the assets. Instead, the main driver of the stronger house prices in New Zealand, Canada, Australia, and Sweden has been the explosion of their price-to-rent and price-to-income ratios (Chart 3, bottom two panels). Rising real estate prices boosted economic activity relative to the underlying trend GDP of these countries. As a result, the long-term growth numbers of these four nations potentially overstate their underlying rate of growth. Even more importantly, real estate prices and activity are extremely sensitive to interest rates. Therefore, the risk of bursting bubbles in New Zealand, Canada, Australia, and Sweden limits how high interest rates may rise there without causing growth to plunge and deflationary spirals to emerge. Chart 4Rapidly Rising Debt Loads Rapidly Rising Debt Loads Rapidly Rising Debt Loads The accumulation of debt in these four countries accentuates the threats to growth created by real estate activity. The private-sector debt of New Zealand, Canada, Australia, and Sweden has risen much more quickly than has been the case in Germany and the US (Chart 4). Ultimately, these debt burdens create major headwinds against higher interest rates and suggest that the effective r-star of these nations lies well below the estimates constructed using only trend growth and the savings/investment balance. Table 2Drastic Changes Once Debt Is Accounted For Neutral Rates Around The World Neutral Rates Around The World To account for the private-sector leverage, we estimated new debt-adjusted r-stars. The impact of high debt loads on r-star estimates is evident in Table 2. The average real neutral rate of New Zealand, Australia, and Canada drops from 1.9% to -1.9%. In fact, Australia and Canada would sport the lowest r-star estimates of the nations under study. Sweden’s neutral rate also experienced a big decline from 0.6% to 0.2%. The US r-star estimate is also lowered by the addition of debt metrics in its equation, declining from 0.2% to -0.4%. The Eurozone average r-star experiences a significant decrease as well, driven mostly by Spain and France. The Swiss economy also sports a large private debt load, and its r-star is therefore curtailed from -0.75% to -1.3%. Finally, Japan’s r-star estimate barely changes, which confirms that the approach does not work well for that country. The greatest drawback of the method is that it is backward-looking. The main force that has brought down the global r-star over the past 20 years is the collapse in trend growth among most advanced economies (Chart 5). Consequently, neutral rates could improve from their current low levels if trend growth were to pick up in the coming years. On the positive side, the current age of the capital stock in both Europe and the US is extremely advanced (Chart 6), which suggests that a capex upturn is likely. Such an upturn would boost productivity and lift the r-star among most major economies. On the negative side, the growth of human capital is deteriorating as educational attainment stalls among most DM nations. The decline in the growth rate of human capital is a large threat to productivity over the coming decades. These problems are magnified in the Eurozone, as its high degree of economic fragmentation, lack of common fiscal policy, and higher regulatory burden create further handicaps to trend growth. Chart 5R-star And Global Growth R-star and Global Growth R-star and Global Growth Chart 6A Capex Revival? A Capex Revival? A Capex Revival? Bottom Line: Estimating the real neutral rates for the global economy often relies on trend growth and the savings/investment balance. However, such an approach often misses the vulnerability to higher interest rates created by high private-sector indebtedness. If this constraint is considered, the high r-star recorded in countries like New Zealand, Australia, or Canada is reduced dramatically. The US r-star also declines but significantly less so. As we already showed seven weeks ago, the same phenomenon is also visible in the Eurozone, albeit driven by France and Spain, not Germany or Italy. Investment Implications There are three main conclusions from the analysis above. First, the risk of a financial accident in commodity-producing economies is growing increasingly large. On the one hand, economies like New Zealand, Australia, and Canada are buoyed by the recent surge in commodity prices, with agricultural prices up 90% since their 2020 lows, metal prices up 68%, and energy prices up 340% since April 2020. On the other hand, the inflationary pressures created by robust commodity sectors invite the RBNZ, the RBA, and the BoC to lift interest rates quickly, which is hurting massively indebted private sectors. Already, in response to the 275bps and 300bps of hikes implemented by the RBNZ and the BoC, house prices in New Zealand have begun to buckle, down 12% and since their more recent peaks, and they are expected to plunge by as much as 25% in Canada by the end of next year. Chart 7NZD And CAD At A Disadvantage Neutral Rates Around The World Neutral Rates Around The World This suggests that non-commodity equities in Canada, Australia, and New Zealand, especially financials, could experience significant periods of underperformance, both against their domestic equity benchmark and global market averages. Additionally, while the NZD, AUD, and CAD all benefit from improving terms of trades, the potential for domestic weakness is such that these currencies are likely to lag their historical sensitivity to commodity price fluctuations. In fact, according to BCA’s foreign exchange strategist, the New Zealand and Canadian dollars are among the most expensive currencies in the G10 (Chart 7), and thus, it is likely to underperform other pro-cyclical currencies once the USD bull market reverses. Second, the neutral rate in the US has risen by 200bps relative to the rest of the world over the past seven years. The US economy has undergone a long deleveraging period in the wake of the GFC, which means that its private-debt-to-GDP ratio has declined relative to other advanced economies. Consequently, the vulnerability of the US economy to higher interest rates has decreased, even if relative US trend growth has not improved meaningfully. The market implications of this pickup in the neutral rate are manifold. To begin with, it allows US rates to rise further relative to other DM economies. BCA’s Global Fixed Income Strategy team continues to underweight US Treasurys in global fixed-income portfolios, especially relative to German Bunds (Chart 8). As a corollary, it also means that US financials are likely to continue to outperform their foreign peers, especially Canadian and Australian ones which will bear the brunt of the negative consequences of their debt bubbles. The increase in the US r-star relative to the rest of the world has been a key contributor to the dollar rally. It helps explain why the recent dollar strength has not hurt relative profit growth (Chart 9). However, the dollar is trading at a 32% premium to its purchasing power parity, or the same overvaluation as in 1985 and 2001. Thus, with the worsening US balance of payment picture, the US dollar is vulnerable to an eventual improvement in global growth next year. Chart 8US Rate Differentials Have Upside Neutral Rates Around The World Neutral Rates Around The World Chart 9The US Fares Better The US Fares Better The US Fares Better Chart 10Easy Or Not? Easy Or Not? Easy Or Not? Finally, despite the recent increase in rates, the high level of inflation recorded around the world implies that real policy rates are still well below r-star for major global economies, whether one uses actual inflation or the smooth formulation recommended by the HLW paper (Chart 10). This suggests that a recession is unlikely, especially in the US. The recession threat is higher in Europe but has little to do with policy. It is mostly a consequence of the massive terms of trade shock caused by the sudden jump in European energy prices in the wake of the Ukrainian war. However, because policy remains accommodative even in Europe, it follows that the Eurozone economy will rebound quickly once the worst of the energy shock is over next spring. Some humility is required. It is hard to gauge how much of the inflation surge over the past 18 months reflects supply factors. If inflation suddenly becomes much weaker because the easing in supply constraints has a greater-than-anticipated impact on inflation, real interest rates would jump rapidly around the world. In this scenario, policy rates could rise quickly and overtake r-star. This would mean that the disinflation impulse could rapidly morph into an outright deflationary environment, which implies that the odds of a deflationary bust like the one experienced in 1921 is greater than the market currently prices in.  Bottom Line: The debt-fueled real estate bubbles in the dollar-bloc economies suggests that they are at a greater risk of a financial accident than the US or the Eurozone. As a result, their financial sector looks vulnerable. Meanwhile, the higher US r-star compared to that of the rest of the world will continue to support higher yields in the US rather than in Europe or Japan. This phenomenon has been hugely positive for the US dollar, but it has likely run its course. Finally, global real interest rates remain below r-star estimates. Hence, the current slowdown is likely to prove to be a mid-cycle slowdown and Europe will rebound quickly from a potential recession caused by the recent surge in its energy prices. The ECB Joins The 75bps Club Last week, the ECB increased interest rates by 75bps, which brought its deposit rate to 0.75%. Interestingly, the euro did not rally much in response to this policy decision, even though it has not been fully discounted by the market. At first glance, the lack of responsiveness from European assets seems strange, especially since the vote for a 75bps rate hike was unanimous. The ECB is taking advantage of strong economic numbers to push up rates rapidly. The Eurozone Q2 GDP growth was robust at 0.6%, while the unemployment rate hit an all-time low of 6.6%. Meanwhile, inflation continues to beat consensus forecasts, with Eurozone core CPI and headline CPI standing at 4.3% and 9.1%, respectively in August. Chart 11Big ECB Revisions Big ECB Revisions Big ECB Revisions The market believes that more rapid interest rate hikes now will not translate into a much higher terminal rate, with the expected rates for June 2023 moving from 2.2% on September 7th to 2.4% after last Thursday’s decision. The ECB may have increased its inflation forecasts for the whole horizon, but it has also brought down GDP forecasts to 0.9% and 1.9% in 2023 and 2024, respectively (Chart 11). Moreover, ECB President Christine Lagarde went out of her way to telegraph to investors that the number of upcoming hikes was finite. The jumbo hike does not spell the start of a euro rally—for now. First, the lack of major change in the ECB’s terminal deposit rate is more important than the more rapid pace of hikes for the remainder of 2022. Second, the Fed is also lifting rates faster than investors expected ahead of the Jackson Hole meeting three weeks ago. Third, the euro remains vulnerable to any flare-ups in the energy market. True, natural gas and electricity prices have recently fallen, but the situation in Ukraine continues to be highly fluid, which suggests that volatility will linger in the energy market over the coming weeks.   Despite the near-term hurdles, the euro’s medium-term outlook is brightening. We are gaining confidence in our thesis that energy prices will peak once natural gas inventories have reached approximately 90% by November. Additionally, the support of the Governing Council’s doves for a 75bps hike suggests that they received something in exchange for their votes. In our view, this “something” is an activation of the Transmission Protection Instrument (TPI) before year-end. The TPI activation will allow for a normalization of the risk premia in the Italian debt market and will support the ECB’s ability to increase interest rates further down the road, despite the much lower r-star in Italy, Spain, and France than in Germany (Table 3). Table 3The Eurozone’s Different R-Stars Will Force The TPI’s Activation Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The ECB may have delivered a jumbo hike last week, but its market impact was muted. Investors understand full well that the ECB is taking advantage of the recent bout of robust economic activity to front-load interest rate increases ahead of a likely economic contraction in Q4 2022 and Q1 2023. As a result, the terminal rate estimates have scarcely moved. Ultimately, we expect the ECB deposit rate to settle between 1.5% and 2% in the summer of 2023. While the move may not provide much of a boost to the euro in the near term, conditions are falling into place for a euro rally later this year.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1     For the US, we opted for core PCE, since it is the benchmark inflation measure the Federal Reserve uses.

Executive Summary A Structural Downshift In China’s Real Estate Investment Growth Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower The Politburo has set a date for the much-anticipated 20th Communist Party Congress at which President Xi will most likely secure his third term as general secretary. Although we expect China’s leaders to focus on supporting the economy following the Party Congress, there are high odds that the authorities will underdeliver on policy easing. Beijing may recalibrate its stringent zero-Covid policy next year, but the conditions are presently not yet met for a turnaround in the current strategy. China’s structural issues remain, and policymakers will likely continue to tackle them while downplaying the importance of GDP growth. The housing market remains the epicenter of risk to both China’s financial system and social stability. China’s leaders have incrementally introduced accommodative initiatives, but they still continue to seek reduced leverage among property developers. Investors should be prepared for a scenario that China will avoid “irrigation-type” stimulus in the next six months. Therefore, the economy will continue to expand at below potential growth. Bottom Line: There is a nontrivial risk that China’s stimulus will fall short of market expectations following the upcoming Party Congress. This poses risks to Chinese share prices.   Market participants believe that the 20th Communist Party Congress beginning October 16 will be a jumping off point for Chinese leaders to stimulate the economy more aggressively. This would signal a shift in the leadership’s focus, from securing political stability ahead of the Party Congress to ensuring an economic recovery next year. However, to achieve a meaningful and sustainable rebound in economic activity and equity market performance, policymakers will need to overcome two major hurdles: the zero-Covid policy and the "three red lines" regulation for property developers. At the risk of being wrong, we identify some of the factors that will preclude using irrigation type of stimulus after the conclusion of the Party Congress. Given the prevailing headwinds to China’s economy and the lack of “all-in” type of stimulus, we recommend that global equity portfolios stay neutral for now on Chinese onshore stocks and underweight offshore stocks. The Date Is Set! The Politburo’s announcement that the 20th Party Congress would take place earlier than November, in our view, is a sign of political stability and marginally positive for the economy. On the opening day, President Xi will deliver the Party’s work report, which will chart China’s policy trajectory for the next five years and beyond. It is generally believed that President’s Xi’s vision to turn China into an advanced global power will be endorsed by the Party. The earlier date for the Congress is significant for the following reasons: It shows that preparations for the Party Congress are progressing on schedule. President Xi will most likely cement his third term as general secretary, leaving little room for surprises from a political standpoint. The Party Congress will provide some indication whether the leadership will revise policies, including the zero-Covid strategy and industry regulations. Lower-level officials have been waiting to see which way the political winds are blowing. The Party Congress will clarify the situation and allow officials to focus on their economic work. Bottom Line: The Party Congress, along with the Central Economic Work Conference in December, will set the tone for China’s key economic, social, and industry policies for 2023 and beyond. Endgame To The Zero-Covid Strategy? Chart 1The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The primary risk to China’s economic recovery is its stringent zero-Covid policy, which has significantly impacted the service sector, household income and consumption (Chart 1). In recent months policymakers have incrementally adjusted their Covid-containment measures, such as shortening the quarantine period for international travelers and streamlining mass testing procedures. However, the fundamental goal of eradicating domestic Covid cases remains intact. The best scenario in the coming year, in our view, is that China will adopt hybrid measures to combat Covid. Countries like Japan, South Korea, New Zealand, and Australia have all adopted a mixed series of Covid-control policies. These include a gradual reduction in testing and quarantine protocols, an increase in targeted vaccination among the elderly, an introduction of antiviral drugs and strengthening the quality of primary care. However, China may not tolerate the level of Covid experienced in these countries, especially since their number of new cases and related deaths have risen of late (Chart 2A and 2B). Chart 2ACovid Case Counts In Other Countries Have Risen Or Remain Elevated... Covid Case Counts In Other Countries Have Risen Or Remain Elevated... Covid Case Counts In Other Countries Have Risen Or Remain Elevated... Chart 2B...Along With Number Of Deaths ...Along With Number Of Deaths ...Along With Number Of Deaths   China sees its extremely low case count as proof that the dynamic zero-Covid policy has succeeded (Chart 3). It argues that if it shifts course and re-opens before proper protective measures have been introduced, then the losses might exceed a million deaths. China’s authorities believe that Hong Kong SAR’s high death rate in the spring is stark proof of that possible scenario (Chart 4). Chart 3China Has Managed To Keep Its Covid Case And Death Counts Extremely Low China Has Managed To Keep Its Covid Case And Death Counts Extremely Low China Has Managed To Keep Its Covid Case And Death Counts Extremely Low Chart 4Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Thus, a sudden pivot from zero-Covid to living with the virus next year seems farfetched. China’s National Health Commission experts recently stated that victory over the virus would require effective vaccines, treatments and mild variants. We examine these three premises as follows: Covid vaccination rate: China’s overall Covid vaccination rate is high at 90% as of August this year. However, more than 35% of Chinese over age 60 have not received a booster dose and only 61% above age 80 have had a primary vaccination. Given that the majority of China’s population has not been exposed to the virus and is immunologically naïve, unlike their Western counterparts, the population relies completely on immunity acquired through Covid vaccines.  Chart 5China's Vaccination Progress Has Stalled China's Vaccination Progress Has Stalled China's Vaccination Progress Has Stalled China’s daily vaccination rate has fallen to below 200,000 per day, sharply down from the peak of 3-5 million per day in March and April (Chart 5). Even if we assume that three doses of China’s domestically produced vaccines are as effective as the West’s mRNA vaccines, at the current pace it would take several years to provide three doses of Covid vaccines to China’s 1.4 billion people. Hence, to significantly loosen zero-Covid policy, we would need to see a huge acceleration in the country’s vaccination rate. Treatment drugs: China okayed the imports and use of Pfizer’s antiviral drug Paxlovid in February and approved its first homegrown Covid antiviral medication “Azvudine” in July. Azvudine’s efficacy in reducing Covid-related hospitalization and deaths remains to be seen. The manufacturer, Genuine Biotech, says that the facility's annual production capacity is 1 billion tablets (each tablet is 1 mg), but is expected to reach 3 billion tablets in the future. Assuming each patient will need 50 mgs of Azvudine to complete a full course of treatment (as instructed by the drug manufacturer), the company can provide enough tablets for approximately 20 million Chinese within one year. To put the number into respective, China has more than 26 million people over age 80, of which more than 10 million have not had their first Covid vaccine. Chart 6The Level Of Beijing's Covid Policy Stringency Remains Elevated The Level Of Beijing's Covid Policy Stringency Remains Elevated The Level Of Beijing's Covid Policy Stringency Remains Elevated ​​​​​​​ Milder variants: Another possibility is if new mild variants emerge next year and they cause no harm or panic among the population. However, there is no guarantee that Beijing will be willing to relent on its Covid policy based on evidence and statistics from other countries where the populations may have received mRNA vaccines. Even statistics provided within China may not warrant a decisive reopening of the economy. A recent study conducted by leading Chinese public health experts found that only 22 of the nearly 34,000 Covid patients hospitalized in Shanghai from March 22 to May 3 developed severe illness. Nonetheless, the study has not prompted policymakers to step back from the tight Covid control protocols (Chart 6). Bottom Line: The conditions do not seem to be met for a drastic change in Beijing’s dynamic zero-Covid strategy. China’s transition from zero tolerance to an orderly, managed approach to life with an evolving Covid virus will likely be long and difficult. The Housing Market Policy Dilemma The other key to achieving a meaningful recovery in China’s economy is through stimulating the country’s housing market. We expect that more accommodative real estate policy initiatives will be introduced later this year and early next year. However, structural headwinds in the property market will limit the government's willingness to stimulate the sector as aggressively as in previous cycles. China’s shrinking working population since 2015 likely led to a peak in the demand for housing in 2017/18. Moreover, it is estimated that China's total population growth will turn negative this year, further suppressing demand (Chart 7). The combination of demographic headwinds and a slowdown in urbanization, means that if policymakers overstimulate the sector as in the past, then they will have a bigger bubble to pop in the future.  There is no indication that the authorities will stop focusing on deleveraging and reducing financial risks in the real estate sector. The magnitude of mortgage rate cuts so far this year is much smaller than in the 2008/09 and 2015/16 cycles. Moreover, mortgage rates remain higher than growth in household income and home prices (Chart 8). The positive gaps between mortgage rates and both household income growth and house price appreciation discourage house purchases. Chart 7Demand For Housing In China Is On A Structural Downtrend Demand For Housing In China Is On A Structural Downtrend Demand For Housing In China Is On A Structural Downtrend Chart 8Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Importantly, while policymakers have intervened and provided liquidity to cash-strapped real estate developers, the “three red lines” policies restraining developers’ leverage remain intact. The message is clear: Beijing will use all necessary tools to prevent systemic risks and social unrest by ensuring the completion of existing housing projects. However, the authorities will continue to force developers to structurally shift their business models and reduce their leverage. Chinese authorities would be more incentivized to bail out the sector if there were risks of widespread mortgage loan defaults among households. In our view, this risk remains low in the next 6 to 12 months. The mortgage down payment ratio is relatively high in China and mortgages are full recourse loans as borrowers are personally liable beyond the collateral (i.e., the property asset). This combination reduces the incentive for homebuyers to stop paying mortgages even in a situation of negative equity (i.e., when the value of the property asset falls below the outstanding mortgage). Indeed, ongoing mortgage boycotts have been isolated to unfinished apartments in stalled projects. The boycotts are driven by homebuyers to pressure developers to finish these projects and are not due to household financial difficulties. There will likely be more defaults by overleveraged developers next year. The sector will consolidate further, with opportunistic, well-funded developers taking advantage of the situation to acquire distressed assets at a discount. Many of these may be state-owned or state-backed companies and investment funds. Chart 9Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower Real Estate Investment Growth In China Will Structurally Shift Lower Bottom Line: Policymakers will continue to feed the housing sector with stimulus measures, but the leadership might be reluctant to overstimulate the sector. China’s real estate market dynamics, particularly the completion of existing projects, will likely improve on the margin in the next 6 to 12 months. Structurally, however, China’s home sales and real estate investment growth will continue shifting to a lower gear (Chart 9).    Investment Conclusions At the start of the year, China was expected to aggressively stimulate its economy. This was based on the premise that policymakers would not tolerate slower economic growth ahead of the Party Congress. Nonetheless, Chinese leaders downplayed the annual GDP growth target this year, a major deviation from the past. Post October’s Party Congress, we think that the authorities will continue to roll out measures to support the economy, but we recommend that investors remain realistic about the magnitude of policy easing. There are nontrivial risks that policymakers will continue to tackle structural issues, while allowing the economy to muddle through. With piecemeal stimulus, China may still be able to manage a soft landing in its property market and prevent the risks from spilling over to other sectors of the economy. In this case, we will monitor macro and financial market dynamics and change our stance on Chinese equities if warranted (Chart 10A and 10B). Chart 10AWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Chart 10BWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Without More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Lastly, investors should be prepared for greater emphasis of common prosperity policies at the Party Congress. Reducing income inequality and improving social welfare will remain core principles of President Xi’s political agenda. Common property policies mean that there will be a continued shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 11). The pandemic in the past 2.5 years has likely exacerbated the country’s income inequality and discontent among middle-class households. Chart 11Implications Of China’s Common Prosperity Policy Implications Of China's Common Prosperity Policy Implications Of China's Common Prosperity Policy Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com ​​​​​​​Jing Sima Consulting China Strategist Strategic Themes Cyclical Recommendations

Highlights Chart 1A Hot Labor Market A Hot Labor Market A Hot Labor Market The balance of data that’s come out during the past month points to a labor market that is not cooling very quickly. In fact, it is cooling much more slowly than we anticipated. First, nonfarm payroll growth of +315k in August is well above the +79k that is needed to maintain the unemployment and participation rates at current levels (Chart 1). Second, what had initially looked like a significant drop in job openings was revised away with the July JOLTS report. While the ratio of job openings to unemployed has leveled-off just below 2.0, it is no longer showing any signs of falling (bottom panel). Finally, the employment component of August’s ISM Manufacturing PMI jumped back above 50 and even initial unemployment claims have reversed their nascent uptrend. The conclusion we draw from this spate of strong employment data is that the Fed’s tightening cycle is not close to over. This means that the average fed funds rate that is priced into markets for 2023 is almost certainly too low. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Still Too Hot Still Too Hot Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Still Too Hot Still Too Hot Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to -267 bps. The average index option-adjusted spread tightened 4 bps on the month, and it currently sits at 145 bps. Our quality-adjusted 12-month breakeven spread ticked up to its 56th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see some modest spread narrowing during the next couple of months as inflation heads lower. That said, spread compression will be limited by the inverted yield curve and the persistent removal of monetary accommodation. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 28 basis points in August, dragging year-to-date excess returns down to -519 bps. The average index option-adjusted spread tightened 15 bps on the month and it currently sits at 494 bps, 125 bps above the 2017-19 average and 43 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – increased modestly in August. It currently sits at 6.6% (Chart 3). As is the case with investment grade, high-yield spreads could stage a relief rally during the next few months as inflation falls and recession fears abate. However, the inverted yield curve will likely prevent spreads from moving much below the average level seen during the last tightening cycle (2017-19). All that said, even a move back to average 2017-19 levels would equate to a roughly 7% excess return for the junk index if it is realized over a six month period. This return potential is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to our 4% estimate of its underlying trend.3 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 100 basis points in August, dragging year-to-date excess returns down to -144 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’ poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is over. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have an incentive to refinance at current mortgage rates. With the duration extension trade over, the only thing preventing us from increasing exposure to the Agency MBS space is that spreads still aren’t sufficiently attractive. The average index spread versus duration-matched Treasuries is roughly midway between its post-2014 minimum and post-2014 mean (panel 4). Meanwhile, the option-adjusted spread has moved above its post-2014 mean (bottom panel), but at just 42 bps, it still offers less compensation than a Aa-rated corporate bond or a Aaa-rated consumer ABS. At the coupon level, we moved to a neutral allocation across the coupon stack last month, but this month we initiate a recommendation to favor high-coupon (3%-4.5%) securities over low coupon (1.5%-2.5%) ones. Given the lower duration of high coupon MBS, this position will profit from rising bond yields on a 6-12 month investment horizon. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 156 basis points in August, bringing year-to-date excess returns up to -563 bps. EM Sovereigns outperformed the Treasury benchmark by 117 bps on the month, bringing year-to-date excess returns up to -677 bps. The EM Corporate & Quasi-Sovereign Index outperformed by 180 bps, bringing year-to-date excess returns up to -491 bps. The EM Sovereign index outperformed the duration-equivalent US corporate bond index by 111 bps in August. Meanwhile, the yield differential between EM sovereigns and US corporates moved deeper into negative territory (Chart 5). As such, we continue to recommend a maximum underweight (1 out of 5) allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 168 bps in August. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. China is the most important trading partner for most EM countries and thus represents a major source of economic growth. Consequently, Chinese import volumes are a useful gauge for the outlook of EM economies. The persistent contraction of Chinese import volumes (bottom panel) therefore sends a negative signal for EM bond performance. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 126 basis points in August, bringing year-to-date excess returns up to -44 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire (Chart 6).5 The result is that net state & local government savings are incredibly high (bottom panel) and it will take some time to deplete those coffers. On the valuation front, munis have cheapened up relative to both Treasuries and corporates since last year. The 10-year Aaa Muni / Treasury yield ratio is currently 82%, up from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation municipal bonds and duration-matched US corporates is 80%. The same measure for Revenue bonds is 94%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5/30 Barbell Versus 10-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in August as investors significantly marked up their 12-month rate expectations. Our 12-month Fed Funds Discounter – the market’s expected 12-month change in the funds rate – rose from 78 bps to 175 bps during the month and this caused the 2-year/10-year Treasury slope to flatten by 8 bps and the 5-year/30-year Treasury slope to flatten by 33 bps (Chart 7). We initiated a position in 5/30 flatteners (short 10-year bullet versus duration-matched 5/30 barbell) in our August 9th report.6 The main reason for this recommendation is our view that the Fed tightening cycle is not close to over. Therefore, it is too soon to position for a steepening of the 5-year/30-year Treasury slope. An analysis of past Fed tightening cycles shows that the 5-year/30-year Treasury slope tends to trough earlier than other segments of the yield curve. However, that trough has always occurred within a window spanning five months before the last Fed rate hike and three months after.7 On average, the 5-year/30-year slope troughs 1-2 months before the last Fed rate hike. Given our view that the Fed tightening cycle still has a lot of room to run, we think it makes sense to bet on a further flattening of the 5-year/30-year slope. This trade looks particularly attractive when you consider that a position short the 10-year bullet and long a duration-matched 5/30 barbell provides a yield pick-up of 12 bps (bottom panel). TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 8 basis points in August, bringing year-to-date excess returns up to +264 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month, moving back into the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator shows that 10-year TIPS are close to fairly valued versus nominals. In a recent report we unveiled our Golden Rule of TIPS Investing.8 In that report we showed that TIPS of all maturities tend to outperform equivalent-maturity nominal bonds whenever headline CPI inflation exceeds the 1-year CPI swap rate during a 12-month period. The 1-year CPI swap rate is currently 2.77%, and we think this will turn out to be too low based on our modeling of headline CPI. While we see value in TIPS relative to nominals, especially at the front-end of the curve, we also suspect that more value will be created during the next few months as CPI prints come in soft. Therefore, we are reluctant to immediately upgrade TIPS to overweight. Instead, we recommend that investors initiate a 2-year/10-year TIPS breakeven inflation curve flattener. The 2/10 TIPS breakeven inflation curve has recently jumped into positive territory (bottom panel), but an inverted inflation curve is much more consistent with the current macro environment where the Fed is battling above-target inflation. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to -25 bps. Aaa-rated ABS outperformed by 19 bps on the month, bringing year-to-date excess returns up to -24 bps. Non-Aaa ABS outperformed by 76 bps on the month, bringing year-to-date excess returns up to -28 bps. Substantial federal government support caused US households to build up an extremely large buffer of excess savings during the past two years. This year, consumers are starting to draw down that savings and are even starting to take on more debt. The amount of outstanding credit card debt is still low relative to household income, but it is rising quickly in absolute terms (Chart 9). Elsewhere, consumers are still paying down their credit card balances at high rates (panel 4), but banks are no longer easing lending standards on auto loans or credit cards (panel 3). To us, the prevailing evidence suggests that it will be a long time before delinquencies are a serious problem for consumer ABS. This justifies our overweight recommendation. That said, given that the trend toward consumer re-leveraging is in full swing, it makes sense to turn more cautious at the margin. We therefore close our prior recommendation to favor non-Aaa over Aaa-rated consumer ABS and move to a neutral allocation across the consumer ABS credit curve. Non-Agency CMBS: Overweight Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 26 basis points in August, bringing year-to-date excess returns up to -150 bps. Aaa Non-Agency CMBS outperformed Treasuries by 20 bps on the month, bringing year-to-date excess returns up to -103 bps. Non-Aaa Non-Agency CMBS outperformed by 41 bps on the month, bringing year-to-date excess returns up to -280 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently close to their historic averages. However, the most recent Senior Loan Officer Survey showed tightening lending standards and weaker demand for commercial real estate (CRE) loans (Chart 10). This suggests a more negative back-drop for CRE prices and CMBS spreads and causes us to reduce our recommended allocation from overweight (4 out of 5) to neutral (3 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 29 basis points in August, dragging year-to-date excess returns down to -44 bps. The average index option-adjusted spread held flat on the month, close to its long-term average (bottom panel). At 55 bps, the average Agency CMBS spread continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 175 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Still Too Hot Still Too Hot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 1, 2022) Still Too Hot Still Too Hot Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 1, 2022) Still Too Hot Still Too Hot Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -7 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 7 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Still Too Hot Still Too Hot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of September 1, 2022) Still Too Hot Still Too Hot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3    For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5    Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 6    Please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 7     In our analysis we examined seven Fed tightening cycles. The five most recent cycles and the two cycles that occurred during the inflation spike of the early 1980s. 8    Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Chair Powell’s Jackson Hole speech did not change our fundamental take on the economy; we still think the expansion will survive through the first half of 2023 at a minimum. Financial markets’ reaction to Powell’s remarks highlighted that volatility will likely remain elevated but we continue to expect that equities will generate meaningful excess returns over Treasuries and cash over the rest of the year. The flow of data continues to send mixed signals about the outlook for financial markets and the economy, but the biggest risks to our view are no closer to occurring today than they were when we laid them out last month. An Eventful Intermeeting Period An Eventful Intermeeting Period An Eventful Intermeeting Period Bottom Line: We remain more optimistic than the consensus and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are still on high alert, however, and remain open to changing our views if incoming data begin to hint at an approaching inflection. Feature At the outset of a Zoom call last week, a US-based client asked if Chair Powell’s Jackson Hole speech had changed our view. The short answer is no, though it certainly roiled financial markets, providing the latest reminder that investors’ conviction levels should be lower than normal. This week’s report offers a longer answer, analyzing Powell’s comments while revisiting the risks to our view that we laid out in August. The principal risks have not gotten any closer to fruition and we therefore stand by our glass-half-full view, though we reiterate that it is contingent on incoming data flows – if they point to a worse outcome than our current base case, we may yet join the bearish chorus. The Fed Bigwigs Went To Grand Teton National Park … Chair Powell opened his speech by promising brevity, focus and directness and he delivered on all three counts. He used less than a third of his allotted 30 minutes to hammer home the Fed’s commitment to bringing inflation back to its 2% target and he didn’t mince words. The speech was short enough to allow the following close reading of it in which we excerpt a key line from nearly every paragraph, followed by our italicized takeaways. Powell: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.” US Investment Strategy: We are prepared to accept a lengthy stretch of subpar growth as the cost of getting inflation under control. Until further notice, fighting inflation takes precedence over encouraging growth. “The labor market … is clearly out of balance, with demand … substantially exceeding … supply[.]” The rip-roaring labor market is so strong that we have no choice but to lean against it given the inflation backdrop. “In current circumstances, … [the dots’] estimates of [the] longer-run neutral [fed funds rate] are not a place to stop or pause.” It will take a good bit more monetary tightening to get inflation back to the 2% target. “I said [in July] that another unusually large increase could be appropriate at our next meeting.” Another 75-basis point hike is on the table in September. The pace of increases will eventually slow, but we don’t yet know when. “Restoring price stability will likely require maintaining a restrictive policy stance for some time.” Don’t count on rate cuts any time soon. “[C]entral banks can and should take responsibility for delivering low and stable inflation.” The Fed is obligated to combat high inflation, even if some of its causes are beyond our control. Though we can’t relieve supply constraints, we can bring demand into better balance with supply. Related Report  US Investment StrategyRisks To Our View (Again) “If the public expects that inflation will remain low and stable over time, absent major shocks, it likely will. Unfortunately, the same is true of expectations of high and volatile inflation.” High inflation expectations can be self-fulfilling and we cannot allow them to become entrenched à la the 1970s. “The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.” We cannot take it for granted that inflation expectations will remain well anchored despite high inflation prints. The public’s focus on inflation threatens future price stability and future growth and we would be playing with fire if we didn’t address it now. “[W]e must keep at it until the job is done.” If we do not act forcefully now, the cost of getting inflation back to the 2% target will be much greater. “We will keep at it until we are confident the job is done.” In case you missed my first reference to Paul Volcker’s memoir, Keeping At It, a moment ago, or the two times I spoke his name, understand that we’re willing to do whatever it takes to getting the inflation genie back in the bottle. … And All Investors Got Was A Lousy Selloff Our italicized translations should have sent a chill down the spines of equity investors and the S&P 500 duly plunged 3.4% after Powell’s speech, then followed up by sliding as much as another 3.8% in last week's sessions. BCA has always viewed 2023 rate cuts as something of a pipe dream, and we have been relieved to see the money market raise its terminal fed funds rate estimate while pushing out the date it will be reached. As Chart 1 shows, the expected terminal rate has risen by about 75 basis points and rate cuts have been pushed back since the July FOMC meeting, but even Jackson Hole didn’t get investors to give up on them entirely. Our best guess is that they still question the Fed’s commitment in the face of a slowdown. Chart 1A Lot Can Change In Five Weeks A Lot Can Change In Five Weeks A Lot Can Change In Five Weeks That interpretation offers a ready answer for why the glass-half-full view has taken a beating over the last six sessions but suggests that the glass-half-empty view could be at risk before too long. A higher terminal fed funds rate implies lower near-term earnings as well as a reduced willingness to pay for those earnings, so stocks have suffered as investors revised their expectations to better align with the Fed’s guidance. But the need to hike more and faster than investors expected underscores aggregate demand’s surprising resilience. If the labor market, consumption and corporate earnings all continue to hold up better than expected, equities have a path to move higher once the terminal rate outlook fully discounts the Jackson Hole rhetoric. Risks To Our View: Unanchored Inflation Expectations If it takes longer than markets expect for rate hikes to bite, and corporate earnings and economic growth surprise to the upside while inflation intrinsically recedes along with COVID's threat, underweight investors are likely to find themselves pulled back into equities. That scenario remains our base case, but it would become highly improbable if inflation expectations were to become unmoored, forcing the Fed to race to get the fed funds rate above 4% and keep it there. We therefore deem a breakout in inflation expectations to be an existential threat to our view. One month’s flat headline CPI reading certainly does not meet the Fed’s “clear and consistent” standard for falling inflation but various indications that consumer prices have peaked have begun to provide some near-term expectations relief. Two-year TIPS breakevens fell 35 basis points in two weeks, to 2.3%, their lowest level since January 2021 (Chart 2, top panel). Two-year CPI swap rates dipped 15 basis points in that stretch and are at their lowest level since last October (Chart 3, top panel). Intermediate- (Charts 2 and 3, middle panel) and long-term (Charts 2 and 3, bottom panel) expectations have ticked slightly higher in the last two weeks but reduced near-term expectations will take some of the pressure off them. Consumers see it the same way, with one-year inflation coming down sharply in the University of Michigan’s August survey (Chart 4, top panel) while long-term inflation expectations held steady at the bottom of the 2.9-3.1% range that has been in place for a year (Chart 4, bottom panel). Chart 2Way Lower Near-Term And ... Way Lower Near-Term And ... Way Lower Near-Term And ... ​​​​​ Chart 3... Range-Bound Longer-Term Expectations ... Range-Bound Longer-Term Expectations ... Range-Bound Longer-Term Expectations ​​​​​ Chart 4No Vicious Inflation Expectations Cycle Yet No Vicious Inflation Expectations Cycle Yet No Vicious Inflation Expectations Cycle Yet Risks To Our View: Consumer Retrenchment Our sanguine take on economic growth and corporate earnings will be in trouble if consumers begin to hoard their excess savings. The Personal Income report released the morning of Powell’s Jackson Hole speech indicated that the aggregate household savings rate was just 5% in July, matching June’s downwardly revised number. We view the steadily declining trend (Chart 5) as ongoing validation of our thesis that consumers will deploy their excess savings to keep consumption and the US economy growing at trend, despite uncomfortably high inflation. Chart 5Staying Out Of The Paradox-Of-Thrift Trap Staying Out Of The Paradox-Of-Thrift Trap Staying Out Of The Paradox-Of-Thrift Trap Risks To Our View: A Softening Labor Market The major labor market datapoints that have arrived over the last two weeks have been consistently robust. Job openings, which had appeared to have entered a steady decline, turned out to be in a holding pattern following a significant July beat and an upward revision to June’s reading. Before the release, job openings were projected to be 12.5% below their March peak; instead, they’ve only shrunk by 5%, or about 100,000 more than July’s net payroll additions (Chart 6, top panel). Meanwhile, job quits data softened a little more, falling for the fourth straight month (Chart 7, top panel) and pushing the quits rate to its lowest level since May 2021 (Chart 7, bottom panel). Taken together, the openings and quits data hint that a Goldilocks outcome – labor demand remains strong but not so strong that employees are able to command higher wages simply by walking to the competitor across the street – is not impossible. Chart 6Job Openings Have Gotten A Second Wind ... Job Openings Have Gotten A Second Wind ... Job Openings Have Gotten A Second Wind ... ​​​​​ Chart 7... While Quits Are Slowing ... While Quits Are Slowing ... While Quits Are Slowing ​​​​​ The four-week moving average of initial unemployment claims extended its modest decline after a smaller-than-expected number last week and a downward revision in the previous week’s estimate (Chart 8). Markets let out a sigh of relief after the August employment situation report managed to thread the needle,1 showing that net payrolls robust growth is gently moderating (Chart 9). The numbers below the headline were also encouraging; average hourly earnings increased just 0.3% from July and the labor force participation rate rose by 30 basis points to match the post-COVID high set in March (Chart 10). The part rate remains a full percentage point below its pre-COVID level, amounting to 2.75 million missing workers – if they were to return, payrolls would have room to expand even as the unemployment rate ticks higher. Chart 8Jobless Claims Have Been Falling Since Mid-July Jobless Claims Have Been Falling Since Mid-July Jobless Claims Have Been Falling Since Mid-July Chart 9Payrolls Are Still Growing At A Healthy Clip Payrolls Are Still Growing At A Healthy Clip Payrolls Are Still Growing At A Healthy Clip ​​​​​​ Chart 10Yet Another Supply Constraint Yet Another Supply Constraint Yet Another Supply Constraint ​​​​​ Investment Implications The data received over the last two weeks suggest that the economy retains considerable momentum. Solid nonfarm payrolls gains, the month-and-a-half interruption in initial unemployment claims’ uptrend and the job openings and job quits data paint a picture of a labor market that is still humming even as upward pressure on wages may be moderating. We continue to be heartened by the low and slightly declining savings rate, which lends support to our thesis that excess pandemic savings will provide households with a cushion to keep spending despite painful increases in the price of necessities. Finally, despite eye-popping inflation readings, household, business and investor inflation expectations have remained well anchored. Though the fundamentals have been good since we elaborated on the key risks to our view two weeks ago, the technical picture turned against us with a vengeance. The S&P 500 support at 4,175 folded like a cheap lawn chair after Chair Powell took to the podium at Jackson Hole. We are CFAs, not CMTs, though we posit that technical analysis has a place in fundamental practitioners’ processes as a means of identifying advantageous entry and exit points. Going forward, however, we will not float ideas about technical levels without explicitly defining stops to exit a position if the technical level fails to hold. The stock swoon that ensued after Jackson Hole underlines how much investors are hanging on the Fed. Any perceived change of emphasis or direction has the potential to scramble financial markets and we continue to advise that investors carefully manage their holding periods and benchmark deviations. Although we think the Fed will eventually force a sober reckoning for risk assets, we believe equities can outperform over the next three to six months and therefore recommend overweighting equities in multi-asset portfolios through the end of the year. If inflation decelerates over the rest of the year as we expect, the Fed’s rhetoric should become less frightening and risk assets should see renewed inflows as the gloomy scenarios take longer to arrive than the consensus currently expects.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      As we went to press, however, equities were selling off sharply, apparently on reports of an extended Gazprom pipeline shutdown.

A message for Foreign Exchange Strategy clients, There will be no report next week, as we take a summer break. We will be joining our clients and colleagues for our annual investment conference to be held in New York, on September 7 & 8. We will resume our publication the following week, with a Special Report on the Hong Kong dollar, together with our China Investment Strategy colleagues. Looking forward to seeing many of you in person. Kind regards, Chester Ntonifor, Foreign Exchange Strategist Executive Summary No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy The biggest medium-term threat for Japan remains deflation, rather than inflation. This suggests that the BoJ will be loathe to abandon yield curve control anytime soon. That said, inflation is still accelerating globally, and has meaningfully picked up in Japan. Betting on a hawkish BoJ policy shift could therefore be a significant macro trade. We have identified five conditions that need to be met for the BoJ to begin removing accommodation. None are currently indicating an imminent need to alter monetary policy settings, particularly with the Japanese economy softening alongside subdued inflation expectations. The yen will soar on any hawkish BoJ policy shift. Currently, BCA Foreign Exchange Strategy is short EUR/JPY. That said, the historical evidence suggests waiting for an exhaustion in yen selling pressure, before placing fresh bets on selling USD/JPY. Longer-term bond yields in Japan, for maturities beyond the BoJ yield target, are already moving higher, while speculative interest in shorting JGBs has increased.  We recommend fading these trends for now – shorting JGBs outright will remain a “widowmaker trade”. Bottom Line: The yen has undershot and longer-term investors should buy it - our preferred way to express that view in the near-term is to be short EUR/JPY.  Bond investors should be underweight “low-beta” JGBs in fixed-income portfolios on a tactical basis, not as a hawkish BoJ bet, but because global bond yields are more likely to stay in broad trading ranges than break to new highs. Feature Chart 1The BoJ Is A Lonesome Dove When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? Almost every G10 central bank has raised rates over the last 12 months, even the perennially dovish banks like the ECB and Swiss National Bank, in response to soaring inflation.  The one exception has been the Bank of Japan (BoJ). The BoJ has kept policy rates unchanged throughout the year (Chart 1), while also maintaining its Yield Curve Control policy of capping 10-year Japanese government bond (JGB) yields at 0.25%. There has been interest from the macro investor community on Japan in recent months, betting on the BoJ eventually succumbing to the global monetary tightening trend.  If the BoJ were to shift gears and turn less accommodative, then the yen would surely soar, while JGBs will go on a fire sale. In this report, jointly published by BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy, we explore the necessary conditions that need to be in place for the BoJ to meaningfully shift policy, most likely starting with the end of Yield Curve Control before interest rate hikes. We see five such conditions, which will form a “checklist” to be monitored in the months ahead. Condition 1: Overshooting Inflation Expectations The BoJ has a policy mandate on inflation and most measures of underlying Japanese inflation are still well below its 2% target. For example, the weighted median and mode CPI inflation rates are only at 0.5%, even as headline CPI inflation has climbed to 2.6% on the back of two primarily non-domestic factors – rapidly rising prices for energy and goods (Chart 2). With such low baseline inflation, it has been hard to lift market-based Japanese inflation expectations like CPI swap rates above 1%, even as far out as ten years (Chart 3). CPI swaps have tended to provide a more realistic assessment of underlying Japanese inflation, adhering more closely to trends in realized core CPI inflation, and thus deserve the most attention from the BoJ.  This is in stark contrast to the BoJ’s own consumer survey of inflation expectations, that has consistently overestimated inflation over the years, which is currently showing both 1-year-ahead and 5-year-ahead inflation expectations at a startling, yet highly inaccurate, 5%.  Chart 2Low Underlying Inflation In Japan Low Underlying Inflation In Japan Low Underlying Inflation In Japan Chart 3No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan The BoJ is likely to side with the more subdued read on market-based inflation expectations in determining if monetary policy needs to turn less dovish – especially with the BoJ’s own estimate of the output gap now at -1.2%, indicating spare capacity in the economy and a lack of underlying inflation pressures (Chart 4). Chart 4Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Condition 2: Excessive Yen Weakness Our more comprehensive measure of determining the pressure to change monetary policy is captured in our central bank monitor for Japan, a.k.a. the BoJ Monitor.  The Monitor includes economic, inflation and financial variables. This measure suggests that the BoJ should not be tightening monetary policy today (Chart 5). One of the variables that goes into our BoJ Monitor is the yen. The yen impacts monetary conditions through two ways. First, import prices tend to rise as the yen weakens, feeding into domestic inflation. In short, it eases monetary conditions. That has been the story over the last year with the yen falling -15% on a trade-weighted basis (Chart 6). The second impact is through profit translation effects. Overseas earnings for Japanese exporters are buffeted in yen terms as the currency depreciates. Both impacts would tend to put more pressure to tighten monetary policy, on the margin. Chart 5No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy Chart 6Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation However, the impact of yen weakness in boosting profit translation costs for Japanese concerns has eased over the years. As many Japanese companies have offshored production, lower wages in Japan have been offset by higher costs abroad. As a result, profit margins for multinational Japanese corporations are not rising meaningfully relative to their G10 peers, despite yen weakness (Chart 7). That puts the central bank in a quandary regarding how to interpret yen weakness vis-à-vis future policy moves. On the one hand, soaring global inflation and a weak yen should be allowing the BoJ to declare victory on rising inflation expectations in Japan. On the other hand, domestic wage growth will not reach “escape velocity” (Chart 8), and inflation will fail to overshoot on a sustainable basis, if corporate profit margins are not rising meaningfully. Chart 7No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness Chart 8No Escape Velocity Yet In Japanese ##br##Wages No Escape Velocity Yet In Japanese Wages No Escape Velocity Yet In Japanese Wages Of course, Japanese authorities care about excessive moves in the yen, but they also understand their limited ability to alter the path of the currency. The Ministry of Finance last intervened to support the currency in 1998. That helped the yen temporarily, but global factors dictated its longer-term trend. A BoJ monetary tightening designed solely to stabilize the yen, before inflation expectations stabilize at the BoJ target, is a recipe for failure on both fronts. The bottom line is that yen weakness is giving a lift to inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year just to generate a one percentage point increase in Japanese inflation. As such, the current bout of yen weakness is unlikely to alter the longer-term goals of BoJ policy, unless a wave of selling undermines financial stability. Condition 3: Continually Rising Energy Costs Chart 9Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Policy makers in the eurozone have told us that even in the face of a recession, a threat to their credibility on price stability – like the energy-fueled overshoot of European inflation - is worth defending through monetary tightening. Thus, a continued external energy shock could also cause the BoJ to shift. Our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium on oil to increase in the near term. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 9). A rise in energy costs that unanchors inflation expectations is a threat worth monitoring for the BoJ, one that could drag it into monetary tightening as has been the case in Europe. That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent is likely to soften, assuaging energy import costs (Chart 10). Japan is also ramping up nuclear power production, which can help provide alternative sources to imported energy (Chart 11). Chart 10An Unprecedented Arbitrage An Unprecedented Arbitrage An Unprecedented Arbitrage Chart 11Nuclear Power Could Help? Nuclear Power Could Help? Nuclear Power Could Help? The BoJ would likely not consider an early exit from accommodative monetary policy based solely on energy-fueled inflation.  After all, the current surge in global energy prices, compounded by yen weakness, has barely pushed headline inflation above the BoJ 2% target – with little follow-through into core inflation or wage growth. Condition 4: An Economic Revival In Japan A burst in Japanese growth that absorbs excess capacity and tightens labor market conditions could convince the BoJ that a policy adjustment is due. This could result in higher Japanese interest rates and bond yields.  The yen also tends to appreciate when the Japanese economy is improving (Chart 12). Unfortunately, Japanese growth momentum is going in the wrong direction for that outcome. Chart 12The Yen And the Japanese Economy The Yen And the Japanese Economy The Yen And the Japanese Economy Domestic demand has been under siege from the lingering effects of the pandemic, including an unprecedented collapse in tourism. As the pandemic effects have faded, however, Japan’s economy faces new threats from slowing global growth, waning export demand, and declining consumer confidence (Chart 13). It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains nearly three percentage points below the level implied by its pre-pandemic trend. While Japan’s unemployment rate is 2.6% and falling, it remains above the low reached just before the start of the pandemic. Chart 13A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth What Japan needs now is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Stronger fiscal spending could lift animal spirits in Japan and cause the BoJ to shift. Yet even on that front, the evidence does not point to a direct link from fiscal stimulus to rising inflation expectations – a necessary catalyst for the BoJ to turn more hawkish. A recent study by the Federal Reserve Bank of San Francisco concluded that there was no boost to depressed Japanese inflation expectations from the massive Japanese government fiscal programs during the worst of the 2020 COVID-19 pandemic shock. Waning Japanese economic momentum is not putting any pressure on the BoJ to begin considering a shift to less accommodative monetary settings. Condition 5: More Hawkish Members At The BoJ There are important transitions occurring within the BoJ’s nine-member board that could change the policy bias in a less dovish direction.  In July, two new board members – Hajime Takata and Naoki Tamura – were appointed to the BoJ board. Both brought up the notion of the need for an “exit strategy” from current easy monetary policies at their introductory press conference, although both were also careful to state that they did not think the conditions were in place yet for that to occur. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? Nonetheless, the two new appointees represent a marginally hawkish shift in the policy bias of the BoJ board, especially Takata who replaced one of the more vocal advocates for maintaining aggressive monetary easing, economist Goushi Kataoka.  Of course, the big change at the top of the BoJ will come next April when Governor Haruhiko Kuroda’s current term ends. This will follow the departures of the two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe in March. That means five of nine board members would be changed in less than one year, including the most senior leadership. That would be a huge change for any central bank, but especially for the BoJ where Governor Kuroda has overseen the introduction of all the current aggressive monetary policies, from negative interest rates to massive quantitative easing to Yield Curve Control. A growing constraint for the future of Yield Curve Control As outlined earlier, underlying inflation and growth trends in Japan are nowhere close to justifying an end to Yield Curve Control or even a mere upward tweak of the current 0.25% yield target on 10-year JGBs. However, there are negative spillover effects from the BoJ’s bond market manipulation that could make the current policies less sustainable over the medium term for the new incoming BoJ leadership. We addressed one of those issues earlier with the extreme yen weakness, which is largely a product of the BoJ keeping a lid on Japanese interest rates while almost the entire rest of the world is in a monetary tightening cycle. But another issue to be addressed is the impaired liquidity of the JGB market. After years of steady, aggressive bond buying, the BoJ has essentially “cornered” the JGB market.  The central bank now owns roughly 50% of all outstanding JGBs, doubling its ownership share since Yield Curve Control started in 2016 (Chart 14).  The numbers are even more extreme when focusing on the specific maturity targeted by the BoJ under Yield Curve Control, with the central bank now owning nearly 80% of all 10-year JGBs (Chart 15). Chart 14The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market Chart 15BoJ Now Owns 80% Of 10yr JGBs When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? By absorbing so much supply of the main risk-free asset in the Japanese financial system, the BoJ has made life more difficult for Japanese commercial banks, insurance companies and pension funds that require JGBs for regulatory and risk management purposes. In the most recent BoJ survey of bond market participants, 68 of 69 firms surveyed described the JGB market as having poor liquidity conditions, with an equal amount stating that JGB trading conditions were as bad or worse than three months earlier. The change in BoJ leadership could also bring about a change in policymakers’ desire to continue manipulating the JGB market via Yield Curve Control.  Although the BoJ would have to be very careful in how it signals and executes any change to Yield Curve Control.  There is currently a very wide gap between a 10-year JGB yield at 0.25% and a 30-year JGB yield at 1.25% (Chart 16). If the BoJ completely ended Yield Curve Control, the 10-year yield would converge rapidly towards that 30-year yield, likely reaching 1%. That would create a major negative total return shock to the Japanese banks and institutional investors that still own nearly 40% of JGBs. Chart 1610yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control A more likely outcome would be the BoJ raising the yield target on the 10-year to something like 0.50%, or perhaps shifting to a different maturity target where the BoJ owns a smaller share of outstanding JGBs like the 5-year sector. Yet without an actual trigger for such a move coming from faster economic growth or core inflation hitting the 2% BoJ target, it is highly unlikely that the BoJ would dare tinker with its yield curve policy, and risk a JGB market blowup, solely over concerns about bond market liquidity. Investment Conclusions None of the items in our newly constructed “BoJ Checklist” are currently indicating that a shift in Japanese monetary policy is imminent.  We therefore see it as being too early to put on the legendary “widowmaker trade” of shorting JGBs, although a case can be made to go long the yen based on longer-term valuation considerations. Japanese yen The carnage in the yen is in an apocalyptic phase, but the BoJ is unlikely to rescue the yen in the near term. As such, short-term traders should be on the sidelines. 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 17). Meanwhile, according to our PPP models (and a wide variety of others), the Japanese yen is the cheapest G10 currency, undervalued by around -41% (Chart 18). BCA Foreign Exchange Strategy is currently long the yen versus the euro and the Swiss franc. Chart 17The Yen Is On Sale The Yen Is On Sale The Yen Is On Sale Chart 18The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap JGBs Chart 19Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs In the absence of a bearish domestic monetary policy trigger, JGBs should be treated by global bond investors as a risk management tool as much as anything else. The relative return performance of JGBs versus the Bloomberg Global Treasury Index of government bonds is highly correlated to the momentum of global bond yields (Chart 19). Thus, increasing the exposure to JGBs in a global bond portfolio is akin to reducing the interest rate duration of a bond portfolio – both positions will help a portfolio outperform its benchmark when global bond yields rise. On a tactical basis (3-6 month time horizon), an underweight allocation to JGBs in government bond portfolios seems appropriate, even with JGBs offering relatively attractive yields on a currency-hedged basis, most notably for USD-based investors.  Global bond yields are more likely to stay in broad trading ranges, capped by slowing global growth and decelerating goods inflation but floored by stickier non-goods inflation and hawkish central banks. Thus, the defensive properties of JGBs as a “duration hedge” in global bond portfolios are less necessary in the near-term. Beyond the tactical time horizon, the uncertainty over the potential makeup of new BoJ leadership in 2023, along with some easing of global inflation pressures from the commodity space, could justify lower JGB exposure on a more structural basis - if it appears that a new wave of more hawkish policymakers is set to take over in Tokyo. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 7Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued The Euro Is Undervalued The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Special Trade Recommendations Current MacroQuant Model Scores Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing?      

Executive Summary US Military Constraint: Strait Of Hormuz Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? A US-Iran deal would make for a notable improvement in the geopolitical backdrop during an otherwise gloomy year. It would remove the risk of a major new oil shock. We maintain our 40% subjective odds of a deal, which is well below consensus. The risk of failure is underrated. Our conviction level is only moderate because President Biden can make concessions to clinch a deal – and Supreme Leader Khamenei may want to earn some money and time. Yet we have high conviction in our view that the US will ultimately fail to provide Iran with sufficient security guarantees while Iran will pursue a nuclear deterrent. Hence the Middle East will present a long-term energy supply constraint. In the short term, global growth and recession risk will drive oil prices, not any Iran deal. Asset Initiation Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Any US-Iran deal will be marginally positive for risky assets. However, the failure of a deal would sharply increase the odds of oil supply disruptions in the short run. Feature Negotiations over Iran’s nuclear program remain in a critical phase. Rumors suggest Iran has agreed to rejoin the 2015 Joint Comprehensive Plan of Action (JCPA) with the United States. But these rumors are unconfirmed, while the International Atomic Energy Agency (IAEA) just announced that Iran has started operating more advanced centrifuges at its Natanz nuclear site.1 In this report we provide a tactical update on the topic. A US-Iran nuclear deal is one item on our checklist for global macro and geopolitical stability (Table 1). We are pessimistic about a deal but it would be a positive outcome for markets. Table 1Not A Lot Of Positive Catalysts In H2 2022 Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? A decision could come at any moment so investors should bear in mind our key conclusions about a deal: Chart 1Oil Volatility: The Only Certainty Of Iran Saga Oil Volatility: The Only Certainty Of Iran Saga Oil Volatility: The Only Certainty Of Iran Saga 1.  Any deal will be a short-term, stop-gap measure to delay a crisis until 2024 or beyond. This is not a small point because a crisis could lead to a large military conflict. 2.  The short-run implication of any deal is oil volatility, not a drop in oil prices (Chart 1). Global demand is wobbly and OPEC could cut oil production in reaction to a deal. 3.  Over the long run, global supply and demand balances will remain tight even if a deal is agreed. 4.  If there is no deal, then a major new source of global supply constraint will emerge immediately due to a new spiral of conflict in the Middle East. Iran’s nuclear program will continue which will prompt threats from Israel and the Gulf Arab states and Iranian counter-threats. We are sticking with our subjective 40/60 odds that a deal will occur – i.e. our conviction level is medium, not high. The Biden administration wants a deal and has the executive authority to conclude a deal. Iran wants sanctions lifted and can buy time with a short-term deal. Our pessimism stems from the fact that neither side can trust the other, the US can no longer give credible security guarantees, and Iran has a strategic interest in obtaining nuclear weapons. A deal can happen but its durability depends on the 2024 US election. Status Of Negotiations Table 2Iran’s Three Demands Of US For Rejoining 2015 Nuclear Deal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Ostensibly there were three outstanding Iranian demands over the month of August that needed to be met to secure a deal (Table 2). Iran reportedly dropped the first demand: that the US remove the Iranian Revolutionary Guard Corps from the US State Department’s list of Designated Foreign Terrorist Organizations. This concession prompted the news media to become more optimistic about a deal. This leaves two outstanding demands. Iran wants the IAEA conclude a “safeguards” investigation into unexplained uranium traces found at unauthorized sites in Iran, indicating nuclear activity that has not been accounted for. The IAEA will be very reluctant to halt such a probe on a political, not technical, basis. But it could happen under US pressure. Related Report  Geopolitical StrategyRoulette With A Five-Shooter Iran also wants the US to provide a “guarantee” that future presidents will not renege on the nuclear deal and reimpose sanctions like President Trump did in 2019. President Biden cannot give any credible guarantee because the JCPA is an executive action, not a formal treaty, so a different president could reverse it. (The deal always lacked sufficient support in the Senate, even from top Democrats.) Iran is demanding certain diplomatic concessions and/or an economic indemnity in the event of another American reversal. Aside from attempting to incarcerate former President Trump, Biden can only offer empty promises on this front. In what follows we review the critical constraints facing the US and Iran. The US’s Constraints The first constraint on the US is the stagflationary economy. High inflation and oil prices pose a threat to President Biden and the Democrats not only in this year’s midterm elections but also in the 2024 presidential election. A recession is not at all unlikely by that time, given the inverted yield curve (Chart 2). If the US can help maintain stability in the Middle East, then the odds of another major oil supply shock (on top of Russia) will be reduced. Lifting sanctions on Iran will free up around 1 million barrels of oil to feed global demand. With Europe and the US imposing an oil and oil shipping embargo on Russia, the world is likely to lose around two million barrels of crude per day that the Gulf Arab states can only partially make up for, according to our Chief Commodity Strategist Bob Ryan (Table 3). This is a notable material constraint – and the main reason that Bob is more optimistic about an Iran deal than we are. Chart 2US Economic Constraint: Stagflation US Economic Constraint: Stagflation US Economic Constraint: Stagflation ​​​​​ Table 3The Oil Math Behind Any Iran Deal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? However, Saudi Arabia would be alienated by a US-Iran détente. The American view is that Iranian production would threaten Saudi market share and force the Saudis to produce more. But the Saudis are seeing weakening global demand and have signaled that they will cut production. There is still an economic basis for an Iran deal but it is not clear that it will lower prices, especially in the short run. Over the long run the Saudis are a more reliable oil producer than Iran for both economic and geopolitical reasons. The second constraint is political. The US public is primarily concerned about the economy. Stagflation or recession could ultimately bring down the Biden administration. However, in the short run, American voters are much more concerned about domestic social issues (such as abortion access) than they are about foreign policy. In the long run, American voters are likely to maintain their long-held negative view of Iran (Chart 3). So the Biden administration has an incentive to prevent geopolitical events from hurting the economy but not to join arms with Iran in a major diplomatic agreement. The third constraint is military. Americans are not as war-weary today as they were in 2008 or 2016 but they are still averse to any new military conflicts in the Middle East. An Iranian nuclear bomb could change that view – but until a bomb is tested it will persist. Chart 3US Political Constraint: Americans Ignore Foreign Policy, Dislike Iran Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? ​​​​​​ Chart 4US Military Constraint: Strait Of Hormuz Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? If Iran freezes its nuclear program then it will reduce the odds of a Middle Eastern war and large-scale oil supply disruptions. If Iran does not freeze its nuclear program, then Israel will have to demonstrate a credible military threat against nuclear weaponization, and then Iran will have to demonstrate its region-wide militant capabilities, including the ability to shut down the Strait of Hormuz (Chart 4). The Biden administration wants to delay this downward spiral or avoid it altogether. Chart 5US Strategic Constraint: Avoid Mideast Quagmires Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? The fourth constraint is strategic. The Biden administration wants to avoid conflict if possible because it is attempting to reduce America’s burden in the Middle East so that it can focus on emerging great power competition in Eastern Europe and East Asia. The original motivation for the Iran deal was to enable the US to “pivot to Asia” and counter China. Iranian hegemony in the Middle East is less of a threat than Chinese hegemony in East Asia (Chart 5). This logic is sound if Iran can really be brought to halt its nuclear program. The Europeans need to stabilize and open up the Middle East to create an alternative energy supply to Russia. The Americans need to avoid a nuclear arms race and war in the Middle East that distracts them from China. However, if Iran continues to pursue a nuclear weapon, then the US suffers strategically for doing a short-term deal that provides Iran with time and access to funds. Ultimately the only thing that can dissuade Iran from going nuclear is American power projection in the Middle East – and this capability is also one of the US’s greatest advantages over China. Bottom Line: The US has a strategic, military, and economic interest in concluding a deal that freezes Iran’s nuclear program. It arguably has an interest in a deal even if Iran violates the deal and pursues nuclear weaponization, since that will provide a legitimate basis for what would then become a necessary military intervention. The Biden administration faces some political blowback for a deal but will suffer more if failure to get a deal leads to a Middle Eastern oil shock. For all these reasons Biden administration is attempting to clinch a deal. But Iran is the sticking point. Iran’s Constraints Our reasons for pessimism regarding the nuclear talks hinge on Iran, not the United States. Supreme Leader Ayatollah Ali Khamenei’s goal is to secure the regime and arrange for a stable succession in the coming years. A deal with the Americans made sense in that context. But going forward, if dealing with the Americans does not bring credible security guarantees and yet makes the economy vulnerable again to a future snapback of sanctions, then the justification for the deal falls apart. We cannot read Khamenei’s mind any more than we can read Biden’s mind, so we will look at the material limitations. Chart 6Iran's Economic Constraint: Stagflation Iran's Economic Constraint: Stagflation Iran's Economic Constraint: Stagflation First, the economic constraint: The Iranian economy suffered a huge negative shock from the reimposition of sanctions in 2019 (Chart 6). However, the economy has sputtered through this shock and the Covid-19 shock without collapsing. Social unrest is an ever-present risk but it has not spiraled out of control. There has not been an attempted democratic revolution like in 2009. The upswing in the global commodity cycle has reinforced the regime. Sanctions do not prevent exports entirely. There is still a huge monetary incentive to let the Biden administration lift sanctions if it wants to do so: a deal is estimated to free up $100 billion dollars per year in revenue for the regime for ten years.2 Realistically this should be understood as more than $275 billion for two years since the longevity of the deal is in question. The problem is that Iran’s economy would be fully exposed to sanctions again if the US changed its mind. The bottom line is that the economic constraint does not force Iran to accept a deal but it is enticing. Second comes the political constraint. President Ebrahim Raisi hopes to become supreme leader someday and is loath to put his name on a deal with weak foundations. He originally opposed the deal, was vindicated, and does not now want to jeopardize his political future by making the same mistake as his hapless predecessor, Hassan Rouhani. Opinion polls may not be reliable in putting Raisi as the most popular politician in Iran but they probably are reliable in showing Rouhani at the bottom of the heap (Chart 7). There is a significant political constraint against rejoining the deal. Chart 7Iran’s Political Constraint: Risk Of American Betrayal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Chart 8Iran’s Military Constraint: Outgunned, Unsure Of Allies Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Third comes the military constraint. While Iran is extremely vulnerable to Israeli and American military attack, it is also a fortress of a country, nestled in mountains, and airstrikes may not succeed in destroying the entire nuclear program or bringing down the regime. An attack by Israel could convert an entirely new generation to the Islamic revolution. And Iran may believe that the US lacks the popular support for military action in the wake of Iraq and Afghanistan. Iran may also believe that China and Russia will provide military and economic support (Chart 8). Ultimately, America has demonstrated a willingness to attack rogue states and Iran will try to avoid that outcome, since it could succeed in toppling the regime. But if Iran believes it can acquire a deliverable nuclear weapon in a few short years, then it may make a dash for it, since this solution would be a permanent solution: a nuclear deterrent against western attack, as opposed to temporary diplomatic promises. We often compare Iran’s strategic predicament to that of Ukraine, Libya, and North Korea. Ukraine gave up its Soviet nuclear weapons after the 1994 Budapest Memorandum, which promised that Russia, the US, the UK, France, and China would guarantee its security. Yet Russia ended up invading 20 years later – and none of the others prevented it or sent troops to halt the Russian advance. Separately Libya gave up its nuclear program in 2003 but NATO attacked and toppled the regime in 2011 anyway. Meanwhile North Korea played the diplomatic game with the US, ever inching along on the path toward nuclear weapons, and today has achieved nuclear-armed status and greater regime security. The outflow of refugees from the various regimes shows why Iran will emulate North Korea (Chart 9). Chart 9Iran’s Strategic Constraint: The Need For A Nuclear Deterrent Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Bottom Line: Iran has a short-term economic incentive to agree to a deal and a long-term military incentive. But ultimately the US cannot provide ironclad security guarantees that would justify halting the quest for a nuclear deterrent. A nuclear deterrent would overcome the military constraint. Therefore Iran will continue on that path. Any deal will be a ruse to buy time. Final Assessment The 2015 deal occurred in a context of Iranian strategic isolation, when American implementation was credible, oil prices were weak, and Iran had not achieved nuclear breakout capacity. Today Iran is not isolated (thanks to US quarrels with Russia and China), American guarantees are not credible (thanks to the polarization of foreign policy), oil prices are not weak (thanks to Russia), and Iran has already achieved nuclear breakout (Table 4). Table 4Iran’s Nuclear Program Status Check, Aug. 31, 2022 Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? The US’s strategic aim is to create a balance of power in the region but Iran’s strategic aim is to ensure regime survival. The US’s emerging balancing coalition (Israel and the Gulf Arab states) increases the strategic threat to Iran and hence its need for a nuclear deterrent. While Russia and China formally support the 2015 deal, they each see Iran as a valuable asset in a great power struggle with the United States. Iran sees them the same way. Russia needs Iran as a partner to bypass western sanctions. Regardless, it benefits from Middle Eastern instability, which could entangle the United States. China must develop a deep long-term partnership with Iran for its own strategic reasons and does not look forward to a time when the US divests from that region to impose tougher strategic containment on China. China can survive a US conflict with Iran – and such a conflict could reduce the US ability to defend Taiwan. While neither Russia nor China positively desire Iran to obtain nuclear weapons, neither power stopped North Korea from obtaining the bomb – far from it. Russia assumes that Israel and the US will take military action to prevent weaponization, which would be catastrophic for the region but positive for Russia. China also assumes Israel and the US will act, which reinforces its need to diversify energy options so that it can access Russian, Central Asian, and Middle Eastern oil via pipeline. Investment Takeaways Our negative view on the global economy and geopolitical backdrop is once again being priced into global financial markets as equities fall anew. An Iran deal would delay a notable geopolitical risk for roughly the next 24 months and hence remove a major upside risk for oil prices. This would be marginally positive for global equities, although it will not be the driver. Europe’s and China’s economic woes are the drivers. The failure of a deal would bring major upside risks for oil into the near term and as such would be negative for equities – and could even become the global driver, as Middle Eastern oil disruptions will follow promptly from any failure of the deal. We continue to recommend that investors overweight US equities relative to global, defensive sectors relative to cyclicals, and large caps relative to small caps. We are overweight aerospace and defense stocks, India and Southeast Asia within emerging markets, and underweight China and Taiwan.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Iran International, “Exclusive: Ex-IAEA Official Says US And Iran To Sign Deal Soon,” August 30, 2022, iranintl.com. See also Francois Murphy, “Iran enriching uranium with more IR-6 centrifuges at Natanz -IAEA,” Reuters, August 31, 2022, reuters.com. 2     See Saeed Ghasseminejad, “Tehran’s $1 Trillion Deal: An Updated Forecast of Iran’s Financial Windfall From a New Nuclear Agreement,” Foundation for Defense of Democracies, August 19, 2022, fdd.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix