Sectors

Listen to a short summary of this report     Executive Summary Sales & Profit Margins: The Two Propellers That Powered The Post-GFC US Rally What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? US equity markets underperformed the global benchmark by 10% over 2000-08. Since then, the US has outperformed the global benchmark by about 170%. So, what has driven the US’ chartbusting performance in the post-GFC period? If we break down the US’ price performance into three parts – namely price-to-earnings ratio, net profit margins, and sales – then it becomes clear that growth in the latter two elements played a key role in driving US outperformance in the post-GFC era. Can the US’ outperformance relative to global markets persist going forward? It appears unlikely that the US’ high profit margins can sustain these levels of growth going forward. Distinct from the mean reversion argument, the US’ high profit margins are unusually concentrated amongst a fistful of firms.  US firms may also find it challenging to maintain high sales growth as US GDP growth slows and given that America’s antitrust philosophy may soon undergo a once-in-a-generation change. Finally, it is worth noting that ‘sector composition’ effects played a significant role in driving US outperformance over 2008-22. Given that we expect outperforming sectors like Tech to become underperformers, this effect could become weaker going forward, thereby subverting another source of the US’ outperformance.   Bottom Line: Forecasting is a tenuous science but given that the two prime propellers of the US’ performance engine are likely to confront headwinds going forward, investors should consider reducing allocations to US equities over a longer term, strategic horizon.   Dear Client,  I am meeting clients in Asia this week while also working on our Fourth Quarter Strategy Outlook, which will be published next week, followed by my webcast the week after. In lieu of our regular report this week, you are receiving a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards,  Peter Berezin, Chief Global Strategist US Stock Market Dominance – It Wasn’t Always This Way Let us assume that you could travel back in time, and today was December 31, 2008. On this day you know that US and Japanese equity markets have underperformed the global benchmark (Chart 1). You also know that Europe (i.e., EU-27) has done marginally better than the US, while Emerging Markets (EM) have been the star outperformer. Let us further assume that by close of play today you have to deploy US$10bn across these four equity markets (across the US, Europe, Japan, and EM).  As if the task of taking this decision on the last day of this historic year was not enough, let us assume that the funds you invest must be locked in until the fall of 2022. Finally, let us add one more condition to this task – let us suppose that you have no idea how markets would perform over the 2008-22 period, but you have perfect foresight about how the nominal GDP of these four regions would look like in 2022. Specifically, you know that EM GDP will have a terrific run between 2008 to 2022, US GDP will increase but by a far less impressive degree, European GDP will grow only slightly, and Japan’s GDP would be lesser in 2022 than it was in 2008 (Chart 2).  Chart 1US Equities Underperformed The Global Benchmark By 10% Over 2000-08 US Equities Underperformed The Global Benchmark By 10% Over 2000-08 US Equities Underperformed The Global Benchmark By 10% Over 2000-08 Chart 2EM GDP Has More Than Doubled Since The GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 3US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD If you were to take an investment decision based only this information, what is certain is that the fund you manage would underperform by a painful degree. This is because we now know that even though US markets had poor momentum in 2008, and the US’ GDP expansion paled relative to EM, US equity markets outperformed global markets by a wide margin since 2008 (Chart 3). On the other hand, despite positive momentum and high GDP growth, EM emerged as a distant second-best performer. Japan miraculously made it to third place despite a contraction in nominal GDP, and finally Europe ended up being the worst performer. If market momentum and GDP growth cannot explain these market movements, then what drove the US' outstanding performance in the post-GFC period? In this Special Report, we delve into answering this question in detail. The purpose of peeling the onion of the US' performance is simple – we hope to extract the insights that investors need to construct alpha-generating portfolios, in a world where forward time travel is not a possibility (yet). The US’ Performance Has Been Powered More By Earnings, Less By Valuations The two basic building blocks of any equity index are its earnings and its price-to-earnings ratio. The former captures the fundamentals backing an index, while the latter quantifies the valuation element. Breaking down the US’ performance into these two parts shows that earnings have been the prime factor that have propelled the rise of US equity markets in the post-GFC era (Chart 4). That earnings have been an important driver of the US’ outperformance becomes even more apparent when US earnings are compared to that of other major markets. For instance, the steep expansion in US earnings contrasts with the situation across the Atlantic. In Europe, earnings have trended lower relative to the global benchmark since 2008 and an increase in relative valuations has helped lend a floor to the index (Chart 5). The earnings report card for Japan and EM, on the other hand, have been surprisingly similar as earnings failed to rise meaningfully in both these geographies in the post-GFC period (Chart 6 and 7). Chart 4Earnings Have Played A Key Role In Propelling The Post-GFC US Rally What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 5European Equities Supported More By Valuation Multiples What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 6Earnings Growth Has Been Unimpressive In Japan Too What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 7Earnings Have Trended Lower In EM Since 2008 What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? In summary, the US' price-to-earnings ratio has had a meaningful role in driving US outperformance in the post-GFC period (Chart 8), but earnings expansion has played an outsized role (Chart 9). Chart 8Relative Valuation Multiples Have Played A Key Role In Supporting European Markets What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 9Earnings Expansion In The US Has Been Phenomenal What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? In fact, the growth in earnings in the US in the post-GFC era has been so noteworthy that if US equity market prices were to be broken down into its two building blocks i.e., earnings and price-to-earnings ratio, then the lion’s share of US equity market prices today would be attributed to its earnings (Chart 10). Expectedly, this contrasts with the situation in Europe where equity market prices have managed to stay afloat owing to a re-rating in its price-to-earnings ratio (Chart 11). These attribution analysis numbers are not meant to be taken literally, but rather, reflect the relative role played by earnings and price-to-earnings ratios in supporting the prices of regional indices. Chart 10US Equities: Supported More By Earnings What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 11EU Equities: More Reliant On Multiples What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The Unsung Hero Behind The US’ Outperformance - Record Sales Expansion The index of a region can also be envisaged as the product of three elements, namely: (1) its price-to-earnings ratio; (2) its net profit margins; and (3) its sales. In other words: Price = (Price / Earnings) x (Earnings / Sales) x (Sales) While the US' healthy earnings tend to attract disproportionate investor attention, this formulation shows how a surge in US sales was the bigger driver of US outperformance (Chart 12). US profit margins experienced a sharp surge relative to global profit margins over the 2008-12 period, but then this parameter flatlined. US sales, on the other hand, have managed to register a steady march upwards over the entirety of the post-GFC period. The growth in sales of listed American corporations has in fact been so remarkable that a grand total of ten American firms now have annual sales of over $200 billion – which marks an all-time high for the US (Chart 13). Chart 12Post-GFC US Rally Powered By Record Sales Expansion What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 13The US Is Home To Ten Firms With Revenues Of +$200bn What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Furthermore, the US’ lead on sales today is meaningful not only by its own historical standards, but by cross-country standards too. The rise in US sales has meant that the US is now home to half of the twenty largest listed corporations globally (Table 1). Conversely, Europe and Japan, despite being the third and fourth largest economies of the world, respectively, together account for only three names on this list. Notably however, Emerging Markets have managed to punch above their weight and are home to six of the top twenty firms by sales globally. Table 1The US Today Dominates The Global List Of Top 20 Firms By Revenue What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The steep rise in America’s sales in the post-GFC world is also unique because no other major market has experienced such a clear upward move in sales as the US has. Europe and Japan in fact saw their sales-per-share trend downwards in the post-GFC period (Chart 14 and Chart 15). Emerging markets  were the only other major global market where sales-per-share managed to stay steady relative to the global benchmark (Chart 16). Chart 14Europe’s Sales Have Trended Lower Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 15Japan’s Sales Also Trended Lower Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Finally, thanks to the high growth in US sales, the contribution of sales to US equity prices is far higher than the contribution of its net profit margins or its price-to-earnings ratio (Chart 17). This once again is in sharp contrast to a market like Europe, where only a smidgeon of the European equity prices pie can be attributed to its sales. Chart 16EM Sales Have Expanded Marginally Post-2008 What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 17The Main Engine That Powers US Markets Is ‘Sales’ What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 18US Profit Margins Have Also Been Expanding Steadily Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Distinct from the role played by growing sales, the US’ stellar post-GFC performance has also been powered by growing profit margins. It is notable that the US has experienced an unusually strong upward movement in its profit margins in the post-GFC period (Chart 18). Japan is the only other region which has seen its profit margins expand post-GFC, with both Europe and EM having experienced a fall in profit margins from the levels seen in 2008. A Quick Note On Dividends: The US Lags On Dividend Yields But Leads On Buybacks Thus far we have focused on the returns generated by the US market relative to the world and the factors that drove US outperformance since the GFC. If one were to focus on the dividend yield component, then it is notable that the US lags its peers on this front. Post-GFC, the first major cresting of dividend yields globally took place in 2009-10. Then the next major move down in yields took place in 2020 (Chart 19). While globally, yields have now recovered from this last dip, the US finds itself lagging on this metric which matters for pension funds that rely on annuities (Chart 20). Not only have dividend yields in the US almost halved since the GFC, but the gap between dividend yields offered by the US and other markets has widened over the last few years. Europe however has managed to stay the undisputed leader when it comes to dividend yields through most of the 21st century. Chart 19Global Dividend Yields Have Recovered From The Post-2020 Fall What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 20US Lags Global Markets On Dividend Yields What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 21Pace Of Buybacks In The US Has Been Meaningful Pace Of Buybacks In The US Has Been Meaningful Pace Of Buybacks In The US Has Been Meaningful Notably, however, while the US lags its peers on dividend yields, it leads when it comes to buybacks. The latter is evident from the fact that proxy measures of shares outstanding have trended lower in the US in the post-GFC period, as compared to the rest of the world (Chart 21). Finally, it is important to note that both the growth in dividends-per-share as well as the absolute level of dividends in the US has been high. This parameter has increased by 2.4 times since 2008 and US dividends in absolute terms are nearly 5 times that of Europe’s dividends today. The only reason why dividend yields have stayed low despite this is because US equity prices have had a stellar run in the post-GFC period.     Can This Extent Of US Outperformance Persist? Having delved into the drivers of the US’ performance, we now know that a record expansion in sales and net profit margins have driven its outstanding performance in the post-GFC era. This in turn means that the probability of the US continuing to outperform over the next few years will be closely linked to its ability to maintain a lead on these two parameters. So how is the US positioned with respect to both these factors?   The US’ High Profit Margins Appear Unsustainable, For A Wide Range Of Reasons We have established the fact that expanding profit margins have been a supporting driver of the US’ outperformance in the post-GFC period. Now, the consensus view is that US profit margins are extraordinarily high and that they will eventually come down to earth. The logic for this argument is often grounded in mean reversion. We have also previously highlighted that most of the increase in US profit margins has occurred due to rising margins within the tech sector and the accompanying increase in the market cap weight of tech within benchmark indices. Chart 22US High Profit Margins Are Concentrated Amongst Top Firms What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Aside from these reasons, two more factors could lead to the compression of US profit margins over the next few years. Firstly, it is worth noting that the US' high profit margins are unusually concentrated amongst a handful of firms. While the US as a market is characterized by high margins at the headline level, profit margins of companies below the top tier are notably lower than that of the top tier (Chart 22). If profit margins were uniformly high across the US listed space and the divergence was low, then the probability of sustaining elevated margins would have been higher. But given that the US uniquely suffers from a high profit margin concentration problem, the probability of the sustainability of US high profit margins appears lower. Secondly, history suggests that in the globalized world that we live in, any region’s profit margins fail to persist above the global average beyond a maximum of 15 years (Table 2). This makes sense and is in line with economic theory which suggests that when profitability in a particular market is excessive, then new firms will enter this space, increase competition, and thereby exert downward pressure on the incumbents’ profit margins. Table 2Regional Profit Margins Seldom Persist Above The Global Average Beyond 15 Years What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Given that US profit margins have now persisted above global levels for almost 13 years, if history were to repeat itself, then it appears highly likely that US profit margins would trend towards the global average over the next 2 years.   US Sales Growth: A Peak Appears Nigh We now know that the rapid sales expansion experienced by US firms has been the prime driver of the US stock market outperformance since the GFC. However, the prognosis for this variable also appears shaky for the US. Chart 23US GDP And Sales Tend To Move In Lockstep What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The key macro variable which has the tightest theoretical link to the sales generated by the companies in a country is the country’s nominal GDP. Even as companies headquartered in the US end up selling to the global economy, history suggests that the link between the US’ nominal GDP and the sales generated by listed American firms are closely linked (Chart 23). Given that the pace of US nominal GDP growth is set to slow over the next few years (relative to both its past and relative to other major economies), US companies’ sales growth could end up slowing too (Chart 24). Also, given that the US revenue-to-nominal GDP ratio is already elevated, it is likely that even as the US’ nominal GDP keeps growing, the pace of conversion of this GDP into revenues will stay the same or may even diminish over the coming decade.   Chart 24US GDP Growth Is Set To Slow What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Then from a bottom-up perspective, we are also of the view that the US economy’s ability to spawn mega-sized companies (by sales) may become increasingly compromised over the next decade. This is because a peculiar stagnation is in the works in the middle tier of American firms, which tend to become the mega-sized corporations of tomorrow. Finally, the US' antitrust philosophy is likely to undergo a once-in-a-generation change under the Biden administration. This could mean that America’s mega-scaled firms (which have had a free run up until now) could end-up baiting regulatory attention, restricting their ability to grow sales.   US Price Performance: Strong Sector Effects Are Unlikely To Persist Chart 25Sector Composition Effect: Strongest For The US What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Lastly, it is worth noting that the price performance of the broad US equity index subverts the role played by “sector composition” in driving the US' outperformance. The fact that returns generated by the US benchmark are higher than the returns generated by a hypothetical US index which weights all sectors equally suggests that “sector composition” effects had a meaningful role in driving US outperformance. In fact, as compared to other major markets, the sector composition effect is the most prominent for the US (Chart 25). Another way of quantifying the role of sector effects is to compare the US’ market cap expansion relative to a global benchmark after removing the market cap of top-performing sectors. Expectedly, US outperformance relative to the global benchmark over the post-GFC period gets substantially reduced if the market cap of the three top-performing sectors (namely Information Technology, Consumer Discretionary, and Health Care) is adjusted for (Chart 26). To complicate matters, the sector composition effect in the US has been unwinding but remains high (Chart 27). Given that we expect outperforming sectors like Tech to turn into underperformers, the sector constitution effect in the US could weaken going forward, thereby subverting another source of US outperformance.  Chart 26Extent Of US Outperformance Weakens Sans Tech, Consumer Discretionary, And Health Care What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 27Sector Composition Effect In The US Remains High What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Investment Conclusions The prime drivers of US outperformance relative to the global benchmark in the post-GFC period have been ascendant sales and rising net profit margins. Forecasting is a tenuous science but given that both these propellers of the US equity market engine are set to face headwinds, investors should consider reducing allocations to US equities over a longer term, strategic horizon. Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com  

Executive Summary Robotization Is Gaining Pace The Robot Revolution The Robot Revolution ​​​​In today’s publication, we will zero in on one of the most exciting areas of technological innovation that also presents substantial long-term investment potential – robotics. The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of favorable long-term trends such as deteriorating global demographics, and a shift of manufacturing toward onshoring and customization. Thanks to technological breakthroughs in the areas of AI, machine learning, lidars, and machine vision, robots are becoming more intelligent and dexterous, thus suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Increased connectivity and broad-based automation and robotization, are ushering in Industrial Revolution 4.0, improving productivity manyfold. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. Bottom Line: Robotics is an exciting story of technological innovation, which also presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, the recent correction in robotics stocks presents an attractive entry point for patient investors with longer investment horizons.     Chart 1US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging Last month we published a report: “Industrials: A Trifecta Of Positives” in which we noted that the US is entering a period of industrial boom prompted by favorable government policy and generous spending, and strong new trends in onshoring and automation (Chart 1). This trifecta of positives helps the sector defy the gravity of the slowing economy.   In this week’s publication, we will zero in on automation and robotization. This is one of the most exciting areas of technological innovation, which presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, robotics ETFs such as BOTZ, ROBO, IRBO, and ROBT are off some 40%-50% from their recent post-pandemic peaks (Table 1) and present an attractive entry point for patient investors with longer investment horizons. Table 1An Attractive Entry Point for Long-term Investors The Robot Revolution The Robot Revolution What Is A Robot? Recent breakthroughs in AI and robotics technology are awe-inspiring and unsettling. The "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity, and the microchip. GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time The most basic definition is "a device that automatically performs complicated and often repetitive tasks". Interestingly, according to the definition of the International Standards Organization (ISO), software (bots, AI, process automation), remotely controlled drones, voice assistants, autonomous cars, ATMs, smart washing machines, etc. are not robots. Broadly speaking, there are three types of robots: Industrial, service, and collaborative (cobots). Industrial robots work on assembly lines in manufacturing, service robots perform necessary as well as potentially harmful tasks for humans, while collaborative robots (or “cobots”) work next to human workers. We will discuss different types of robots in more depth in later sections. Robotics Industry Is Growing Steadily Global Adoption Chart 2Robotization Is Gaining Pace The Robot Revolution The Robot Revolution According to the International Federation of Robotics, as of 2020, industrial robot stock has constituted 3 million units and between 2015 and 2020 has been growing at 13% per year. A total of 383,000 units of industrial robots were installed in 2020. Industrial robots reported record preliminary sales in 2021, with 486,800 units shipped globally, a 27% increase from 2020. The pace of installations is forecasted to stay robust well into 2024 (Chart 2). Service robot adoption has also clearly been crossing the chasm: In 2020, nearly 132,000 service robots were installed, a 41% increase over 2019, and 19 million consumer service robots were installed, a 6% increase over 2019. Together, the service robot turnover was approximately $12 billion in 2020. The US Is Lagging But The Pace Is Accelerating Chart 3Industrial Robots Across The Globe The Robot Revolution The Robot Revolution The US has been lagging other developed countries in terms of automation and robotization (Chart 3). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3), the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots in Q1, a 28% increase over Q1-2021. Multiple Tailwinds Promote Ubiquitous Robotization The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of forces, such as deteriorating global demographics, manufacturing shifts toward onshoring and customization, and technological breakthroughs that make robots more capable and affordable.  Aging Population Leads To Labor Shortages Populations in both developed and emerging markets is aging: More people both in high and upper-middle-income countries will retire in the next decade than will enter the workforce, making labor shortages inevitable. In the US, the problem is particularly acute. Since 2020, labor force participation has declined from 63.4% to 62.4%, most likely due to early retirements, while the unemployment rate stands at a historically low 3.7%. There are two job openings per job seeker, and many businesses report difficulty finding qualified staff. As companies are struggling to fill existing openings, they are increasingly turning towards robots: Replacing labor with automation/robots allows them to produce more and avoid a profit margin squeeze. IFR reports that an increasing number of small- and medium-sized businesses are deploying robots.  Related Report  US Equity StrategyIndustrials: A Trifecta Of Positives Onshoring And Reshoring As we pointed out in the recent report on Industrials, the onset of the pandemic and geopolitical tensions have accelerated the pace of reshoring. Supply chain disruptions have highlighted corporate vulnerabilities and made companies realize that “just-in-case” trumps “just-in-time.” However, companies that bring their businesses back home do realize that finding workers is a challenge, while labor costs are many times higher. Hence, one of the solutions they pursue is automation and robotization.   Mass Customization The “new normal” in many industries is mass customization, i.e., variations for a growing number of products, dubbed a “batch of one.” The shift towards high mix, low volume production raises the importance of manufacturing flexibility and agility – and that is when the industrial robot, capable of working in high to low-volume productions on simple to complex processes, comes to the rescue. The Lower Total Cost Of Ownership Technological advances have made robots both more sophisticated and more affordable. In addition, to a growing supply of low-cost robots, there are also novel pricing models, such as “Robots-as-a-Service” and pay-as-you-use, which support the ubiquitous adoption of robots even by smaller enterprises. Technological Breakthroughs Recent advances in artificial intelligence (AI), computer vision, radars, and networks have expanded the range of tasks that robots can do. Effectively, new technology gives the robot the ability to see, hear, and pick up objects, acting differently according to the data the robot receives, offering it a certain level of autonomous decision-making. Now that robots can “see” and “hear,”, they are being taught how to “feel,” and some of the recent technological advances are truly mind-boggling. Glasgow University researchers have developed ultra-sensitive electronic skin that learns from sensations it experiences. A robotic hand covered with the new e-skin recoiled from what it recognized as “painful” stimuli. This new technology will allow robots to interact with the world in a whole new way, an invention that can be leveraged in a wide range of applications, from prosthetic limbs to the “internet-of-things”.1 And this is just one of many recent inventions. Virtuous Cycle Of Innovation The Robotics industry is going through a perpetual and ever-accelerating cycle of innovation (Chart 4). Improvements to one domain of robotic applications can be transferred to others, benefitting from “adjacent” technologies. In other words, innovations in vacuum cleaners or transport trucks can be easily applied to other areas of robotics, as despite differences in prices and value-add, all the robotic applications are trying to solve the same problems. Advances in different fields in robotics create opportunities for ever more applications, creating a virtuous cycle. Chart 4Robotics Will Enter Into A Virtuous Cycle The Robot Revolution The Robot Revolution Furthermore, robotics is a poster child for Moore’s Law, which refers to the phenomenon whereby transistors on a microchip double every two years, eventually leading to exponential improvements in computing power. Automation and robotics take advantage of these improvements as they are challenged with more complex tasks. We predict the virtuous cycle for robots will span several decades. As the cost of automation drops, better solutions will be developed, resulting in the ‘early retirement’ of dated but otherwise fully functional robotic systems. The following is a brief synopsis of advances in technology and their applications to robotics. Technologies That Help Robots Act Like Humans AI And Machine Learning (ML) AI and ML not only teach robots to perform certain tasks but also makes machines more intelligent by training them to act in different scenarios. To do this, vast amounts of data are consumed. For example, to “teach” a robot to recognize an object and act accordingly, a massive number of images are used to train the computer vision model. Dexterity And Deep Imitation Learning One of the major challenges of roboticists is improving the dexterity of robots and empowering them to manipulate objects gripped by the hand, akin to humans. Some researchers are using machine learning to empower robots to independently identify and work out how to grab objects. Deep Imitation Learning, neural-network-based algorithms, allow the robot to “learn” from humans. For example, in a robotics study led by researchers from the University of Tokyo, the machine learning embedded in the robot practiced a method observed by a human demonstrator. After watching one of the researchers peel a banana periodically for thirteen hours, a robot successfully learned how to peel a banana without crushing the fruit.2 There are also major improvements in hardware, with grippers ranging from pincer-like appendages to human-like hands. Lidar Lidar (Light Detection and Ranging) technology uses sophisticated laser radars that allow robots to navigate their surroundings through object perception, identification, and collision avoidance. Lidar sensors provide information in real-time about the robot’s surroundings such as walls, doors, people, and various objects. While originally expensive, Lidar costs are starting to fall thanks to a more effective chip design and more economical mechanical implementation. Lidars are crucial for advances in industrial automation and warehouse robots. Machine Vision Deep Learning has brought about a groundbreaking advancement in machine vision. One of the early hurdles in machine vision may be described with a simple question: “Am I looking at a large object that’s far away or a tiny object that’s up close?”  The modern approach to answering this question is to use both 3-D cameras and the context. 3-D is simulated by using two or more overlapping cameras, correlating the information on camera movements with changing images from the cameras. Deep Learning algorithms help formulate the context of these changing images.3 Machine vision provides higher quality mapping at a more affordable cost than Lidar, especially when it comes to indoor robotics and automation. Industrial Internet Of Things In Robotics The implementation of the “Industrial Internet of Things” (IIoT) is vital for manufacturing automation and robotics. Its main goal is to create a constant tracking of inputs and outputs, enabling communication along the entire supply chain, passing data between enterprise level and plant floor systems, and improving productivity through the use of big data.  Robots working at different stages of the manufacturing process are interconnected, ensuring flawless production. IIoT technology aims to improve productivity by reducing human-to-human and human-to-computer interactions, reducing costs, and minimizing the probability of mistakes. Similar to smart homes, IIoT factories are smart factories.4 Industrial Revolution 4.0 Early industrial robots performed very specific operations under carefully controlled conditions – an assembly robot that encountered a misaligned component would simply install it that way, resulting in a defective product. However, thanks to improvements in vision systems, computing, AI, and mechanics, the ability of robots to perform increasingly complex tasks that involve some limited decision-making has improved. Increased connectivity, brought about by IIoT, and ubiquitous automation and robotization, are ushering in a new Industrial Revolution, dubbed 4.0. As in previous industrial revolutions, innovation improves productivity manifold. Chart 5Robots Are Proficient In Many Tasks The Robot Revolution The Robot Revolution Industrial robots are deployed to carry out a wide variety of tasks (Chart 5). Arc welding, spot welding, assembly, palletizing, material removal, inspection, material handling, and packaging are some of the most popular applications for robots, but the list does not stop with just those. Industrial robots limit the need for human interaction while being able to complete tasks accurately with a high level of repeatability. Proficiency with these many tasks allows robots to add value to a multitude of industries, such as automotive, electronics, aerospace, food, and medical. While in the past the automotive sector was the key end-demand market for global robotics sales, non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in terms of the purchase of robots (Charts 6 & 7). Chart 6Robots Are Gaining Traction In Multiple Industries The Robot Revolution The Robot Revolution Chart 7In The US, Robotization Is Broad-Based The Robot Revolution The Robot Revolution We expect the rising digitalization of the manufacturing sector to lead to a new wave of automation investment in developed countries. Key Players In Industrial Robots Space The global industrial robotics market is largely dominated by established Japanese and European companies: ABB, Yaskawa, KUKA, and Fanuc. However, the sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the established players, as many industrial companies, such as Rockwell Automation, Eaton, and Caterpillar, are becoming leaders in this new space. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous spring for high-value crops. These companies will benefit from strong demand for their products and should exhibit strong sales and profit growth. Service Robots Are Here To Help Service robots can significantly benefit humans in a variety of fields, including healthcare, automation, construction, household, and entertainment. These robots are managed by internal control systems, with the option of modifying the operation manually. These service robots remove the possibility of human error, manage time, and increase production by lowering the workload of staff and labor. Chart 8Service Robots Across Industries The Robot Revolution The Robot Revolution Service robots are quickly becoming an essential part of business for service-focused companies in healthcare, logistics, and retail (Chart 8). Developments in edge artificial intelligence processors and the arrival of 5G telecom services are likely to propel the market for service robots to new heights. The usage of service robots is extremely broad and range from cleaning to preparing meals to delivering goods. The following are some of the key areas that benefit from service robots. Healthcare Common duties assigned to service robots include setting up patient rooms, tracking inventory and placing orders, and transporting supplies, medication, and linens. Cleaning and disinfection robots can also help create a safe and sanitized facility for everyone. Further, robots assist in performing difficult surgeries and medical procedures.  Robots also help the elderly and disabled. For example, ReWalk has developed a wearable robotic exoskeleton that provides powered hip and knee motion to enable individuals with spinal cord injury (SCI) to stand upright, walk, turn, and climb and descend stairs. The system allows independent, controlled walking while mimicking the natural gait pattern of the legs. Military Defense Autonomous Mobile Robots (AMR) are helpful for combating fires, disarming bombs, and traversing through dangerous areas. Fully automated drone robots are indispensable for military intelligence and combat operations. Logistics As e-commerce sales continue to surge, logistics businesses are using service robots to help overcome current labor shortages, assist current workers to avoid workforce burnout, and enable warehouse automation. Robotic arms are often assigned tasks like picking, placing, and sorting objects, and because these cobots can navigate warehouses independently, they are used to deliver materials to human workers for accurate and efficient order fulfillment. Some logistics companies, such as FedEx, are experimenting with using AMR for last-mile delivery of goods, which is often the most expensive and least productive part of the entire delivery chain. AMR can navigate sidewalks, unpaved surfaces, and steps while carrying cargo. Key Players In Service Robots Space Many US companies are active in this space. Amazon (AMZN) developed robots to support its fulfillment center operation: Robots help automate storage and retrieval mechanisms throughout vast warehouses. IRobot (IRBT) has developed a series of AI-enabled robot vacuums, mops, and pool cleaners – friendly pet-like bots you may see in many American homes. There are also highly sophisticated surgical robots, developed by Stryker (SYK) and Intelligent Surgical (ISRG).  Collaboration Between Humans And Robots Collaboration between humans and robots is still in its infancy but it is one of the fastest-growing fields within robotics. Cobots work alongside humans, allowing humans to be more productive and avoid tedious or strenuous tasks. Cobots can be installed directly in the current production system, with less space than conventional robots. Equipped with intelligent features such as vision and force sensors, the flexibility of cobots means they can perform tasks like parts handling, assembly, and bin picking. Manufacturers adopting cobots, particularly those featuring vision and inspection systems, are seeing an increase in quality and efficiency. Investment Characteristics I hope we have convinced our readers that Robotics is a promising long-term investment theme. We also noted that the robotics ETFs are currently down substantially from their peaks. However, this report would not have been complete without a closer look at the investment characteristics of the robotics ETFs. A few salient points: Table 2Price Sensitivity The Robot Revolution The Robot Revolution Robotics ETFs have betas to the S&P 500 ranging from 1.2 to 1.4 (Table 2), which signals that the robotics sector is a high octane play on the US equity market. The recent pullback in the S&P 500 was particularly punishing for the stocks exposed to robotics. In terms of market capitalization, companies in this space tend to be smaller than the median company in the S&P 500, as they constitute the robotics ecosystem and supply chain (AI, Lidar), and tend to be younger and smaller. Robotics ETFs have always traded at a premium to the market given their superb growth potential. However, currently, ROBO ETF, which is a proxy for the rest of the cohort on a relative basis, is trading just under a half standard deviation above the historical mean (Chart 9). In terms of macroeconomic exposure, all of the robotics ETFs have a pronounced negative exposure to the US dollar – after all, robotics and automation are a global phenomenon. A stronger dollar makes American multinational sales from abroad lower both because of the translation effect and higher prices. The robotics theme doesn’t have much exposure to interest rates, inflation, or commodities, but is somewhat positively exposed to bitcoin (Table 3). Chart 9Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Table 3Robotics Is A High Octane Equities Theme With A Significant Sensitivity To USD The Robot Revolution The Robot Revolution Investment Implications Robotics is a compelling long-term investment theme as Industrial Revolution 4.0 is taking place in front of our eyes. And while over the short term, monetary tightening and slowing economic growth, both at home and abroad, will be a headwind; over time a new Google or Facebook may emerge in this space. We have already watched the success of Nvidia, a supplier of sophisticated chips for the industry. Table 4Comparing ETFs The Robot Revolution The Robot Revolution There are four ETFs that focus on Robotics and Automation (Table 4). BOTZ Is the largest ETF with $2.1 billion AUM, followed by ROBO at $1.7 billion, which is also the most expensive (Table A1 in the Appendix) Which one is the best? To answer this question, we have turned to the quant wizards at the BCA Equity Analyzer team. To compare the ETFs, they have assigned a BCA stock selection and Owl Analytics ESG scores to stocks in each of the robotics ETFs, to calculate composites.  We note the BCA composite score is low across the board, as robotics as a nascent investment theme scores low on valuations. We note that while ESG scores are comparable across the portfolios, there is some variation in BCA scores. Overall, ROBO is marginally better than the other options: It has the highest BCA score and is the most liquid. It also has a lower beta to the S&P 500 than BOTZ and IRBO, making it slightly less risky. Unfortunately, it is also the most expensive.  Bottom Line Robotics is an exciting long-term theme that benefits from multiple tailwinds, such as demographic trends, continuous technological innovation, reshoring, and customization. Robots are also becoming more intelligent and dexterous, and have better “senses,” making them suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. And that is a future from which investors should certainly profit.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix Table A1ETF Universe The Robot Revolution The Robot Revolution Footnotes 1     Clive Cookson in London, "Ouch! Robotic hand with smart skin recoils when jabbed in the palm,”  Financial Times, June 1, 2022, ft.com 2     Ron Jefferson, "Deep Learning Robot with Fine Motor Skills Peel Bananas Without Crushing the Fruit,”  Science Times, March 29, 2022, sciencetimes.com 3     "Is Lidar Going to be Replaced by Machine Vision?”  LiDAR News, January 12, 2022, blog.lidarnews.com 4     Jennifer Stowe, "Automation‌ ‌and‌ ‌IoT‌‌: ‌Transforming‌ ‌How‌ ‌Industries‌ ‌Function‌‌,”  IoT For All, October 12, 2020, iotforall.com Recommended Allocation Recommended Allocation: Addendum The Robot Revolution The Robot Revolution

Executive Summary Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Property Prices In Hong Kong Will Drop Property Prices In Hong Kong Will Drop Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning Banks In Hong Kong Are Facing A Tough Reckoning Banks In Hong Kong Are Facing A Tough Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive The HKD Is Expensive The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting  a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor  qingyunx@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB.​​​​​. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Property Prices In Hong Kong Will Drop Property Prices In Hong Kong Will Drop Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning Banks In Hong Kong Are Facing A Tough Reckoning Banks In Hong Kong Are Facing A Tough Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive The HKD Is Expensive The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting  a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor  qingyunx@bcaresearch.com

Executive Summary At the margin, the European Union’s proposed €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power will blunt the message markets are sending to consumers to conserve energy, by distributing this windfall to households to offset higher energy costs. A “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of “fossil-fuel tax” – will reduce capex at a time when it is needed to expand supply. These measures – the direct fallout of the EU’s failed Russia-engagement policy – will compound policy uncertainty in energy markets, which also will discourage investment in new supply. Efforts to contain energy prices of households and firms in the UK will be borne by taxpayers, who will be left with a higher debt load in the wake of the government’s programs to limit energy costs, and higher taxes to service the debt. EU Still At Risk To Russia Gas Cutoff EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Bottom Line: The EU and UK governments are inserting themselves deeper into energy markets, which will distort fundamentals and prices, leaving once-functioning markets “unfit for purpose.” This likely will reduce headline inflation beginning in 3Q22 by suppressing energy prices, and will discourage conservation and capex. Energy markets will remain tight as a result. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We will re-open these positions at tonight’s close with 10% stop-losses. Feature The EU is attempting to address decades of failed policy – primarily its Ostpolitik change-through-trade initiative vis-à-vis Russia – in a matter of months.1 This policy was brought to a crashing halt earlier this year by Russia’s invasion of Ukraine, which led to an economic war pitting the EU and its NATO allies against Russia. This conflict is playing out most visibly in energy markets. For investors, the most pressing issue in the short term center around the trajectory of energy prices – primarily natural gas, which, unexpectedly, has become the most important commodity in the world: It sets the marginal cost of power in the EU; forces dislocations in oil and coal markets globally via fuel substitution, and drives energy and food inflation around the world higher by increasing space-heating fuel costs and fertilizer costs. These effects are unlikely to disappear quickly, especially in the wake of deeper government involvement in these markets. The EU is dealing with its energy crisis by imposing taxes on power generators and hydrocarbons producers. It is proposing a €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power, and is advancing a “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of a “fossil-fuel tax. Lastly, the EU will mandate energy rationing to stretch natural gas supplies over the summer and winter heating season. The tax hikes under consideration will reduce capex at a time when it is needed to expand supply. Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy The UK is taking a different route v. the EU, by having the government absorb the cost of stabilizing energy prices for households and firms directly on its balance sheet. Beginning 1 October, annual energy bills – electricity and gas – will be limited to £2,500. The government is ready to provide support for firms facing higher energy costs out of a £150 billion package that still lacks formal approval via legislation to be dispensed. This obviously has businesses concerned.2 Over the medium to long term, this economic war will realign global energy trade – bolstering the US as the world’s largest energy exporter, and cementing the alliance of China-Russia energy trade. Whether this ultimately evolves into a Cold War standoff remains an open question. EU Policy Failures And The Power Grid’s Limitations Chart 1Russia Plugged The Gap In EU Energy Supply EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason In addition to its failed Russia policy, the EU’s aggressive support of renewable energy disincentivized domestic fossil fuel production and forced an increased reliance on imports – with a heavy weighting toward Russian hydrocarbons – instead. Once Russia stopped playing the role of primary energy supplier to the EU, the bloc’s energy insecurity became obvious (Chart 1). The EU’s current power-pricing system is forcing households and industries to bear the brunt of energy insecurity and high natgas prices resulting from poor energy policy design.3 And it forces the government to tax energy suppliers – with “windfall profits” taxes ostensibly meant to capture economic rents, as officials are wont to describe the taxes – to fund consumer-support programs. While REPowerEU aims to alleviate the bloc’s energy insecurity by importing non-Russian LNG and increasing renewable energy’s share in the energy mix, both alternatives face bottlenecks, which could delay their implementation. This could keep energy markets in the EU tight over the medium term, until additional LNG capacity comes online in the US and elsewhere. Renewable electricity is not as reliable as electricity generated by fossil fuels on the current power grid, which needs to be constantly balanced to avoid cascading failure. This means power consumed must equal power supplied on a near-instantaneous basis to avoid grid failure. However, given its reliance on variable weather conditions, renewable energy by itself cannot keep the grid balanced, primarily due to the lack of utility-scale storage for renewable power. Battery-storage technology and green-hydrogen energy can be used in conjunction with other renewables to balance the power grid, but they still are nascent technologies and not yet scalable to the point where they can replace hydrocarbon energy sources. Furthermore, the continued addition of small-scale renewables-based power generation located further away from demand centers – cities and industrial complexes – will continue to increase the complexity and scale of the power grid.4 Realizing the importance of incumbent power sources and the infrastructure requirements to diversify away from Russian fuels, the EU labelled investments in natural gas and nuclear power as green investments in July.5 Of the two energy sources, natural gas will likely play a larger role in ensuring the bloc’s energy security over the next 3-5 years, given the polarized views on nuclear power.6 In its most recent attempt to stabilize power prices, the EU plans to redirect “inframarginal” power producers’ windfall profits to households and businesses, provided those producers do not generate electricity using natgas. The Commission did not suggest capping Russian natgas prices since that could be divisive among EU member states, and could further jeopardize the bloc’s energy security. The redistribution of the windfall profits taxes is coupled with calls for mandatory electricity demand reductions in member states. We are unsure of the net effect of these directives on physical power and natural gas balances. However, government interference will feed into the policy uncertainty surrounding electricity and natural gas markets. EU Storage Continues To Build Against all odds, the EU has been aggressively building gas in storage (Chart 2), as demand from Asia has been low during the summer months (Chart 3). This has allowed high Dutch Title Transfer Facility (TTF) prices – the European natgas benchmark – to lure US LNG exports away from Asia (Chart 4). According to Refinitiv data, US exports of LNG to Europe increased 74% y/y to a total of over 1,370 Bcf for the first half of 2022. Chart 2Europe Has Been Aggressively Building Gas Storage EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Chart 3US LNG Exports To Asia Dropped In H1 2022 US LNG Exports To Asia Dropped In H1 2022 US LNG Exports To Asia Dropped In H1 2022 Chart 4High TTF Prices Attract US LNG EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Since Russian gas flows to Asian states have not been completely cut off, this will reduce ex-EU demand for US LNG, providing much needed breathing room for international LNG markets. However, as the pre-winter inventory-injection period in Asia continues, there is an increasing likelihood the spread between Asian and European gas prices narrows. This could incentivize US producers to export more fuel to Asia, slowing the EU’s build-up of gas storage. US plans to increase LNG export capacity will alleviate current tightness in international gas markets over the medium term, as new export facilities are expected to begin operations by 2024, and be fully online by 2025 (Chart 5). Until US LNG exports increase, global natgas markets will continue to remain tight and prices will be volatile. Chart 5US LNG Export Capacity Projected To Rise EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Russia’s Asian Gas Pivot Since the energy crisis began, China has accelerated the rate at which it imports discounted Russian LNG.7 Russia is aiming to increase gas exports to China to replace the sales lost to the EU following its invasion of Ukraine. Russia recently signed a deal with China to increase gas flows by an additional 353 Bcf per year, with both states agreeing to settle this trade in yuan and rouble to circumvent Western currencies, primarily the USD. Additionally, the Power of Siberia pipeline is expected to reach peak transmission capacity of ~ 1,340 Bcf per year by 2025. Chart 6China Will Not Want All Eggs In One Basket EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason Adding to the China-Russia gas trade is the planned Power of Siberia 2 pipeline, which will have an annual expected capacity of 1,765 Bcf. This will move gas to China from western Siberia via Mongolia, and is expected to come into service by 2030; construction is scheduled to begin in 2024. This will redirect gas once bound toward the EU to China. Russia’s ability to develop and construct the required infrastructure to pivot gas exports to China and the rest of Asia will be hindered by Western sanctions, as international private companies walk away from Russian projects and international investment in that state decline. This is a deeper consequence of the sanctions imposed by the US and its allies, as it denies Russia the capital, technology and expertise needed to fully develop its resource base. On China’s side, even if both Power of Siberia pipelines are developed to operate at full capacity, the world’s largest natgas importer may be wary of becoming overly reliant on Russia for a significant proportion of its gas (and oil) imports. China has developed a diversified network of natgas suppliers, which, as the experience of the EU demonstrates, is the best way to avoid energy-supply shocks (Chart 6). Investment Implications We expect natural gas price volatility to remain elevated over the next 2-3 years. EU governments’ interference with the natgas and power markets' structure and pricing mechanisms – be it via natgas price caps or skimming gas suppliers’ profits – will distort price signals, detaching them from fundamental gas balances. This will perpetuate the energy crisis currently plaguing the EU, by encouraging over-consumption of gas and reducing capex via taxes and levies on profitable companies operating below the market’s marginal cost curve. As a result of the dislocations caused by Russia’s invasion of Ukraine, dislocations in natural gas trade flows will continue, forcing markets to find work-arounds to replace lost Russian pipeline exports in the short-to-medium term. The EU will become more reliant on US LNG supplies, and will – over the next 2-3 years – have to outbid Asian states for supplies. Trade re-routing will take time and likely will lead to sporadic, localized shortages in the interim. The US is the largest exporter of LNG at present, but, by next year, it’s export capacity will max out. It will only start to increase from 2024, reaching full capacity by 2025. While higher export capacity from the world’s largest LNG supplier will help alleviate tight markets, in the interim, global gas prices, led by the TTF will remain elevated and volatile. The EU still receives ~ 80mm cm /d of pipeline gas from Russia, or ~ 7.4% of 2021 total gas consumption on an annual basis (Chart 7). A complete shut-off of Russian gas flows to the EU means the bloc would face even more difficulty refilling storage in time for next winter. This would keep the energy- and food-driven components of inflation high, and constrain aggregate demand in the EU generally. Chart 7EU Still At Risk To Russia Gas Cutoff EU Energy Markets: "Not Fit For Purpose" For A Reason EU Energy Markets: "Not Fit For Purpose" For A Reason We continue to expect global natural gas markets to remain tight this year and next. We also expect natural gas prices to remain extremely volatile – particularly in winter (November – March), when weather will dictate the evolution of price levels. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We remain bullish commodities generally and oil in particular, and will re-open these positions at tonight’s close with 10% stop-losses.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate and jet-fuel stocks recovered slightly in the week ended 9 September 2022, rising by 4.7mm barrels to just over 155mm barrels, according to the US EIA. Distillate inventories – mostly diesel fuel and heating oil – stood at 116mm barrels, down 12% y/y. At 39.2mm barrels, jet fuel stocks are 7% below year-earlier levels. Refiners are pushing units to build distillates going into winter, in order to meet gas-to-oil switching demand in Europe and the US. Distillate inventories have been under pressure for the better part of the summer on strong demand. This is mostly driven by overseas demand. Distillate demand fell by 492k b/d last week, which helped domestic inventories recover. Year-on-year distillate demand was down 1.6% in the US. Ultra-low sulfur diesel prices delivered to the NY Harbor per NYMEX futures specification are up 50% since the start of the year (Chart 8). Base Metals: Bullish On Monday Chile’s government launched a plan to boost foreign investments, which includes providing copper miners with a 5-year break from the ad-valorem tax proposed in a new mining royalty. The plan however does not provide relief from the tax on operating profits, which are also part of the royalty. According to Fitch, the originally planned mining royalty would have significantly depleted copper miners’ profits, disproportionately impacting smaller operators, which cannot avail themselves of the benefits of economies of scale. In a sign that higher taxes spooked bigger players as well, in mid-July, BHP stated that it would reconsider investment plans in Chile if the state proceeded with the mining royalty in its original format. Ags/Softs: Neutral In its September WASDE, the USDA adjusted its supply and demand estimates for soybeans, and made substantial changes to new-crop 2022/23 US production estimates. This reduced acreage and yields by 2.7% from the previous August 2022 forecast. Ukraine’s soybean production was increased in the USDA's estimate. The USDA's soybean projections also include lower ending stocks, which are reduced from 245 million bushels to 200 million bushels. This is 11% below than 2021 levels for beans. The USDA's 2021/22 average price for soybeans remains at $14.35/bu, unchanged from last month but $1.05/bu above the 2021/22 average price (Chart 9). Chart 8NY Harbor ULSD Price Going Down NY Harbor ULSD Price Going Down NY Harbor ULSD Price Going Down Chart 9Soybean Prices Going Down Soybean Prices Going Down Soybean Prices Going Down   Footnotes 1 For a discussion of the EU’s past policy mistakes which laid the foundation for current crisis, please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022. It is available at ces.bcaresearch.com. 2 Please see UK business warned of delay to state energy support, published by ft.com on September 13, 2022. 3 The current EU power pricing system is set up so that the most expensive power generator – currently plants using natgas – set the price for the entire electricity market. This system was put in place to incentivize renewably  generated power, however, the EU does not have the required infrastructure and technology to be reliant solely on green electricity. 4 For a more detailed discussion on power grid stability, and how renewables will affect it, please ENTSO-E’s position paper on Stability Management in Power Electronics Dominated Systems: A Prerequisite to the Success of the Energy Transition. According to estimates by WindEurope and Hitachi Energy, Europe will need to double annual investments in the power grid to 80 billion euros over the next 30 years to prepare the power grid for renewables. 5 For our most recent discussion on the infrastructure requirements of pivoting away from Russian piped gas, please see Natgas Markets: The Eye Of The Storm, which we published on June 9, 2022. It is available at ces.bcaresearch.com.  6 In 2021, nuclear power constituted majority of France’s energy mix at 36% and had nearly the lowest share for Germany at 5%. In response to the current energy crisis, Germany has opted to restart coal power plants and only keep nuclear plants on standby, signaling that the EU’s largest energy consumer would prefer to use coal despite its carbon emissions target. 7 According to Bloomberg, China signed a tender to receive LNG from Russia’s Sakhalin-2 project through December at nearly half the cost of the spot gas rates at the time. Investment Views and Themes  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG THE COMT ETF WITH A LOSS OF 5.4% AND OUR XOP ETF WITH A GAIN OF 24.6%. WE WILL RE-OPEN THESE POSITIONS AT TONIGHT’S CLOSE WITH 10% STOP-LOSSES. Strategic Recommendations Trades Closed in 2022

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  

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

Dear client, We will not be publishing the US Equity Strategy next week, as I will be participating in BCA Investment Conference. We will return to our regular publishing schedule on September 19, 2022. Kind Regards, Irene Tunkel   Executive Summary Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes In today’s sector Chart I-pack report we recap our structural investment themes. EV Revolution: The EV cohort benefits from a structural transformation of the automobile industry that is further supported by favorable legislative tailwinds, and shifting consumer preferences. Generation Z: Generation Zers are coming of age and wield an increasing influence over consumer trends. Cybersecurity: The pandemic-driven shift to remote work, broad-based migration to cloud computing and increasing geopolitical tensions, are all structural forces that will ensure a healthy demand pipeline for cybersecurity companies. Green And Clean: Green energy is becoming cheaper to produce, which supports a wider adaptation of green technologies. Green tech also enjoys favorable legislative tailwinds that are coming on the back of rising geopolitical tensions, the ongoing energy crisis, and climate change action. Renewables help to diversify energy sources and offer a path towards energy security. Bottom Line: Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities for investors who can stomach short-term volatility. Feature This week we are sending you a Sector Chart I-Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will overview recent equity performance and provide a recap of the US Equity Strategy structural investment themes. August – When The Rally Came To A Stall As we predicted in the “What Will Bring This Rally To A Halt?” report, the “inflation is turning, and the Fed will be dovish” rally has come to a screeching halt. The S&P 500 was down 8% in August as investors finally believe that Jay Powell’s Fed is hell-bound on extinguishing inflation even if it means squelching economic growth (Chart I-1). The message from Jackson Hole was very much Mario Draghi-like: “whatever it takes.” The market reaction was swift and brutal. The rally winners were in the epicenter of the sell-off that ensued on the back of Powell’s comments. Invesco QQQ Trust is already down nearly 9% off its August 16 peak, while Ark Innovation (ARKK) is down 13% (Chart I-2).  We expect that equities will continue to revert to their pre-summer lows. Chart I-1Summer Rally Winners Are At The Epicenter Of The Sell-off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-2Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes With rates on the rise again, last week we shifted our overweight of Growth and underweight of Value to a neutral allocation. The last few months have been a rollercoaster. However, long-term investors may successfully survive the grind by resolutely sticking to some of the winning structural investment themes and ignoring short-term volatility. The fact that many themes are now more than 50% off their pandemic highs may indicate an opportune entry point. EV Revolution We initiated the EV Revolution theme in June 2021. Since then, the theme has outperformed the S&P 500 by 19%. The Auto and Components industry group is in the middle of a momentous transition to electric and autonomous vehicle manufacturing, thanks to technological advances in battery storage, AI, and radars. These technological breakthroughs help overcome most of the obstacles to the wide adoption of EVs. Multiple new entrants develop charging networks. Driving ranges are also rapidly increasing – Lucid promises a 500-mile range compared to Tesla’s 350. Couple that with the rising price of gas, the aging vehicle fleet, and the expectation that EVs will approach sticker parity with gas-powered cars as soon as 2023 (Chart I-3)  and there is no turning back to gas-guzzling vehicles. LMC Automotive forecasts that by 2031, EVs will reach 17 million units. Chart I-3EVs Will Reach Price Parity With ICEs In 2023 Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes The entire EV cohort also benefits from favorable legislative tailwinds, thanks to this administration’s support of decarbonization. The Inflation Reduction Act (IRA) includes approximately $370 billion in clean energy spending, as well as EV tax credits for both new and used cars. In addition, executive action by President Biden has tightened fuel economy standards. California has mandated a complete switch to EV vehicles by 2035. The surge in EV Capex and R&D spending will boost the entire supply chain, which consists of chip manufacturers, battery and lidar R&D, part manufacturers, and charging networks. Many of these companies are still small. An ETF may be the best way to capture the theme (Table I-1). Table I-1EV/AV ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Generation Z: The Digital Natives The GenZ theme, which we identified exactly a year ago, has collapsed since the beginning of the market downturn and is down 47%. Its success was at the root of its demise – it captured overcrowded names most popular among GenZers, who are avid investors (Chart I-4). However, the theme is not “dead,” as a new cohort of Americans is coming of age, and they are not shy about it. Generation Z in the US includes 62 million people born between 1997 and 2012 (Chart I-5). With $143B in buying power in the US alone making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. Chart I-4Gen Zers Are Avid Investors... Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-5Gen Zers Are Taking Over Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Gen Z is an umbrella theme that captures many other prominent themes, such as Fintech (Paypal & Social Finance), Crypto (COIN), Meme-investing (HOOD), Gaming and Alternative Reality (GAMR & ESPO), and Online Dating. But GenZers have a few behavioral quirks that make them different even from Millennials: Quality-Over-Price Shoppers: Gen Z was found to be less price sensitive when buying products, choosing quality over price. Lululemon (LULU) and Goose (GOOS) are among Gen Z’s favorites. Healthy Lifestyle: Gen Z is a “green” generation that deeply cares about the planet, loves the outdoors and traveling, and is crazy about pets. This is also a generation that prizes a healthy lifestyle and working out: Beyond Meat (BYND), Planet Fitness (PLNT), and Yeti (YETI). Generation Sober Chooses Cannabis: GenZers perceive hard liquor and tobacco as bad for their health. Curiously, marijuana is considered “healthy.” MSOS, CNBS, YOLO, and THCX are the biggest ETFs in this space. How To Invest In Gen Z? Gen Z is a nascent investment theme, so there are no ETFs available in the market yet. We propose that investors follow our Gen Z investment themes or replicate fully or partially our Gen Z basket. Cybersecurity: A Must-Have For Survival Despite its celebrity status, this is an industry that is still in the early innings of a growth cycle. The pandemic-driven shift to remote work, broad-based migration to cloud computing, development of the internet-of-things, and increasing geopolitical tensions create new targets for hackers who are after valuable data or just want to achieve maximum damage to the networks. Ubiquitous digitization requires increasingly more complex cyber defenses. With cybercrime costing the world nearly $600 billion each year and cyberattacks increasing in number and sophistication, the global cybersecurity market is expected to grow from $125 billion in 2020 to $175 billion by 2024. Both large and small businesses are yet to fully implement cybersecurity defenses. According to a survey by Forbes magazine, 55% of business executives plan to increase their budgets for cybersecurity in 2021 aiming to prevent malicious attacks. In response to the numerous breaches, the current US administration is placing a high priority on defensive cyber programs. Since 2017, US government departments have seen the cybersecurity share of their basic discretionary funding rise steadily from 1.38% to 1.73%. These developments are a boon for cybersecurity stocks (Chart I-6 & Chart I-7 ), the sales of which are soaring (Chart I-8). Chart I-6Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Chart I-7Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Chart I-8Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring We introduced cybersecurity as a structural investment theme back in October 2021. So far, the CIBR ETF, which we use as a proxy for the performance of the theme, has underperformed the S&P 500 by 11%. Monetary tightening has weighed on the performance of these companies as they tend to be younger, smaller, and less profitable than their S&P 500 counterparts, i.e., CIBR has a strong small-cap growth bias. However, with cybersecurity stocks down 26% off their November-2021 peak and valuation premium back to earth, now may be an opportune moment to add to the theme. After all, these stocks have tremendous growth potential, warranting a long-term position in most equity portfolios. There are several highly liquid ETFs powered by the cybersecurity theme, such as CIBR, BUG, and HACK, which can be excellent investment vehicles (Table I-2). Table I-2Cybersecurity ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Green And Clean We introduced the “Green and Clean” theme back in March. Since then, it has outperformed the S&P 500 by 22%, benefiting from this administration’s focus on the mitigation of climate change. Putin’s energy stand-off with Europe has also put the industry into the global spotlight. The development of renewables will help diversify energy sources and offer a path toward energy security. Thus, renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. The International Renewable Energy Agency (IRENA) expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract the lion’s share of investments. Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7% in 2000 to 10% in 2020 (Chart I-9). Chart I-9A Structural Trend A Structural Trend A Structural Trend The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year (Chart I-10). Renewables are similar to traditional utility companies: They require a massive upfront investment, but also enjoy substantial operating leverage. As production capacity increases, the cost of energy generation falls. Solar power generation is a case in point (Chart I-11). Hence, we have a positive reinforcement loop: more usage begets even more usage, bolstering the economic case for transitioning to cleaner energy resources. Chart I-10R&D Is Paying Off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-11Capacity Is Inversely Correlated To Prices Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Increased renewables adaptation is possible thanks to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table I-3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table I-3Clean Tech ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Bottom Line Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities. However, these investments come with a warning: Technological innovation themes are intrinsically risky as they are rarely immediately profitable and require both continuous investment and technological breakthroughs to succeed. Also, most technological innovation themes carry high exposure to the small-cap growth style and are sensitive to rising rates and slowing growth. As such, they are fickle over the short term but pay off over a longer investment horizon.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9C Macroeconomic Backdrop C Macroeconomic Backdrop C Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up

Executive Summary The Recovery of Chinese Property Market Relies On Home Sales The Recovery of Chinese Property Market Relies on Home Sales The Recovery of Chinese Property Market Relies on Home Sales Property sales, starts, developers’ total financing, and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate. More supportive government policies will be released in the coming months, including mortgage rate cuts. It will take time for a recovery in sales and construction activity to occur, because of enormous excesses in the mainland property market/industry. Plus, China’s economy is challenged by the dynamic zero-COVID policy, a budding contraction in exports, and generally weak income growth.   Property developers started to shift their business model from “pre-selling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market by reducing financial stability risk. However, it means that the industry will take a longer time to contribute to growth in the broader economy. Bottom Line: We continue to hold a bearish view on the share prices of both onshore and offshore Chinese property developers in absolute terms and relative to China’s overall equity benchmark. A continued weakness in construction volume in the next few months implies less demand for commodities, such as iron ore, steel, cement, and glass.   Chart 1Low Sentiment in Both Current and Future Income Low Sentiment in Both Current and Future Income Low Sentiment in Both Current and Future Income The turmoil in China’s property market has not abated. Homebuyers remain unwilling to buy houses because of concerns over widespread sold but unfinished properties, falling confidence in future incomes, and worsening employment expectations (Chart 1). Property sales, starts, and completions have all collapsed by 25-45% from their mid-2021 peak (Chart 2 and 3). However, these variables will likely start to improve on a rate-of-change basis (i.e., the pace of contraction will moderate) in the months ahead (Chart 3). The rationale is that accelerated policy easing in the housing sector will help on the margin. Notably, policies curbing housing demand have loosened much more this year than they did in 1H2020. Plus, the authorities will introduce more accommodative real estate policy initiatives later this year and early next year, including additional mortgage rate cuts. Chart 2Property Sales, Starts, And Completions Will Further Decline In Their Level Terms… Property Sales, Starts And Completions: Further Decline In Their Level Terms... Property Sales, Starts And Completions: Further Decline In Their Level Terms... Chart 3...Albeit Improving On A Rate-Of-Change Basis ...Albeit Improving On A Rate-Of-Change Basis ...Albeit Improving On A Rate-Of-Change Basis Nevertheless, the construction industry, its suppliers, and the entire economy will take small consolation from the moderating pace of decline in the property sector. The basis for this response is that the level of activity will continue falling in the next three-to-six months, albeit at a slower rate than that of the present moment. Overall, aggressive policy easing will take time to produce a meaningful recovery in the mainland’s property market because it is occurring amid the structural breakdown in the real estate market and a confidence crisis among stakeholders. Policy Support Has Accelerated  Chinese authorities have accelerated their policy initiatives in the real estate sector to restore homebuyers’ confidence and stabilize the sagging domestic property market. Chart 4The Recovery of Chinese Property Market Relies On Home Sales The Recovery of Chinese Property Market Relies On Home Sales The Recovery of Chinese Property Market Relies On Home Sales A nearly 30% year-on-year decline in floor space sold in residential commodity buildings has exacerbated a liquidity crisis among property developers. Deposits, advanced payments, and mortgage payments originating from property pre-sales, have historically contributed to about 50% of property developers’ financing (Chart 4, top panel). Hence, renewed homebuyers’ confidence and a revival in house purchases would alleviate the liquidity crunch among cash-strapped developers (Chart 4, bottom panel), who could then complete more housing units under construction. Chinese authorities have introduced an assortment of supportive housing measures, including the following: Measures To Help Complete Pre-Sold Apartments In response to the homebuyer confidence crisis, the Politburo demanded that local governments be responsible for ensuring the delivery of housing projects. Since July, at least 36 local governments in 15 provinces have released concrete policies in this respect (Box 1).   Box 1 Local Governments:  The Delivery Of Pre-sold Housing Units Turns into a Political Task "Pre-sale fund supervision"1 is an important policy related to "guaranteed delivery" for presold properties. Real estate development enterprises must deposit pre-sale funds into a bank's special supervision account, which can only be used for the construction of a specific project and cannot be withdrawn or used at will. Another important policy is implementing "one building, one policy" and stipulating local government involvement to resolve problems. With the support of local government, a fund required to complete an unfinished building can be raised in various ways including, but not limited to the following: 1) increasing financing from local banks or asset management companies;2  2) encouraging good SOEs or high-quality homebuilders to take over stalled projects; 3) local governments purchasing back unused land from property developers; or 4) asking desperate buyers of those pre-sold and unfinished projects to contribute additional funds.3   Last month, the authorities also established a real estate fund of initially RMB 80 billion, which was funded by China Construction Bank and the central bank. In mid-August, China introduced procedures to ensure property projects are delivered to buyers through special loans from policy banks. The amount of this special loan will be about RMB 200 billion.4 This will be also a part of the real estate fund established last month, which could potentially be increased to RMB 300-400 billion and will be used only to ensure the delivery of presold but unfinished projects. Moreover, the government started to ease policies on property developers’ onshore bond issuance. In August, Chinese regulators instructed China Bond Insurance to provide guarantees for onshore bond issuance by private property developers. We expect more policy easing on developers raising funds though bank loans and more onshore bond issuance (Chart 5).  Measures To Increase Homebuyers’ Affordability The average mortgage rate has been decreased three times so far this year, falling to 4.3% for first-time home buyers. This is the lowest rate since 2009 (Chart 6).  Chart 5Chinese Developers Needs More Policy Easing On Their Borrowing Chinese Developers Needs More Policy Easing On Their Borrowing Chinese Developers Needs More Policy Easing On Their Borrowing Chart 6Easing Policies On Mortgage Rate Easing Policies On Mortgage Rate Easing Policies On Mortgage Rate Since the beginning of this year, over 80 cities relaxed their restrictive policies on loan borrowing. Among these cities, nearly 60 lowered their down payment ratio for a first home purchase, while about 40 reduced their down payment ratio for a second home purchase.5 Local governments also offered financial support for shantytown renewal and cash rebates for home purchases. Multiple cities have also issued incentives to encourage households with second or third children to buy additional properties. Bottom Line: Authorities have ramped up their supportive housing policies in recent months.  We expect more policy stimulus (e.g., another mortgage rate cut) to be announced over the next three-to-six months. Housing Turnaround Takes Time Despite considerable supportive policies in place, housing starts and construction activity will continue to contract and home prices will deflate further in the next three-to-six months. The policies will take time to work, especially ones related to ensuring the delivery of pre-sold housing. A significant amount of financing will be required for problematic projects that real estate developers are unable to build and deliver. Many local governments are also facing financial distress. Therefore, it will take time to arrange financing from third parties. Even after securing financing for incomplete housing projects, there will be delays in the construction and delivery of these units. Potential homebuyers may be willing to purchase in installments and provide funds to developers, but only if they witness increased deliveries of pre-sold homes. These funds are critical to developers as they account for about half of their total financing (Chart 4 above). The willingness to buy has been suppressed by falling confidence over future incomes, worsening future employment expectations and weakening growth of current income (Chart 1 on page 2). The willingness of households to save recently hit a record level; it is higher than during the first outbreak of COVID-19 in early 2020. Meantime, the propensity to invest has tumbled to a multi-year low (Chart 7). Chart 7More Chinese Households Intend To Save Rather Than Invest More Chinese Households Intend To Save Rather Than Invest More Chinese Households Intend To Save Rather Than Invest Chart 8Property Sales In Rich Eastern Provinces: Still In A Deep Contraction Property Sales In Rich Eastern Provinces: Still In A Deep Contraction Property Sales In Rich Eastern Provinces: Still In A Deep Contraction The growth of residential floor space sold in the eastern provinces often leads the rest of China (Chart 8). The Eastern provinces account for about 44% of China’s total residential floor space sales. Residential floor space sales in the Eastern provinces were still down by 30% in July.  The lack of an upturn in the Eastern provinces, especially after the re-opening in Shanghai and Shenzhen, indicates that a property market recovery will not be imminent or V-shaped. Chart 9A Majority Of Key Cities Have Declining Housing Prices A Majority Of Key Cities Have Declining Housing Prices A Majority Of Key Cities Have Declining Housing Prices Currently still 70% and 85% of the 70-city house price indexes are showing year-over-year price declines in newly constructed houses and secondary houses, respectively (Chart 9).  Shrinking pre-sales mean less financing for homebuilders and, ultimately, contracting property investment in the next three-to-six months (Chart 10). Many developers will continue to struggle to attract sufficient financing. Hence, they must cut their starts and completions (Chart 11). Chart 10Shrinking Pre-sales Will Lead To Falling Property Investment Shrinking Pre-sales Will Lead To Falling Property Investment Shrinking Pre-sales Will Lead To Falling Property Investment Chart 11Property Developers Have Been Starting And Preselling But Not Completing Property Developers Have Been Starting And Preselling But Not Completing Property Developers Have Been Starting And Preselling But Not Completing High prices/low affordability, speculative behavior of both developers and homebuyers, very high leverage and risky financing schemes, large volumes of supply and high inventories and vacancies , all need to be absorbed. A dynamic zero-COVID policy, a budding contraction in exports and generally weak income growth will challenge China’s economy in general.  Chart 12Insufficient Financing Will Lead To Weaker Construction Activity Ahead Insufficient Financing Will Lead To Weaker Construction Activity Ahead Insufficient Financing Will Lead To Weaker Construction Activity Ahead Bottom Line: The authorities’ supportive policies will take time to relieve the liquidity crisis among property developers and boost sentiment among homebuyers. Property sales, starts, developers’ total financing and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate (Chart 12). A Structural Shift In Developers’ Business Model Chinese property developers started to shift their business model from “preselling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market. It will lower the leverage of and curb real estate assets hoarding by developers and, thereby, improve stability in the industry. The old model of “preselling then completing” is not sustainable. In the past decade, Chinese real estate developers aggressively pursued a business model of “buying land, quickly starting property projects, and preselling unfinished homes but not completing them.”6  Chart 13A Structural Shift In Developers' Business Model A Structural Shift In Developers' Business Model A Structural Shift In Developers' Business Model As this model was essentially raising funds via launching property starts despite shrinking completions (Chart 13, top panel), it has resulted in a significant increase in Chinese property developers’ liabilities and unfinished construction carried on the balance sheet of developers. In short, as we have argued before, real estate developers have been involved in a massive carry trade. This is one of the root causes of the current crisis in China’s real estate sector. With this business model, developers carried real estate assets (land and started properties) on their balance sheets to benefit from the positive “carry”; i.e., the difference between the cost of funding and real estate asset price appreciation. However, the carry has turned negative as property asset prices are now flat or deflating rather than rising at double-digit rates. Hence, developers are under pressure to liquidate their assets and reduce their debts. Yet, to sell their not-pre-sold housing projects that are under construction, they first need new funds to complete unfinished homes before they can be sold. Furthermore, both the “three-red lines” policy for property developers and the new bank lending regulations limiting lending to the real estate sector – both put into effect in H2 2020 – remain in place. This means that Chinese real estate developers have no choice but to change their business model to a more sustainable one – the one with more sales coming from existing properties instead of pre-sales. The new model of “completing first, selling after” is a sustainable one. Homebuyers fear buying unfinished houses, preferring existing ones. Critically, increasing sales of existing houses will provide extra funds to debt-laden builders. In contrast, delivery of pre-sold units does not generate new cash for developers because most cash are received long before completion of a dwelling. Facing a liquidity crunch, there is no incentive for developers to complete pre-sold units. Chart 13 shows such a shift has been underway since mid-2021. Sales of completed houses increased considerably, while properties sold in advance plummeted. This trend also reflects a rising preference among homebuyers for completed properties. Buyers can visit and check the quality of a construction-completed unit versus paying for a future unknown unit. Meanwhile, property developers’ leverage will decline with this new business model. A caveat is that less financing from pre-sales means that developers will have a diminished ability to complete projects already started, and that they also need to reduce land purchases and land hoarding. Local government financing will remain tight as land sales account for 23% of local government aggregate expenditure. This will have negative ramifications on infrastructure spending. Bottom Line: Chinese real estate developers have begun shifting from an unsustainable and high-leverage business model to a new way of operating by which sales of completed properties will be prioritized at the expense of falling pre-sales. This will reduce financial stability risks in the future. Investment Implications We expect a continued decline in property sales, starts, completions, and property price deflation in the next three-to-six months. Thus, we maintain our bearish view of both onshore and offshore Chinese property developers’ share prices in absolute terms and relative to China’s overall equity benchmark (Chart 14).  Construction volume will be persistently weak in the coming months, which means less demand for commodities, such as iron ore, steel, cement, and glass. Hence, we expect prices for those commodities to drop further in the near run (Chart 15). Chart 14Chinese Property Developers' Stocks: Structural Breakdown Chinese Property Developers' Stocks: Structural Breakdown Chinese Property Developers' Stocks: Structural Breakdown Chart 15Bearish On Prices Of Construction-related Commodities Bearish On Prices Of Construction-related Commodities Bearish On Prices Of Construction-related Commodities   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     Supervision of pre-sale funds of presold properties refers to the third-party supervision of such funds by the real estate administrative department in conjunction with the bank. 2     This year, at least six asset management companies injected funds into stalled property projects. So far, the total funds raised for three projects amounts to RMB 17 billion. Source: https://m.huxiu.com/article/644633.html?f=rss 3    Desperate buyers face two options: either add funds to build an unfinished home or continue to wait for an indeterminate period. Buyers tend to increase funds to enable the resumption of construction. 4    Source: https://www.bloomberg.com/news/articles/2022-08-22/china-plans-29-billion-in-special-loans-to-troubled-developers  5    Source: https://news.stcn.com/sd/202208/t20220826_4822460.html  6    Please see China Investment Strategy Special Reports "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, and "China: Is The Property Carry Trade Over?" dated October 28, 2021, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 The Peak In Core PCE Inflation In February 2022 The Peak In Core PCE Inflation In February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound 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 12A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis 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 Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations