Sectors

Executive Summary   Reshoring And FDI Job Creation Have Accelerated After The Pandemic Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives The US is entering a period of an industrial boom thanks to limited manufacturing capacity paired with strong demand for industrial and consumer goods. In addition, a trifecta of positive developments is further boosting US manufacturing: Onshoring, automation, and fiscal stimulus. Onshoring has accelerated after the onset of the pandemic and reshoring announcements are growing steadily. Automation and robotization allow industrial companies to circumvent labor shortages and rising wages and, hence, boost their profit margins.  The domestic political landscape in the US is also favorable for industrial stocks given the three major legislative Acts (Infrastructure Investment & Jobs, Inflation Reduction, and National Defense Authorization) that will secure a healthy demand pipeline. While long-term trends are favorable for the sector, a macroeconomic backdrop of slowing growth is a headwind.  However, thanks to a confluence of positive long-term trends, most companies are optimistic. Bottom Line: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. We remain overweight Industrials on both tactical and strategical time horizons but will continue to monitor it closely, watching out for potential cracks in operating performance. Feature A little over a year ago EMS, GIS, and USES co-published a report “Industrials as equity sector winner in the coming years”. In that report, we posited that the Industrial sector is poised for outperformance as it enjoys a boom thanks to strong new trends in onshoring and automation. In addition to the tectonic shifts described above, the sector has also found itself at the epicenter of the US legislative activity, which will provide a significant tailwind for its performance. Since we published the report on July 30, 2021, Industrials have performed in line with the S&P 500. However, since the beginning of the year, Industrials and Capital Goods outperformed the index by 7%, showing impressive resilience (Chart 1 and Table 1). Chart 1A Resilient Cyclical Sector A Resilient Cyclical Sector A Resilient Cyclical Sector In this week’s report, we take a close look at the trends highlighted above and conduct a deep dive to evaluate whether the sector is still attractive on a tactical basis considering the backdrop of rising rates and slowing economic activity. Our focus is on the Industrial sector in general, and the Capital Goods Industry Group, in particular. We will also assess which industries are best positioned for outperformance. Table 1Industrials Outperformed On The Way Down And During The Summer Rally Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Sneak Preview: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. For now, we are both strategically and tactically bullish on the sector but remain vigilant. US Manufacturing Capacity Has Been Severely Limited For Years US manufacturing capacity has been stagnant over the past 20 years, and the level of US manufacturing employment has declined by 30% since 2000 (Charts 2 & 3). Presently, manufacturing employment accounts for only 8% of total US employment. Chart 2US Manufacturing Employment Has Been Shrinking For Decades US Manufacturing Employment Has Been Shrinking For Decades US Manufacturing Employment Has Been Shrinking For Decades Chart 3US Manufacturing Capacity Has Not Expanded In The Past Two Decades US Manufacturing Capacity Has Not Expanded In The Past Two Decades US Manufacturing Capacity Has Not Expanded In The Past Two Decades The reason for the lack of capacity expansion over the past 20 years has been the outsourcing and shifting of production to other countries, especially China. The peak in US manufacturing capacity and employment occurred after the massive Asian currency devaluation in 1998 and China’s WTO admission in 2001. The semiconductor sector, which has recently come into the limelight, is a case in point: From 1990 to 2020, the percentage of chips manufactured in the US has fallen from 37% to 10%, with the lion’s share of chips manufactured in Asia. This trend has brought about The Chips Act which seeks to reverse the trend for national security reasons. Notably, more recently, the decline in manufacturing capacity and employment has started to reverse. More about this later. American Manufacturing Is Booming Again Limited manufacturing capacity paired with a strong demand for industrial and consumer goods translates into an industrial boom. Industrial companies are incentivized to expand given they are already operating at nearly full capacity (Chart 4) and enjoying considerable pricing power. Building industrial capacity in itself lifts demand for industrial goods and the US may be in the early innings of the new Capex cycle, unless the trend is derailed by headwinds from a significantly tighter monetary policy. After all, the age of US capital stock, at 24 years, is two years older than at previous peaks, indicating that many companies are overdue for replacing some of their equipment and machinery (Chart 5). Chart 4Industrial Companies Operate At Nearly Full Capacity Industrial Companies Operate At Nearly Full Capacity Industrial Companies Operate At Nearly Full Capacity Chart 5The US Capital Stock Has To Be Renewed The US Capital Stock Has To Be Renewed The US Capital Stock Has To Be Renewed Indeed, this may already be happening. According to S&P Dow Jones Indices, which analyzed second-quarter earnings season data, capital expenditures of the companies in the S&P 500, have been growing at a faster pace than stock repurchases for the first time since the first quarter of 2021, rising by 20% from a year earlier. Companies from Pepsi to Google to GM are investing in their production capacity, which in itself may be an encouraging sign that they are comfortable with the demand outlook. Of course, the caveat here is that industrials are late in cycle performance, as companies usually wait towards the end of the cycle to expand, only to find waning demand for their products. You Say “Reshoring,” I Say “Onshoring” A multi-decade decline in US manufacturing employment has started to reverse after the GFC, with the onset of the pandemic and geopolitical tensions accelerating the pace of reshoring and Foreign Direct Investing (FDI). Reshoring and FDI job announcements have increased from 6K in 2010 to 345K in 2022 (Chart 6). The resulting cumulative 950,000 incremental hires represent about 7% of US manufacturing employment. The acceleration of jobs coming back combined with the decline in the rate of offshoring has resulted in a 12-year steady uptrend in US manufacturing jobs. Truly amazing! Onshoring remains on top of mind for companies’ management. According to Statista, mentions of onshoring buzzwords in earnings calls and presentations of US public companies have increased from about 100 throughout 2020 to nearly 200 in Q2-2020. Chart 6Reshoring And FDI Job Creation Have Accelerated After The Pandemic Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives According to Morgan Stanley’s survey of more than 400 executives of large corporations from the US to Germany to Japan, the most important factor in supply chain decisions is geopolitical stability, followed by skilled labor, physical infrastructure, and a developed supply chain ecosystem. On nearly every count, the US outranked Europe, China, and Mexico. Some 18% of the companies planned to significantly expand US manufacturing in the next 12 months, while 36% anticipated doing so within three years. More than 40% of US companies were taking steps to “onshore” supply chains. The reasons are well publicized: The COVID crisis has revealed over-dependence on imports. China’s decoupling from the US, tensions in the Taiwan Strait, and the Russian/Ukraine war have invoked concerns about the reliability of the existing supply chains. Supply chain disruptions have highlighted corporate vulnerabilities and had made companies realize that “just-in-case” trumps “just-in-time.” The US is pursuing protectionist policies that are to benefit companies operating in the US, Mexico, and Canada. According to Reshoring Initiative,1 Industrial and Tech companies are at the forefront of reshoring: Electrical Equipment, Chemicals, Transportation Equipment, Computer, and Electronic Products, and Medical Equipment suppliers are the leaders in onshoring (Table 2). Many large manufacturers such as Caterpillar have implemented or announced plans to bring offshore manufacturing back to the US. Table 2Reshoring Jobs By Top 5 Industries Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Will onshoring benefit some of the former manufacturing hubs? We believe it will, as Kentucky, North Carolina, Georgia, Ohio, and Alabama are the top five destinations (Table 3). However, there is a hitch. The US unemployment rate, which is at an all-time low of 3.5%, is certainly a speed limit. Moreover, companies that bring their businesses back home do realize that labor costs in this country are many times higher than, say, in Asia. Hence, one of the solutions they pursue is automation. After many years in the making, onshoring is finally gaining pace, benefiting the US manufacturing base. Table 32022 Projected Reshoring Jobs By Top 10 States Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Automation To The Rescue! The Pace of Robotization And Automation Is Accelerating A critical constraint for the expansion of US manufacturing is the labor shortage. Open vacancies in manufacturing are now at a record high, 100% above the 2018 peak (Chart 7, top panel). Notably, industrial companies have been experiencing difficulties hiring qualified staff over the past 10 years which has led to high wage growth (Chart 7, bottom panel). Chart 7US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging Chart 8Automation Expands Profits Margins Of Global Industrials Automation Expands Profits Margins Of Global Industrials Automation Expands Profits Margins Of Global Industrials One remedy is automation. Replacing labor with automation/robots allows companies to produce more and avoid a profit margin squeeze (Chart 8). In a recent report published by the International Federation of Robotics, industrial robots reported record preliminary sales in 2021 with 486,800 units shipped globally, a 27% increase from 2020. The US has been lagging behind other developed countries in terms of automation and robotization (Chart 9). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3),2 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. Chart 9US Has Been Lagging Other Developed Nations In Robot Installations Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives 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 the purchase of robots (Chart 10). Chart 10In 2021 The Pace Of Robot Installation Has Picked Up Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Implications For Industrial Companies The Industrials sector is home to companies that create robots and offer automation solutions as well as companies on the receiving end of the trend. Both sellers and buyers are to benefit: Buyers Of Robots: Manufacturing companies automating production and enlisting robots into their operations will enjoy higher operating leverage, lower labor costs, and more resilient margins. It is easier to automate processes in manufacturing than in service sectors. Consequently, we believe profit margins in manufacturing will outperform those of service sector companies, where automation will be slower. Sellers Of Robots: The sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the Tech companies, and many industrial companies are to benefit from these nascent trends. Rockwell Automation, Eaton, and Caterpillar are the leaders in industrial automation. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has just recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous springs for high-value crops. These companies are to benefit from strong demand for their products and should exhibit strong sales and profit growth. To meet strong demand, industrial/manufacturing companies will automate their processes. This will allow them to boost volume and cap costs resulting in widening profit margins. Uncle Sam Loves American Manufacturing Both Biden and Trump before him, have stated that their overarching objective is to revive America’s manufacturing. However, their methods were drastically different, with Trump introducing tax cuts and tariffs, while Biden leans heavily on fiscal stimulus. The following is a recap of some of the recent laws passed by Congress and signed by President Biden. Infrastructure Investment And Jobs Act The $1.2-trillion Infrastructure Investment and Jobs Act will increase US government non-defense spending to bring it to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s. The bill’s focus is on traditional infrastructure – roads, bridges, ports, and electrical grid modernization – but also includes more modern elements such as $65 billion for 5G broadband Internet and $36 billion for electric vehicles and environmental remediation (Table 4). Implementation of the bill is delayed to 2023-24. Table 4Itemized Infrastructure Plan Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives However, the market is forward-looking and companies in Construction & Engineering, and Building Products industries are already winners, and are up 12% in relative terms since the bill was passed on November 15, 2021. The potential increase in public construction will help offset a slump in residential construction on the back of the softening housing market (Chart 11). Chart 11The Increase In Public Construction Will Help Offset A Slump In Residential Construction The Increase In Public Construction Will Help Offset A Slump In Residential Construction The Increase In Public Construction Will Help Offset A Slump In Residential Construction Inflation Reduction Act (IRA) The bill earmarks $370 billion for clean energy spending as well as EV tax credits for both new and used cars. We have written on the topic of “Green and Clean” and the effect of the IRA on renewable energy and EV industries, two industries that are major beneficiaries of the bill. However, the bill also creates an enormous opportunity for industrial companies, which can build and service renewable infrastructure, such as Quanta Services (PWR) and Eaton (ETN). Companies that produce and service wind turbines (GE) and solar batteries will also get a revenue boost from the package. Chips Act Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. While the key beneficiaries are chip foundries, construction of new factories will require equipment and services of a wide range from industrial companies from Construction to Machinery. National Defense Authorization Act In December, the House and Senate Armed Services Committee leadership released the Fiscal Year 2022 National Defense Authorization Act (NDAA). This bill introduces an overall discretionary authorization of $768.2 billion including $740.3 billion for base Department of Defense programs and $27.8 billion for national security programs in the Department of Energy. At a later date, another $37 billion was amended to the bill to include $2.5 billion to help pay higher fuel costs; $550 million for Ukraine, funding for five ships, eight Boeing Co-made F-18 Super Hornet fighter jets, and five Lockheed Martin C-130 Hercules planes; and about $1 billion for four Patriot missile units. For FY 2023, the House has already passed $839 billion, which is $37 billion above the White House request. The Senate will work on the bill after the summer recess. But it is already clear that defense spending has become a bipartisan issue. The increase in the defense budget, as well as additional allocation of funds towards Ukraine, have been a major boost for the Aerospace and Defense industry. We overweighted the sector back in January and it is up 24% in relative terms. Overweight Or Not, That Is The Question Macroeconomic Backdrop Business Cycle: Performance of the Industrial sector tends to lag the business cycle, as sector customers tend to wait until they are sure of recovery and have high utilization of their existing capacity before they expand their own production. However, demand is not entirely cyclical, as the need to replace obsolete or aging equipment or machines is relatively stable. There is also a stark difference in behavior of the largest industrial companies and smaller companies in their ecosystems. Larger manufacturers are long-cycle as it takes months to build machines, planes, or equipment. These companies are less sensitive to the business cycle. On the other hand, their suppliers are “short cycle” as they sell parts to many customers, turn their inventory frequently, and are very sensitive to the economic condition. At present, as economic growth is slowing, long-cycle industrial companies are preferable to short-cycle ones. Despite a bifurcation in demand, Industrials tend to underperform in a generic economic slowdown (Chart 12). This is unsurprising as the relative performance of Industrials is correlated to industrial production and the ISM PMI (Chart 13). Chart 12Historically, Industrials Underperformed During The Slowdown Stage Of The Business Cycle Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Chart 13Industrials Usually Underperform When IP And ISM PMI Decline Industrials Usually Underperform When IP And ISM PMI Decline Industrials Usually Underperform When IP And ISM PMI Decline Chart 14Survey Of Capex Intentions Is Weakening Survey Of Capex Intentions Is Weakening Survey Of Capex Intentions Is Weakening And while we touted the beginning of the new industrial boom in the US, and a brand new Capex cycle, we need to monitor it carefully, as multiple surveys of Capex intentions are decelerating (Chart 14). Tighter Monetary Policy: Another potential headwind comes from rising rates. After all, the higher cost of corporate borrowing may weigh on demand for industrial goods. However, historically, US industrial stocks outperformed the S&P 500 Index in the past 70 years during periods of rising bond yields, including the inflation decade of the 1970s (Chart 15). Industrial companies are well positioned to withstand inflation as strong pricing power allows them to pass on their costs to customers. Chart 15When Rates Rise, Industrials Outperform When Rates Rise, Industrials Outperform When Rates Rise, Industrials Outperform The macroeconomic backdrop presents challenges to Industrial companies Fundamentals Are Strong Significant Pricing Power: While dangers are looming in the macroeconomic backdrop, so far industrial companies have been doing well thanks to their significant pricing power (Chart 16), which they enjoy due to high capacity utilization. The relationship between capacity utilization and selling prices is not linear but exponential. When capacity reaches its limit and shortages arise, potential buyers will likely be willing to pay considerably higher prices to secure the supply of goods that they require. High Operating Leverage: In addition to high pricing power, industrial companies enjoy high operating leverage, which implies that while the economy is growing, even if at a slower pace, they can easily convert sales into profits. This will not be the case when the economy is outright contracting – then high operating leverage will become a liability. Chart 16Industrials Enjoy Substantial Pricing Power Industrials Enjoy Substantial Pricing Power Industrials Enjoy Substantial Pricing Power Strong Q2-2022 Earnings And Sales Results: This explains the strong Q2-2022 sales and earnings results of the Industrial sector. Industrial earnings grew at 17.4%, while its sales increased by 13.3% – a remarkable feat, considering that many companies, especially consumer-facing ones, are struggling with shrinking profitability – earnings growth of the Consumer Discretionary sector was down 12.6%. Clearly, business-to-business companies are faring much better than consumer-facing ones, whose demand was pulled forward by the pandemic, and whose customers are reeling from rising prices and are tightening their belts. Looking ahead, margins are expected to shrink by 0.5% (Chart 17), which is modest compared to the 2.5% contraction expected for the S&P 500. In terms of earnings growth expectations, they have fallen but still exceed the market by an impressive 10% even after a series of downgrades. Importantly, earnings growth in real terms is also positive (Charts 18 & 19). Chart 17Operating Margins Are Expected To Hold Up Well Operating Margins Are Expected To Hold Up Well Operating Margins Are Expected To Hold Up Well Chart 18Industrial Earnings Will Grow Faster Than The Market Industrial Earnings Will Grow Faster Than The Market Industrial Earnings Will Grow Faster Than The Market Chart 19Earnings Expectations Have Been Re-calibrated Earnings Expectations Have Been Re-calibrated Earnings Expectations Have Been Re-calibrated What Companies Are Saying All the charts and numbers align well with what we have heard from companies during the earnings season. For instance, nearly every major player within its own respective sub-industry reported healthy demand, low inventories, and a hefty backlog this quarter. Here are a few quotes from the largest players: Caterpillar (CAT): “We expect production and utilization levels will remain elevated, and our autonomous solutions continued to gain momentum … overall demand remained healthy across our segments … was unable to completely satisfy strong customer demand for our machines and engines.” MMM: “Continued strong demand for our solutions in semiconductor, factory automation, and automotive end markets.” GE: “In Renewables, … we are making progress. Our pricing has substantially improved onshore … we're growing our higher-margin businesses, such as grid automation, which delivered double-digit orders growth.” Honeywell (HON): “Orders were up 12% year over year and closing backlog was also up 12% year over year.” The profitability of the Industrial sector is expected to be resilient and to better the market. Valuations And Technicals The Industrial sector and the Capital Goods Industry group trade on par with the S&P 500 on a forward earnings basis (17.7x and 17.9x to 18.0x). The BCA Valuations Indicator signals a neutral level of valuation which is roughly in line with the 10-year average. From the BCA Technical Indicator standpoint, Capitals Goods are also in the neutral zone (Chart 20). Valuations and technicals are moderate for the sector. Chart 20Valuations And Technicals Valuations And Technicals Valuations And Technicals Investment Implications The US industrial sector is in the middle of a boom fueled by a trifecta of positives: Onshoring, automation, and favorable government policy. And while it is hard to fight the Fed and the business cycle, it appears that for now, the sector is defying gravity despite slowing manufacturing surveys and tighter monetary policy. So far fundamentals appear strong, and earnings expectations are robust thanks to the high pricing power and operating leverage of the sector. Within Capital Goods, we favor industries and companies that benefit from these tailwinds: Aerospace and Defense which is to benefit from increased federal defense spending; Robotics and Automation which is overrepresented in the Electrical Equipment industry; and Renewables, i.e., companies that manufacture and service wind turbines and solar panels. Construction and building materials will have a second breath when Infrastructure spending projects will actually get selected and approved. We are both strategically and tactically bullish on the sector but will monitor it closely from a tactical standpoint. After all, industrial surveys are at odds with the resilient earnings expectations. ETFs There are a number of very inexpensive and highly liquid ETFs from Vanguard, iShares, and State Street, that capture the performance of the Industrial sector (Table 5). Table 5Industrial Sector ETFs Industrials: A Trifecta Of Positives Industrials: A Trifecta Of Positives Bottom Line The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. Companies are optimistic and earnings growth expectations are both robust and resilient. We are both strategically and tactically bullish on the sector but will continue to monitor it closely, watching out for potential cracks in operating performance.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Reshoring Initiative reshorenow.org 2     https://www.automate.org/   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 Cheap But Challenged Cheap But Challenged Cheap But Challenged European equities have bottomed in absolute terms, but they are still underperforming US ones. Eurozone equities are very cheap compared to US ones, but their profitability remains inferior. Five problems continue to hang over the relative performance of European stocks. The first problem is the Chinese and global growth outlook. The second problem is the natural gas crisis. The third problem is Europe’s expanding liquidity risk. The fourth problem is the weak euro. The fifth problem is Europe’s structural profitability weaknesses.     Bottom Line: European stocks may be inexpensive, but too many problems are hanging over their profit outlook. As a result, European shares are unlikely to outperform until natural gas prices peak and the ECB activates the TPI. Until then, continue to underweight European stocks in global equity portfolios.   European assets are on sale. Equities are trading at multigenerational lows against their US counterparts. Meanwhile, the euro is back below parity and embedding a 30% discount to purchasing power parity against the US dollar. These observations suggest that European stocks are very attractive relative to their US counterparts — but are they? Related Report  European Investment StrategyQuestions From The Road On July 4, 2022, we turned positive on European stocks in absolute terms. Nonetheless, we expected US stocks to outperform because of their larger weighting toward defensive and growth names, which derive greater benefit from lower rates, especially when economic activity remains vulnerable. At this point, we maintain this stance. European valuations are appealing, but the entry point is still not right because the global environment continues to be hostile to the relative performance of European equities. Attractive Valuations Anyway you cut it, European stocks are much less expensive than their US counterparts. In theory, these attractive valuations imply higher long-term rates of return in European markets compared to US ones. Chart 1Cheap European Stocks Cheap European Stocks Cheap European Stocks Based on the MSCI indices, the relative forward P/E ratio of Eurozone shares is 25% below that of US stocks, or the deepest discount in more than 20 years (Chart 1, top panel). European shares should naturally sport lower valuations than US ones due to sectoral biases. However, even when we adjust for those sectoral differences, European stocks stand out as exceptionally cheap. A P/E ratio calculated by giving equal weights to all the sectors in both Europe and the US reveals that, outside of the COVID-19 selloff, the European valuation discount has never been lower in the post-dotcom bubble era (Chart 1, bottom panel). Comparing individual sector performances to earnings reinforces that European stocks are uniquely inexpensive compared to US ones. Since 2018, the relative prices of most European sectors compared to their US competitors have underperformed relative earnings (Chart 2). Chart 2ABroad-based Cheapness Broad-based Cheapness Broad-based Cheapness Chart 2BBroad-based Cheapness Broad-based Cheapness Broad-based Cheapness The problem with valuations is that they can be misleading. If European earnings continue to underperform US ones, European equities are likely to underperform further. And, whether we adjust or not for sector composition, European earnings remain in a pronounced downtrend compared to US profits, which is driving relative performance (Chart 3). Perhaps there is hope for European earnings, but, in the short term, we doubt it. European earnings expectations have been downgraded already, with 2022 and 2023 earnings excluding the energy sector, already down 10% and 12% respectively since their February peak (Chart 4). However, five problems are likely to lead to a greater downgrade relative to the US in the coming months. They are the following: the Chinese and global growth difficulties, the energy market’s ructions, the European liquidity risk, the weakness in the euro, and Europe’s structural lack of profitability. Chart 3Earnings Are In The Driving Seat Earnings Are In The Driving Seat Earnings Are In The Driving Seat Chart 4Downward Revisions Have Begun Downward Revisions Have Begun Downward Revisions Have Begun Bottom Line: Compared to the US, European stocks are very cheap. However, European stocks will only begin to outperform once investors see reasons to upgrade European relative earnings. For now, too many problems continue to place Europe’s profit outlook at a disadvantage. Problem 1: Chinese And Global Growth Chart 5Europe Is More Cyclical than the US Europe Is More Cyclical than the US Europe Is More Cyclical than the US The performance of European equities relative to that of US stocks tracks the evolution of the global manufacturing PMI (Chart 5). This makes sense. Europe’s economy and markets are more specialized in the manufacturing sector, whether consumer or capital goods. Consequently, European earnings are also more geared to the fluctuations of global industrial activity and Chinese imports. Today, China remains one of the major risks to European stocks. Despite efforts by Beijing to stabilize growth, the private sector continues to retrench. The zero-tolerance toward COVID creates a powerful brake on animal spirits as lockdowns shift from one city to the next. Most crucially, the real estate sectors’ woes show no end in sight. Floor spaces sold, started, and completed are contracting at double-digit paces and real estate investment is declining at a 12% annual rate (Chart 6 top and second panels). Moreover, the 47% annual contraction in land purchases indicates that the situation will not improve soon. Consequently, consumer loan growth will decelerate further (Chart 6, bottom panel). While authorities are trying to manage the economic slowdown, they are still too concerned with real estate speculation to push as aggressively as the Chinese economy needs. Even the recent 19-point package from the State Council came with a warning that, although “the foundation of economic recovery is not solid,” Beijing will avoid “resorting to massive stimulus or compromising longer-term interests.” In this context, it is likely that China’s marginal propensity to consume will remain weak, that Chinese yields will decline further, and that the CNY will experience additional weaknesses. All these developments are consistent with a deeper underperformance of European equities (Chart 7). Chart 6China's Real Estate Industry Is Sick China's Real Estate Industry Is Sick China's Real Estate Industry Is Sick Chart 7Weak China = Weak Europe Weak China = Weak Europe Weak China = Weak Europe Looking at the global economy offers little hope. A weak China weighs on EMs’ growth prospects. Moreover, the strong dollar invites EMs’ central banks to tighten domestic liquidity and financial conditions, which historically results in lower growth. This softer economic activity ultimately hurts European earnings more than US ones and causes Eurozone shares to underperform US ones (Chart 8). Beyond EMs, the leading indicators of global economic activity do not inspire much confidence either. Arthur Budaghyan, BCA’s Emerging Market chief strategist, often highlights the downside risk to global exports, which would generate an underperformance of European earnings relative to those of the US. In fact, Taiwanese export orders, which lead global exports, are contracting anew. So is the Global Leading Economic Indicator (Chart 9). Ultimately, the tightening in global policy rates is doing what it should do: slowing global growth. Chart 8EM FCIs Matter To Europe's Relative Performance EM FCIs Matter To Europe's Relative Performance EM FCIs Matter To Europe's Relative Performance Chart 9Clouds Over The Global Economy Clouds Over The Global Economy Clouds Over The Global Economy Bottom Line: The weakness in Chinese economic activity is not over yet. Global growth will also continue to suffer as global exports are set to weaken considerably in the coming months. Together, these forces will hurt the earnings prospects of Europe compared to the US. Problem 2: The Energy Market Chart 10Pricey Nat Gas And Electricity Pricey Nat Gas And Electricity Pricey Nat Gas And Electricity Let’s be more specific here: natural gas continues to weigh more on Europe’s earnings prospects than those of the US. European natural gas prices have surged, even when compared to US ones. As a result, electricity prices have also increased across the Eurozone’s main economies (Chart 10). This is deeply negative for domestic economic activity and hurts the competitiveness of European businesses. Consequently, as long as natural gas prices climb higher, European profitability will deteriorate relative to that of US firms. Unsurprisingly, investors are deeply aware of these dynamics. The more natural gas prices rise, the greater European equities underperform. In fact, since mid-2021, Dutch natural gas prices have become the single best explanatory variable for the relative performance of European stocks (Chart 11). Natural gas is likely to remain a problem for European equities until the beginning of the winter. We are currently in the peak period of upward pressure on natural gas prices in Europe. Relentless inventory buildup introduced an inelastic buyer to the market, which is propelling natural gas prices to new heights even though consumption is receding (Chart 12, top panel). In response to these efforts, European natural gas inventories have hit 80% of capacity and are set to rise to 90% by November, even though Russian flows have collapsed (Chart 12, bottom two panels). However, in November, natural gas prices are likely to peak. The re-stocking effort will be completed, coal power will fill in many gaps, and selective conservation efforts will allow most industries and heating to function. Chart 11Europe vs US = Nat Gas Europe vs US = Nat Gas Europe vs US = Nat Gas Chart 12The Worse Is Now The Worse Is Now The Worse Is Now Bottom Line: The surge in natural gas prices is the key force currently hurting the relative performance of Eurozone equities. However, this negative dynamic is likely to fade in the winter because the current price jump reflects inventory building. By November, inventories will be at the 90% of capacity targeted by the European Commission and coal power will fill the remaining production gap. Until then, natural gas prices will continue to hurt European profit margins. Problem 3: European Liquidity Risk Chart 13Unhinged Credit Markets Unhinged Credit Markets Unhinged Credit Markets European equities are also hurt by an increase in risk premia relative to the US. Italian spreads continue to show upside and European junk spreads are widening compared to US ones (Chart 13). This problem could remain saliant in the coming months. The ECB is tightening policy in an economy already fettered by a severe energy shock. This process increases risk aversion. Moreover, because European inflation is likely to prove more sticky than that of the US this fall, this development will continue to hurt the price of European assets compared to US ones. Chart 14A Key Vulnerability A Key Vulnerability A Key Vulnerability The imbalances in the Euro Area create a further source of liquidity risk. The TARGET2 balances remain extremely large, which indicates that Dutch, Luxembourg, and German savings continue to finance France, Spain, and Italy (Chart 14, top panel). However, the import-boosting impact of high energy costs and the negative effects of weaker global growth on exports are likely to worsen the current account balance of the Eurozone, including that of Germany, which acts as the Eurozone’s banker (Chart 14, bottom panel). The decreasing savings of Germany and the Netherlands in conjunction with the wide difference in neutral rates between Germany and France, Italy and Spain increase the odds that peripheral spreads will widen further in the short term. However, this too is likely to be a temporary risk that ebbs after the winter. First, as we wrote four weeks ago, the differences in neutral rates will force the ECB to activate the TPI before year-end. Second, once energy prices peak, the downward pressure on European gross savings will also ease, which will restore liquidity conditions in European credit markets. Bottom Line: The combination of an ECB tightening policy in a weak economy as well as TARGET2 imbalances and declining savings increase the likelihood of a liquidity shortage in European debt markets. Tremors in the credit market would translate into further underperformance of European equities relative to US ones. Problem 4: The Weak Euro At first glance, the weak euro is positive for European equities since it subsidizes profitability. However, in a context in which costs of production are rising faster in Europe than in the US, this benefit is elusive. The weak euro is not translating into greater pricing power for European firms. The increase in producer prices supercharged by higher natural gas prices (among others) is not met by a commensurate rise in consumer prices. The same is true in the US, but to a much lesser extent; as a result, the ratio of CPI to PPI is declining in Europe relative to the US. Chart 15A Weak Euro Reflects Poor Pricing Power A Weak Euro Reflects Poor Pricing Power A Weak Euro Reflects Poor Pricing Power This lack of pricing power is an important driver of the weakness in the euro. EUR/USD closely tracks the evolution of the CPI-to-PPI ratio in Europe relative to the US (Chart 15). This confirms that a weaker euro is not helping the relative performance of European shares because it indicates a problem with the comparative profitability of European businesses. It also implies that the euro will weaken as long as Dutch natural gas prices are rising (Chart 15, bottom panel).  Historically, a weak euro is associated with underperforming European equities. At the most basic level, a depreciating euro arithmetically derails the common-currency performance of European shares. Moreover, because a falling euro is often linked to poor rates of return in the Euro Area, it corresponds to periods when investors prefer foreign shares to European ones. For now, we see a large left tail in short-term distributions of the EUR/USD’s returns, even if the long-term prospects of the euro are brighter. This also signifies that the euro will remain a hurdle for the relative performance of European shares in the coming weeks. Bottom Line: The lack of pricing power of European firms weighs on the profitability of Eurozone businesses compared to that of US ones and on the euro. As long as this problem persists, the euro will suffer, which implies additional weaknesses in the relative performance of European shares. Problem 5: Europe Structurally Poor Profitability Chart 16Europe's Structural Profitability Problem Europe's Structural Profitability Problem Europe's Structural Profitability Problem Since 2008, the EPS of the Eurozone MSCI benchmark have collapsed 73% compared to those of the US index. Moreover, this fall has followed a nearly straight line. This poor performance reflects an underlying structural challenge to European profitability. Europe’s low profit growth follows poor returns on assets. At first glance, lower levels of stock repurchases explain some of the underperformance of European earnings. However, the lower propensity of European firms to conduct buybacks mirrors their poor profitability. As Chart 16 highlights, European firms have much lower RoEs, RoAs, profit margins, and asset utilization rates than their US counterparts. The low profitability of European shares is multifaceted. To a large degree, it corresponds to the Eurozone’s anemic growth, whereby nominal as well as real GDP per capita continue to lag those of the US (Chart 17). This weak per-capita GDP is a consequence of the meager underlying productivity of the Euro Area. Many elements cause Europe’s lower productivity growth. The two most obvious culprits are the region’s greater economic fragmentation and its heavier regulatory burden when compared to the US. But also, the return on investment is much lower in Europe (Chart 17, bottom panel). The lower European return on investment is more complex. A key driver is the greater degree of misallocated capital in Europe than in the US. Europe’s capital stocks, especially in the periphery, represents a much greater share of GDP than it does in the US (Chart 18). A larger capital stock increases the odds that some previous capex was misallocated. Moreover, the greater prevalence of small businesses in Europe compared to the US also increases the likelihood of redundant and misallocated capital. Poor capital allocation hurts investment returns and productivity. Chart 17Weak Growth = Weak ROI Weak Growth = Weak ROI Weak Growth = Weak ROI Chart 18Too Much Capital Too Much Capital Too Much Capital Another reason for Europe’s poor profitability has nothing to do with productivity and tepid growth. European industries are less concentrated than US ones (Chart 19). Lower concentration means higher competition between businesses, which erodes markups and returns on assets.  Chart 19Smaller Profitability Moats In Europe Too Early To Overweight Europe Too Early To Overweight Europe None of Europe’s structural weaknesses in relation to profitability has been addressed. Consequently, this drag on the relative performance of Euro Area equities remains firmly in place, which warrants a significant discount in European equity valuations relative to US ones. Bottom Line: The last problem for European shares is the structural under profitability of the Eurozone. Because of lower productivity, misallocated capital, and lower industry concentration, European firms offer permanently weaker returns on assets than US businesses. Their disadvantage remains unaddressed, which suggests that structural forces are unlikely to generate a re-rating of European shares any time soon. Investment Implications Conditions are still not supportive for an outperformance of European equities relative to US ones. European stocks may have already bottomed in absolute terms and they are very cheap compared to US shares, but Euro Area earnings are set to underperform further. European stocks cannot beat US stocks until most of the five headwinds impacting Europe come to pass. The deceleration in Chinese and global growth, the surge in Dutch natural gas prices, the growing liquidity risk in the Eurozone, the collapse of EUR/USD, and the structural impediments to European profitability are just too strong collectively to allow Europe’s attractive valuation to crystalize into immediate high returns. Nonetheless, we cannot be dogmatic. Before year-end, we expect three of these variables to become favorable for European stocks. Namely, we anticipate the natural gas crisis to reach its apex around November 2022, the ECB to activate the TPI, which will tackle the budding illiquidity in European credit markets, and the euro to bottom. Hence, we are in the late stage of this year’s underperformance of European equities. An opportunity to upgrade Europe is around the corner – we are just not there yet. Even after all the cyclical and short-term negatives ebb, one key hurdle for European stocks will remain intact: the structural under profitability. This force suggests that periods of outperformance of European stocks are likely to be short-lived and that, as long as the profitability gap remains open, the structural relative bear market in European stocks will persist. Bottom Line: It is still too early to overweight European equities. Euro Area stocks are much cheaper than their US counterparts, but too many headwinds continue to blow that are likely to weigh on relative performance. Only after European natural gas prices peak will Europe enjoy a period of outperformance. This is unlikely to happen until this winter.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market In today’s report, we summarize the arguments of bulls and bears to examine the possible longevity of the rally. The Bulls’ view is centered around several key themes:  Inflation has turned.  The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker.  The economy is resilient, and consumers are spending.  Corporate earnings will surprise on the upside thanks to consumer strength. Meanwhile, the bears argue that:  Growth is slowing and a soft landing is elusive, which will lead to earnings disappointment.  Valuations and Technicals are no longer attractive – the best part of the rally is likely over, and risk-reward is skewed to the downside.  Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may continue.  We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. Feature The fast and furious rally off the June 16 lows has taken many investors by surprise. Over the past two months, the S&P 500 has rebounded by 17%, the NASDAQ is up 22%, while Growth has outperformed Value by 9%. Thematic small-cap growth ETFs have fared even better (Chart 1) with Cathie Wood’s ARKG and ARKK up nearly 50%. The Technology and Consumer Discretionary sectors are up 23% and 28% respectively, while Energy and Materials are relatively flat, showcasing a rotation away from the inflation winners to losers. In this week’s report, we will “dissect” the rally and its key drivers to better understand what can bring this rally to a halt. We will also summarize the arguments of the bulls and present our “bearish” rebuttal to some of the assumptions. Sneak Preview: After the powerful rebound, the market is fragile, and risks are skewed to the downside. By summarizing the arguments of bulls and bears, we are offering our take on what can bring this rally to a halt, i.e., hawkish Fed speeches, disappointing inflation readings, rising rates, and bad earnings. However, a positive surprise along each of these dimensions may also result in the next leg up. Chart 1ETF Universe Overview What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Anatomy Of The Rally To understand what fuels the rally, we need to understand what its key catalysts are. Oversold: First and foremost, in mid-June, US equities were severely oversold – the BCA Capitulation Indicator hit levels last seen in the spring of 2020 (Chart 2). The BoA institutional survey has also reported an extreme level of bearishness. Pull back in the price of energy: This created fertile ground for a rebound, but the catalyst came from the turn in commodities and energy prices. Extreme pessimism about global growth after the Fed’s aggressive response to a disappointing inflation print has triggered a sell-off in oil and metals. Since mid-June, the GSCI Commodities and the GSCI Energy index are in a bear market downtrend, 21% and 25% off their peaks. Inflation moderating: This disinflationary development has unleashed a positive reinforcement loop: Lower energy prices led to a turn in the CPI print. And many still believe that, after all, inflation is transitory: With supply disruptions clearing and prices of energy and commodities turning, inflation will dissipate just as fast as it arrived. We know this because inflation breakevens are currently at levels last seen a year ago (Chart 3). Chart 2Capitulated Capitulated Capitulated Chart 3Cooling Off : Back To 2021 Cooling Off : Back to 2021 Cooling Off : Back to 2021 Gentler Fed: That is when the market decided that easing price pressures in concert with slowing growth would compel the Fed to pursue a shallower and shorter path of interest rate increases than initially expected – rate increases derived from OIS started to undershoot the “dot plot” (Chart 4). Effectively, the bond market started to forecast that the Fed will end the year at 3.5% and ease as soon as early 2023. In other words, the Fed is nearing the end of the hiking cycle. Naturally, the long end of the Treasury curve has pulled back to April levels, despite a much higher Fed rate. One way or another, yields have stabilized. Lower rates are a boon for equities: As a long-duration asset, equity valuations are inversely correlated with long yields (Chart 5). A better-than-expected Q2 earnings season was the icing on the cake. Chart 4The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 The Market Expects Cuts As Soon As Early 2023 Chart 5Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Falling Yields Propelled Equities Higher Was The Rally Surprising? The rally itself did not surprise us – after all, we did expect the market to turn on a dime at the earliest whiff of falling inflation (Chart 6). Admittedly, we were taken aback by its strength and longevity. With inflation turning, we also expected a change in leadership from the Energy and Materials sectors to Technology and Consumer Discretionary (Chart 7). We also predicted back in January in our “Are We There Yet?!” report that, based on the previous hiking cycles, Tech would rebound roughly three months after the first rate hike (Chart 8), which was taking us to June. Chart 6When Inflation Turns, Equities Rebound What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 7Turn in Inflation Triggers A Change In Sector Leadership What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? Chart 8A Closer Look At Technology What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? In early July, we upgraded Growth to overweight as an asset that would benefit from an anticipated turn in CPI, rate stabilization, and slowing growth (Chart 9). We have also reaffirmed our overweight in Software and Services as a way to play Growth on a sector level. We have downgraded Energy to underweight to reduce exposure to Value. Chart 9Growth And Quality Lead Markets Higher When Inflation Abates What Can Bring This Rally To A Halt? What Can Bring This Rally To A Halt? What The Bulls Think Let’s summarize what the bulls think are the catalysts for the next leg up: Inflation has turned. Looking for further signs that inflation is easing. The Fed is less hawkish than initially assumed, and Jay Powell is not Paul Volcker. Looking for signs that the Fed is getting closer to the end of the hiking cycle. So far, the economy is resilient, and consumers are spending – excess savings and excess demand for labor will soften the blow. Looking for signs that the recession can be avoided. Corporate earnings will surprise on the upside thanks to consumer strength. In the next section, I will juxtapose these optimistic expectations with those of a bear, i.e., of yours truly. A full disclosure – I am not a perma-bear but even eight weeks into the best recovery rally ever, I can’t shake off my pessimism. After all, I am used to the markets going up on injections of liquidity and expect them to shudder when liquidity is mopped out of the system. What The Bears Think, Or A Litany Of Worries Inflation is embedded and broad-based Broad-based: While headline inflation is turning, mostly thanks to prices of energy and materials, it will take a long time for core inflation to revert to the desired 2% as it is broad-based. This is evident from trimmed and median CPI metrics, which continue their ascent. Inflation has also spilled into sticky service items, such as rent (Chart 10). Wage-price spiral: Then there is that pesky wage-price spiral that is manifesting itself in soaring labor costs (Chart 11), which companies pass on to their customers. In the meantime, productivity is falling, and unit labor costs are increasing at 9.5% per year, a rate of growth last seen in 1980s (Chart 12). Demand for labor still exceeds supply with 1.8 job openings for every job seeker, and much more tightening is required to bring supply and demand into balance. Chart 10Entrenched? Entrenched? Entrenched? Chart 11Wage-price Spiral Wage-price Spiral Wage-price Spiral Chart 12ULC Soaring ULC Soaring ULC Soaring Wages and service inflation are more important to structural inflation than energy. Rent and its equivalents constitute 30% of the CPI basket, while wages are roughly 50% of corporate sales and by far the largest component of the cost structure. Inflation is embedded and broad-based and it will take many months to reach the level that is palatable to the Fed. What Does The Fed Think? Fed minutes: Fortunately, we don’t need to guess. The Fed minutes state that "participants agreed that there was little evidence to date that inflation pressures were subsiding" and that inflation “would likely stay uncomfortably high for some time.” Further, “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities … Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said. The Fed minutes state that in moving expeditiously to neutral and then into restrictive territory, “the Committee was acting with resolve to lower inflation to 2% and anchor inflation expectations at levels consistent with that longer-run goal.” In its previous communications, the Fed emphasized that its commitment to a 2% target is unconditional. Is powell more like burns or volcker? In addition, there is an ongoing debate between bulls and bears on the character of the Fed – is Jay Powell a strong-willed hawk like Paul Volker, or more of a waverer like Arthur Burns, who presided over the relentless march of inflation in the seventies? We think that the Chairman can channel Paul Volcker. After all, the Fed has surprised investors by acting swiftly and decisively. Back in March, the Fed dot plot indicated that by the end of the year, the target rate will reach a mere 1.75%. However, we hit a 2.25%-2.50% rate range as soon as July. Jay Powell is concerned about his legacy: He would not want to be remembered as a Chair who mishandled inflation by keeping rates too low despite historically low unemployment and resilient consumers whose accounts are padded with excess post-pandemic savings. The Fed is more hawkish than what the majority of market participants, unscathed by the inflation of the seventies and eighties, believe. The Fed dot plot, to which the Chairman referred on multiple occasions, projects a Fed funds rate of 4% at year-end and of 4.5-5.0% next year (Chart 13). Meanwhile, Fed funds futures are only pricing a rate of about 3.4% for December 2022, even after the hawkish talk from both ex-dove Kashkari and a hawk Bullard (3.75%-4.0% by year-end and 4.4% by the end of 2023). Further, the Fed itself states in its minutes that rates would have to reach a "sufficiently restrictive level" and remain there for "some time" to control inflation that was proving far more persistent than anticipated. The Chicago Fed President Charles Evans has also affirmed that the Fed is definitely not cutting rates in March 2023. Chart 13The Fed Versus The Market The Fed Versus The Market The Fed Versus The Market Doves latch on to comments from the meeting that the Fed will be data-driven, and that it is concerned about overtightening. To us, these are just the musings of the “responsible grown-ups.” Quantitative Tightening: Now let’s not forget another leg of the stool – Quantitative Tightening. QT has been very tame so far and, since the program commenced, the size of the Fed’s balance sheet, $8.9 trillion, has barely budged. In September, the Fed is scheduled to step up QT to a maximum pace of $95 billion from $47.5 billion— running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Shortages of securities available for run-off due to a dearth of refinancing may trigger a shift to outright selling, further tightening financial conditions. Equities are at odds with the Fed: Last, but not least, equity markets are on a collision course with the Fed. Since June, financial conditions have eased as opposed to tightened, making the Fed’s job so much harder (Chart 14). Chart 14The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Rally Eased Financial Conditions The Fed may prove to be more hawkish than in the past as it is on a quest to combat inflation and takes its mission very seriously. “Don’t fight the Fed” the adage holds. Economic Growth Is Slowing The BCA Business Cycle Indicator signals that economic growth is slowing (Chart 15), which is also evident from a host of economic data releases, ranging from GDP growth to business surveys to housing data. One of the few data series that has defied gravity so far is the jobs report, but the job creation rate is a coincidental indicator at best, and a lagging one at worst. Jobs are usually lost after the start of a recession (Chart 16). Chart 15Economy Is Slowing Economy Is Slowing Economy Is Slowing Chart 16Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Unemployment Never "Just Ticks Up" Can consumers save the day? After all, $2.2 trillion in excess savings should help to handle the pressures of negative real wage growth and income growth that is below trend. Yes and no. Gasoline savings can certainly support increases in discretionary spending, all else equal. As for excess savings – adding this money back into the economy may ignite another bout of inflation, working against the Fed, and triggering more rate increases. Many clients ask us if we anticipate a recession. Broadly speaking we do, as the Fed has an arduous task ahead of it in balancing the supply and demand of labor. However, we do not expect a recession in 2022 or even early 2023. Can the Fed succeed by only reducing excess job openings from 1.8 to 1, thus avoiding a rise in unemployment? This is possible, but the probability of such an outcome is low as unemployment never “just ticks up” (Chart 16). However, what the market is pricing is also important. At the moment, the rally shows that it considers the current growth slowdown just a growth scare to be shrugged off. Will there be more disappointments? We think so, as the US economy is facing multiple headwinds from slowing demand for exports due to geopolitical turbulence and payback of overstimulated consumer demand at home. And it is not a recession per se, but a growth disappointment, that may take equities on the next leg down. Growth is slowing and a soft landing is illusive. Earnings Growth Will Continue Its March Towards Zero We believe that earnings growth will continue to slow into year-end – flagging consumer demand at home and abroad, a strong dollar, and soaring unit labor costs that can no longer be fully passed on to stretched consumers, as corporate pricing power is decelerating. Even in Q2-2022, ex-Energy EPS growth is already negative at -1.5%, with Consumer Discretionary, Financials, Communications, and Utilities reporting an earnings contraction. As we predicted back in October, the S&P 500 margins are also compressing, currently at 50bps off their peak, with consensus expecting them to lose another two points within the next 12 months as companies are grappling with rising costs (Chart 17). Analysts are finally in a downgrading mode (Chart 18), with growth over the next 12 months now expected to be 7.7% compared to 10% earlier this summer. Analyst downgrades will continue, and an earnings recession is highly probable as early as Q4-2022. Chart 17Profitability Is Under Pressure Profitability Is Under Pressure Profitability Is Under Pressure Chart 18Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded Earnings Are Finally Being Downgraded In terms of the durability of the rally – earnings growth disappointment will be enough to cause equities to pull back. Earnings growth is slowing and more disappointments may be in store. Valuations And Technicals The S&P 500 is currently trading at 18x forward earnings, which is nearly a two-point rebound off the market trough of 15.8x. This is roughly where PE NTM was in April when the 10-year yield stood at 2.80%. Therefore, the multiple reverted on the back of falling rates, and the market is fairly valued considering where rates are now. And another factor to consider: Analysts are slashing earnings expectations, and with E in a P/E likely to be downgraded further – the “true” forward multiple is likely higher than it appears. The BCA Valuation Indicator is also flashing “overvalued” (Chart 19). From the equity risk premium standpoint, 3% is low by historical standards (Chart 20). And if we consider Shiller PE, it has come down from an eye-watering 38x to a still elevated 29x. Chart 19Pricey Again? Pricey Again? Pricey Again? Chart 20Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Equities Are No Longer Cheap By ERP Or Shiller PE Metrics Therefore, it is hard to call equities cheap at this point. But being generous, we will call them “fairly priced.” Regardless – at these levels of valuations, the best part of the rally is likely over, and risk-reward is no longer favorable. From a technical standpoint, this rally is broad-based with nearly 90% of the S&P 500 industries trading above their 50-day moving average (Chart 21). But according to the BCA Technical Indicator, equities are no longer oversold and have just crossed into neutral territory (Chart 22). Interestingly, once the Technical indicator starts to rise, it usually ascends for a while, making us wary to boldly call an immediate end to this rally. Chart 21Thrusting Thrusting Thrusting Chart 22No Longer Oversold? No Longer Oversold? No Longer Oversold? Valuations and Technicals are no longer attractive – the best part of the rally is likely over and risk-reward is skewed to the downside. Investment Implications Or Can This Rally Continue? Timing the market is hard at best, impossible at worst. After a 17% rise from the bottom, the S&P 500 is no longer cheap or oversold. Buying equities for valuations or technical reasons is too late – risks are skewed to the downside. Our working assumption is that the rally will pause waiting for the new data that will trigger a new leg up or down. Further, as we pointed out in the Fat and Flat report, the current period is reminiscent of the 1980-1982 Volcker era. So far, the market is following this pattern to a T (Chart 23). The problem is that each leg of the up-and-down market may take months. As such, being (eventually) right and principled does not pay off. After all, the economy is not a market. Therefore, until one of the following happens, the music will continue and the markets can keep dancing, which may be for a while. Chart 23Volcker Era Redux Volcker Era Redux Volcker Era Redux The rally will continue until: There is a communication from the Fed re-emphasizing its hawkish stance and determination to get inflation back to 2%. It may be as one of the FOMC member’s speeches broadcast at Jackson Hole. Long-term Treasury yields pick up either because of the Fed’s actions or speeches or because the economy is overheating. Negative inflation surprise – it may come as either a higher-than-expected inflation reading or evidence that inflation is entrenched, such as rising service or rent inflation, soaring wages, a pick-up in the price of oil or commodities, or a growth surprise out of China, to name but a few. Negative earnings surprise – guidance from a number of companies indicating that economic growth is slowing, and earnings will disappoint. A negative economic surprise may be perceived by the market as “bad news is good news.” We recommend the following: Maintain a well-diversified portfolio, with sufficient allocation to both cyclicals and defensives. Increase exposure to Growth sectors, such as Technology. We particularly favor Software and Services as it leverages the pervasive theme of digitization and migration to the cloud. Reduce allocation to Energy and Materials – these sectors tend to underperform when inflation turns. They are also quintessential value sectors. Maintain some allocation to cyclicals – we are overweight the Industrial sector as it leverages a long-term theme of onshoring and automation. We may be upgrading the Consumer Discretionary sector in the near future. We are also overweight Banks and Insurance for portfolio diversification – these sectors benefit from rising rates and positive growth surprise. Markets turn on a dime and it is good to be prepared. Allocate capital to long-term investment themes: Green and Clean and EV, benefiting from the funds allocated by the IRA bill, Cyber Security, and Defense. Bottom Line: The rally was expected, but its force and durability took us by surprise. Now, after a strong rebound, risks are skewed to the downside and the markets are fragile, but the rally may still continue. We offer our take on what can bring this rally to a halt, and the “danger” signs investors need to be on the lookout for. In the meantime, overweight Growth and maintain a well-diversified portfolio.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   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 China Copper Consumption Failed To Revive Post-Pandemic China Copper Consumption Failed To Revive Post-Pandemic China Copper Consumption Failed To Revive Post-Pandemic A greater-than-expected contraction in manufacturing and construction in China – evidenced by the latest PMI and home sales data – will keep pressure on copper prices. Higher inflation will continue to drive the cost of labor, fuels and materials higher. Lower copper prices and higher input costs will weaken margins, leading to reduced capex. This also will put pressure on the rate of spending on projects already sanctioned. Payouts to shareholders – buybacks and dividends – will fall, reducing the appeal of miners’ equities. Debt-service costs will rise as interest rates are pushed higher by central banks. Civil unrest in critically important metals-producing provinces is forcing some miners to suspend production guidance. This will be exacerbated in Chile by changing tax regimes, which likely will reduce capex as well. Bottom Line: As global demand for copper increases with the renewable-energy transition and higher arms spending in Europe, miners’ ability to expand supply is being seriously challenged. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. With demand expected to double by 2030-35, copper prices will have to move higher to keep capex flowing to support supply growth. We remain long the XME ETF as the best way to express our bullish, decade-long view. Feature Just as the world is scrambling to develop additional energy supplies in the wake of Russia’s invasion of Ukraine, copper supplies – the critical element of the renewable-energy buildout – are being squeezed by an unusual convergence of fundamental, financial and social factors. Chart 1China Copper Consumption Failed To Revive Post-Pandemic China Copper Consumption Failed To Revive Post-Pandemic China Copper Consumption Failed To Revive Post-Pandemic Firstly, copper demand is weak, which, all else equal, is suppressing prices. This is largely down to China’s zero-tolerance COVID-19 policy, and uncertainty over whether the EU will be pushed into a massive recession, following the cutoff of its natural gas supplies from Russia. These are two of the three major pillars of the global economy, and their economies are entwined via trade in goods. China’s COVID-19 policy is hammering its critically important property market – sales were down almost 40% y/y in July – and forcing a contraction in manufacturing. Construction represents ~ 30% of total copper demand in China. Manufacturing is contracting, based on China’s official July PMI report, which showed the index fell below 50 to 49.0 for July.1 Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy China accounts for more than half of global copper demand, and, because of its zero-tolerance COVID-19 policy, was the only major economy to register a year-on-year contractions in copper demand throughout the pandemic up to the present (Chart 1). The EU accounts for ~ 12.5% of global copper demand, which we expect will continue to be supported by the bloc’s renewable-energy and defense buildouts.2 We noted in earlier research the odds of the EU going into recession remain high as the bloc scrambles to prepare for winter, in the wake of its attempts to replace its dependence on Russian natural gas supplies.3 We continue to expect the EU will avoid a major recession, and that it will be able to navigate this transition, leaving it on a better energy footing in subsequent years.4 Lower Copper Prices Will Hurt Capex Chart 2Copper Price Rally Fades Copper Price Rally Fades Copper Price Rally Fades After bottoming in March 2020 at $2.12/lb on the COMEX, copper prices staged a 125% rally that ended in March of this year. This was due to the post-pandemic reopening of most economies ex-China, which was accompanied by massive fiscal and monetary stimulus that super-charged consumer demand. Copper prices have since fallen ~33% from their March highs on the back of a substantial weakening of demand resulting from China’s zero-tolerance COVID policy and a concerted global effort to rein in the inflation caused by governments’ largess (Chart 2). Most year-end 2021 capex expectations for 2022 and into the future among copper miners were drawn up prior to the price collapse in June. After that, fear of central-bank policy mistakes – chiefly over-tightening of monetary policy that pushes the global economy into recession – and weak EM demand took prices from ~ $4.55/lb down to less than $3.20/lb by mid-July. A strong USD also pushed demand lower during this time. Chart 3DRC Offsets Chile, Peru Weakness Copper Capex Under Pressure Copper Capex Under Pressure Following the copper-price rout, miners are re-thinking production goals, dividend policy and capex. Social and governance issues also are contributing to weaker copper output. Rio Tinto, for example, notified markets it would shave $500mm from its $8 billion 2022 capex budget. For 1H22, Rio cut its dividend to $2.67/share from $5.61/share in 1H21. Elsewhere, Glencore said copper output from its Katanga mine in the DRC now is expected to come in 15% lower this year, at 1.06mm MT, owing to geological difficulties. Separately, output guidance for Chinese miner MMG Ltd’s Las Bambas mine in Peru has been suspended, following a 60% drop in production. The company expected it would be producing up to 320k tons this year. Civil unrest at Las Bambas has been ongoing since production started in 2016, according to Reuters. Big producers like Chile and Peru – accounting for ~ 35% of global ore production – along with the DRC face multiple challenges. Chile accounts for ~ 25% of global copper ore production. Its output fell ~ 6% in 2Q22 vs year-earlier output due to falling ore quality, water-supply constraints, and rising input costs (Chart 3). Chile’s government expects copper ore output to decline 3.4% y/y in 2022, with many of the country’s premier mines faltering (Chart 4). Chart 4Chile Expecting Lower Copper Output Copper Capex Under Pressure Copper Capex Under Pressure Chile also is proposing to increase taxes and royalties, to raise money for its budget. However, this may have the effect of driving away investment in the country’s copper mining industry. Fitch notes, “Increased costs will decrease mining cash flows and discourage new mining investments in Chile, favoring the migration of investors to other copper mining districts.”5 BHP Billiton, on que, said it will reconsider further investment in Chile, if the new legislation is approved. Renewables Buildout Will Widen Copper Deficit Markets appear to be trading without regard for the huge increase in copper supply that will be required for the global renewable-energy transition, to say nothing of the upcoming re-arming of the EU and continued military spending by the US and China. In our modeling of supply-demand balances, we move beyond our usual real GDP-based estimates of demand, which estimates the cyclical copper demand, and include assumptions for the demand the green-energy transition will contribute. Hence, this additional copper demand for green energy needs to be added to the copper demand forecast generated by the model. Using projections for global supply taken from the Resource and Energy Quarterly published by the Australian Government’s Department of Industry, Science and Resources, we estimate there will be a physical refined copper deficit of 224k tons in 2022 and 135K tons next year (Chart 5). Among other things, we are assuming refined copper demand will double by 2030 and reach 50mm tons/yr by then. This is a somewhat more aggressive assumption than S&P Global’s estimate of demand doubling by 2035. If we assume refined copper production is 2% lower than the REQ’s estimate, we expect the physical deficit in the refined copper market rise to a ~ 532k-ton deficit in 2022 and ~ 677k-ton deficit in 2023. These results including renewables demand highlight the need to not only account for cyclical demand but also the new demand that will be apparent as the EU, the US and China kick their renewables investments into high gear. Importantly, this kick-off is occurring with global commodity-exchange inventories still more than ~ 35% below year-ago levels (Chart 6). Chart 5Coppers Deficit Will Narrow On Lower Demand Coppers Deficit Will Narrow On Lower Demand Coppers Deficit Will Narrow On Lower Demand ​​​​​​ Chart 6Exchange Inventories Remain Exceptionally Low Exchange Inventories Remain Exceptionally Low Exchange Inventories Remain Exceptionally Low ​​​​​​ Investment Implications Copper prices will have to move higher to keep capex flowing to support supply growth normal cyclical demand and renewable-energy demand will require over coming decades. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. This situation cannot persist unless governments call off their renewable-energy transition, and, in the case of the EU, their efforts to re-arm Europe’s militaries following the invasion of Ukraine by Russia. We remain bullish base metals, particularly copper. We remain long the XME ETF as the best way to express this decade-long view. Commodities Round-Up Energy: Bullish OPEC 2.0 agreed a token increase in oil production Wednesday of 100k b/d, partly as a sop to the US following President Biden’s visit to the Kingdom last month. KSA will be producing close to 11mm b/d in 2H22. We have argued this is about all KSA will be willing to put on the market, in order to maintain some spare capacity in the event of another exogenous shock. OPEC 2.0 spare capacity likely falls close to 1.5mm b/d in 2023 vs. an average of 3mm b/d this year, which will limit the capacity of core OPEC 2.0 – KSA and the UAE – to backstop unforeseen production losses. Separately, the US EIA reported total US stocks of crude oil and refined products rose 3.5mm barrels (ex SPR inventory). Demand for refined products in the US was down 28mm barrels in the week ended 29 July, or 4mm b/d. We continue to expect prices to average $110/bbl this year and $117/bbl next year (Chart 7). Base Metals: Bullish China flipped from a net importer of refined zinc in 2021 to a net exporter for the first half of 2022, despite a high export tax on the metal. This is indicative of the premium Western zinc prices are commanding over the domestic price. Chinese zinc demand has fallen, following reduced manufacturing activity and an ailing property sector. Thursday’s Politburo meeting did little to encourage markets of a Chinese rebound later this year. A subdued Chinese recovery, along with European zinc smelters operating at reduced capacity, if at all, could see this reversal in trade flow perpetuate for the rest of the year. Precious Metals: Bullish As BCA’s Geopolitical Strategy highlighted, US House Speaker Nancy Pelosi’s visit to Taiwan will increase tensions between the US and China but will not lead to war. For now. Increased uncertainty normally is good for gold and its rival, the USD. While geopolitical uncertainty from Russia’s invasion of Ukraine initially buoyed the yellow metal, gold has since dropped below the USD 1800/oz level. The greenback was the main beneficiary from the war (Chart 8). It is yet to be seen how this round of geopolitical risk will impact gold and USD, with the backdrop of increasing odds of a US recession and a hawkish Fed. Chart 7 Brent Backwardation Will Steepen Brent Backwardation Will Steepen Chart 8 Gold Prices Going Down Along With USD Gold Prices Going Down Along With USD   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   Footnotes 1      Please see China’s factory activity contracts unexpectedly in July as Covid flares up published by cnbc.com on July 31, 2022. The PMI summary noted contractions in oil, coal and metals smelting industries led the index’s decline. 2     Please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022, for additional discussion. 3     Please see Copper Prices Decouple From Fundamentals, which we published on July 7, 2022. It is available at ces.bcaresearch.com. 4     Please see Energy Security Rolls Over EU's ESG Agenda published on July 28, 2022. It is available at ces.bcaresearch.com. 5     Please see Proposed Tax Reform Weakens Cost Positions for Chilean Miners (fitchratings.com), published by Fitch Ratings on July 7, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Counterpoint’s August schedule: Next week, I am travelling to see clients in Australia, New Zealand, and Singapore, so we will send you a report on China’s 20th National Party Congress written by our Chief Geopolitical Strategist, Matt Gertken. Given that the outlook for the $100 trillion Chinese real estate market is crucial for the global economy and markets, Matt’s insights will be very interesting. Then on August 18, I will host the monthly Counterpoint webcast, which I hope you can join. We will then take a week’s summer holiday and return with a report on September 1. Executive Summary In the topsy-turvy recession of 2022, real wages have collapsed. This means profits have stayed resilient and firms have not laid off workers. Making this recession a ‘cost of living crisis’ rather than a ‘jobs crisis’. If inflation comes down slowly, then the ‘cost of living crisis’ will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  The double choke on growth means that the bear market in the 30-year T-bond is likely over. This suggests that the bear market in stock market valuations is also over, but that ‘cyclical value’ is now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal trading watchlist: GBP/USD and Hungarian versus Polish bonds. In The 2008 Recession, Real Wage Rates ##br##Went Up So Employment Went Down… In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... …But In The 2022 Recession, Real Wage Rates##br##Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! Bottom Line: The bear market in the 30-year T-bond and stock market valuations is likely over, but equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Feature The US economy has just contracted for two consecutive quarters, meeting the rule-of-thumb definition of a recession. Other major economies are likely to follow. Yet many economists and strategists are in denial. This cannot be a ‘proper’ recession, they say, because the economy remains at full employment. But the recession-deniers are wrong. It is a recession, albeit it is a ‘topsy-turvy’ recession in which employment remains high (so far) because real wage rates have collapsed, circumventing the need for lay-offs. This contrasts with a typical recession when real wage rates remain high, forcing the need for lay-offs.1 The Topsy-Turvy Recession Of 2022 When do firms lay off workers? The answer is, when they need to protect their profits. Profits are nothing more than revenues minus costs, and in a typical recession revenues slow much faster than the firms’ biggest cost, the wage bill. In this event, the only way that firms can protect their profits is to lay off workers. Chart I-1 confirms that every time that nominal sales have shrunk relative to wage rates, the unemployment rate has gone up. Without exception. Chart I-1Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... But what happens during a recession in which nominal sales do not shrink relative to wage rates? In this event, profits stay resilient, so firms do not need to lay off workers. Welcome to the topsy-turvy recession of 2022! In the topsy-turvy recession of 2022, there has been much greater inflation in consumer prices and nominal sales than in nominal wage rates (Chart I-2). The result is that real wage rates have collapsed, profits have stayed resilient, and firms have not needed to lay off workers… so far. Chart I-2...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up ...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up In a typical recession, the pain falls on the minority of workers who lose their jobs, as well as on profits. Paradoxically, for the majority that keep their jobs, real wages go up. This is because sticky wage inflation tends to hold up more than collapsing price inflation. For example, in the 2008 recession, the real wage rate surged by 4 percent (Chart I-3), and in the 2020 recession it rose by 2 percent. Chart I-3In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... Yet in the 2022 recession, the real wage rate has shrunk by 4 percent, meaning that the pain of the recession has fallen on all of us (Chart I-4). In one sense therefore, this recession is ‘fairer’ because ‘we’re all in it together’. This is confirmed by the current malaise being characterised not as a ‘jobs crisis’, but as a ‘cost of living crisis’. In another sense though, the recession is unfair because the pain has not been shared by corporate profits, which have remained resilient… so far. Chart I-4...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! ...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! The crucial question is, what happens next? Using the US as our template, wage rates are growing at 5-6 percent, and this growth rate is typically stickier than sales growth. Assuming inflation drifts lower, nominal sales growth will also drift lower from its current 7 percent clip, meaning that it could soon dip below sticky wage growth. Once the growth in firms’ revenues has dipped below that in nominal wage rates, profits will finally keel over. To repeat, profits are nothing more than revenues minus costs, where the biggest cost is the wage bill (Chart I-5).2 Chart I-5Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs Profits Are Nothing More Than Revenues Minus Costs At this point, the downturn will become more conventional. To protect profits, firms will be forced to lay off workers who will bear the pain of the downturn alongside falling profits. Meanwhile, with inflation easing, real wage growth for the majority that keep their jobs will turn positive. But to repeat, this is the typical pattern in a recession. Accelerating real wage rates are entirely consistent with a contracting economy as we witnessed in both 2008 and 2020.  As Two Huge Imbalances Correct, Demand Will Be Pegged Back All of this assumes that real demand will remain under pressure, so the question is what is pegging back real demand? The answer is: corrections in two huge imbalances in the global economy. A breakdown of the -1.3 percent contraction in the US economy reveals these two corrections:3   Spending on goods, which contributed -1.2 percent Housing investment, which contributed -0.7 percent. These corrections are not over. As we presciently explained back in February in A Massive Economic Imbalance, Staring Us In The Face: “The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a recession. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation” (Chart I-6). Chart I-6The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History Then, in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, we identified a second major imbalance that is starting to correct. Specifically, the global housing boom of the past decade, which has doubled the worth of global real estate to $370 trillion, was predicated on ultra-low mortgage rates that made buying a home more attractive than renting. But in many parts of the world now, buying a home has become more expensive than renting (Chart I-7). Disappearing US and European homebuyers combined with a flood of home-sellers will weigh on home prices and housing investment – at least until policymakers are forced to bring down mortgage rates (Chart I-8 and Chart I-9). Chart I-7Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Buying A Home Has Become More Expensive Than Renting! Chart I-8Homebuyers Have Disappeared... Homebuyers Have Disappeared... Homebuyers Have Disappeared... Chart I-9...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market ...While Home-Sellers Are Flooding The Market Meanwhile, as Chinese policymakers try and gently let the air out of the $100 trillion Chinese real estate market, a collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. More Investment Conclusions In addition to the long-term investment conclusions just described, we can draw some shorter-term conclusions: If inflation comes down slowly, then the current ‘cost of living crisis’, which is pummelling everyone’s real incomes, will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will be forced to lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  Equityinvestors should stick with ‘defensive growth’, specifically healthcare and biotech. This double choke on growth is likely to keep a lid on ultra-long bond yields, even if central banks need to hike short-term rates more than expected to slay inflation. Our proprietary fractal analysis confirms that the sell-off in the 30-year T-bond is likely over (Chart I-10). Chart I-10The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over The Bear Market In The 30-Year T-Bond Is Likely Over For the stock market, this suggests that the valuation bear market is now over, but that ‘cyclical value’ sectors are now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal Trading Watchlist This week we noticed that the sudden 20 percent collapse of Hungarian versus Polish 10-year bonds, has reached the point of short-term fractal fragility that suggests an imminent rebound. Hence, we are adding this to our watchlist. Go long GBP/USD. But our trade is GBP/USD. UK political risk is diminishing, the BoE is likely to be as, or more, hawkish than the Fed, and the 260-day fractal structure of GBP/USD is at the point of fragility that has signalled major turning points in 2014, 15, 16, 18 and 21 (Chart I-11). Accordingly the recommendation is long GBP/USD, setting the profit target and symmetrical stop-loss at 5 percent.   Chart I-11Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Go Long GBP/USD Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 3Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 4US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 6Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 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 10Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 11The 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 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 16ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 17The 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 18The 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 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 22Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 23Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 24USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 25The 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 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The 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 Footnotes 1 The best measure of wage rates is the employment cost index (ECI) because it includes all forms of compensation including benefits and bonuses. 2  In fact, stock market profits are even more cyclical because, as well as wages, there are other sticky deductions from revenues such as interest and taxes. 3 All expressed as annualised rates. Fractal Trading System Fractal Trades Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! Welcome To The Topsy-Turvy Recession Of 2022! 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  

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

Executive Summary Non-Commodity Enterprises: No Profit Expansion For 12 Years Flat Profits For Non-Commodity Enterprises Flat Profits For Non-Commodity Enterprises The past decade has seen a deterioration in the financial performance metrics of industrial Chinese companies. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long-term profitability of China’s industrial sector. Potential deleveraging by local governments, companies and households will cap revenue growth for enterprises and, hence, weigh on their profitability. High commodity prices in the past 18 months have improved profitability and financial metrics for commodity producers. These strengths will reverse as commodity prices sink in the coming months. Corporate earnings are set to disappoint in 2H. Bottom Line: We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. In absolute terms, risks to Chinese shares prices are to the downside. ​​​​Among Chinese industrial companies, underweight commodity producers and overweight food & beverage, autos and utilities.   The data for this report for industrial enterprises, which are sourced from China’s National Bureau of Statistics (NBS), encompass state-owned and holding enterprises (SOEs) and other forms of ownership, including private ones. It covers both listed and non-listed companies. The sectors included are construction materials, steel, non-ferrous metals, energy, coal, machinery, auto, tech hardware, food & beverage and utilities. An analysis based on this dataset shows that China’s corporate profitability and efficiency ratios have experienced a prolonged structural downturn since the early 2010s (Chart 1 and 2). Chart 1Chinese Industrial Companies: Structural Deterioration in Productivity... Chinese Industrial Companies: Structural Deterioration in Productivity... Chinese Industrial Companies: Structural Deterioration in Productivity... Chart 2… And Operational Efficiency ...And Operational Efficiency ...And Operational Efficiency Chart 3Cyclical Improvements Within Structural Downtrend Cyclical Improvements Within Structural Downtrend Cyclical Improvements Within Structural Downtrend In the past 10 years, these measures improved only modestly during recovery periods and stumbled during downturns (Chart 3). The structural deterioration in corporate profitability from 2011 onward has followed structural improvements from the late 1990s to 2010. Beyond cyclical upswings, China's corporate profitability will likely continue to face structural headwinds. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long run profitability of China’s industrial sector. Furthermore, potential deleveraging by local governments, companies and households will curtail revenue growth for enterprises and, hence, weigh on profitability. Investigating The Financial Performance Of Industrial Enterprises Our analysis of corporates’ financial ratios shows the following: Corporate leverage: The total liabilities (debt)-to-sales ratio rose sharply from 2011 until 2021. However, the leverage ratio has declined in the past 18 months. A close examination suggests that the descent in the debt-to-sales ratio has been due to surging revenues of resource producing companies propelled by rising commodity prices. Chart 4 illustrates that the debt-to-sales ratio has dropped substantially for commodity producers, but much less so for other industrial companies. In the case of non-commodity industrial enterprises, the leverage ratio has not declined much because nominal sales have been lackluster. As resource prices continue to drop, revenues of commodity companies will be devastated, and their debt-to-sales ratios will spike. The thesis that corporate leverage has not yet dropped in China is corroborated by data on all companies. The country’s corporate leverage remains the highest worldwide (Chart 5). Chart 4The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices Chart 5China's Corporate Leverage Remains The Highest In the World China's Corporate Leverage Remains The Highest In the World China's Corporate Leverage Remains The Highest In the World Chart 6Corporates' Debt servicing Ability Has Been propelled by falling interest rates Corporates' Debt Servicing Ability Has Improved Due To Lower Interest Rates Corporates' Debt Servicing Ability Has Improved Due To Lower Interest Rates Debt servicing: Even though debt levels of industrial companies remain elevated, their interest coverage ratios – operating profits-to-interest expense – have improved since late 2020. For all industries, interest expenses have dropped substantially because of falling interest rates (Chart 6). On the margin, this has also helped industrials’ profit margins.   Efficiency: Asset turnover (sales/assets), inventory turnover (sales/inventory) and receivables turnover (sales/receivables), have all have sunk in the past 10 years, as shown in Chart 2. Lower turnover indicates falling efficiency. Coal, steel and non-ferrous metals have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign. Meanwhile, there has been no improvement in inventory turnover for non-commodity enterprises.   Profit margins: Net profit margins for industrial corporates have recently risen slightly. However, the entire improvement in industrial profit margins is attributable to commodity producers. With the exception of commodity producing sectors, there has not been any upturn in operating profit margins and/or net profit margins (Chart 7). Rising corporate income taxes from 2011 to 2020 were one of the reasons worsening profitability (Chart 8). Chart 7Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Chart 8Rising Corporate Income Taxes Have Contributed The Divergency Between GPM And Net Profit Margin Corporate Tax Burden Rose From 2010 To 2020 Corporate Tax Burden Rose From 2010 To 2020 Profitability: The return on assets (RoA) and the return on equity (RoE) for industrial corporates have dwindled during the past decade (Chart 1 above). The spike in commodity prices in the past two years has helped profitability of commodity producers, but this is about to reverse. A DuPont analysis1 illustrates that the downturn in corporate profitability was driven by poor operating efficiency and a lack of improvement in net profit margins. Chart 9 shows that the profitability of non-commodity producers has worsened dramatically during the past 10 years. After more than a decade-long structural downturn, the RoA and RoE for commodity producers have recently strengthened along with asset turnovers and net profit margins (Chart 10). However, the commodity bonanza is over for now and profitability measures of resource companies are set to worsen significantly.2 Chart 9A DuPont Analysis: Non-Commodity Enterprises A DuPont Analysis: Non-Commodity Enterprises A DuPont Analysis: Non-Commodity Enterprises Chart 10A DuPont Analysis: Commodity Enterprises A DuPont Analysis: Commodity Enterprises A DuPont Analysis: Commodity Enterprises Bottom Line: The past decade has seen a deterioration in the financial performance metrics of industrial companies. The profitability of corporates has undergone a structural decline along with a prolonged slump in operating efficiency.  High commodity prices in the past 18 months have ameliorated profitability and efficiency parameters for commodity producers. Nevertheless, these improvements will vanish as commodity prices fall materially in the coming months. Structural Headwinds To Corporate Profitability The following factors will weigh on China’s corporate profitability in the long term: 1. Demographics and rising labor costs: A shrinking workforce since mid-2010s has led to higher wages that have weighed on the corporate sector’s profitability (Chart 11). This dynamic is also confirmed by rising labor compensation as a share of non-financial corporates’ value added, as illustrated in Chart 12. Chart 11China: Shrinking Labor Force China: Shrinking Labor Force China: Shrinking Labor Force Chart 12Labor Compensation As A Share Of Corporate Revenues Labor Compensation As A Share Of Corporate Revenues Labor Compensation As A Share Of Corporate Revenues In China, blue-collar labor shortages and upward pressures on wages will likely intensify in the coming decade. A rapid decline in the population’s natural growth rate with the third lowest fertility rate in the world (below Japan) foreshadows a decline in China’s working age population which started in 2015.  2. Common prosperity policies: The share of labor compensation in GDP has risen since 2011 at the expense of the share of corporate profits (Chart 13). China’s common prosperity policies will only reinforce this trend. These policies will encourage enterprises to assume more social duties, distributing a larger share of profits to society at the expense of shareholders. Chart 13Labor's Share Will Continue Rising In China's National Income Labor's Share Will Continue Rising In China's National Income Labor's Share Will Continue Rising In China's National Income Chart 14Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling 3. Declining efficiency of investments: A deteriorating output-to-capital ratio  indicates capital misallocation or falling efficiency (Chart 14). When a nation attempts to invest substantially for a long time, capital will likely be misallocated and the return on new investment will be low. This will drag down the overall return on capital. Falling efficiency ultimately entails lower productivity. 4. Slowing productivity growth: China’s productivity growth has downshifted, and total factor productivity growth slipped again recently. Notably, total factor productivity – a measure of productivity calculated by dividing economy-wide total production by the weighted average of inputs – has contributed less and less to China’s real GDP growth in the past decade. It is unrealistic to expect that China will reverse the downward trend in productivity growth in the next few years. 5. Deleveraging by companies and households: China’s corporate sector continues to face deleveraging pressures. Although some industrial enterprises underwent deleveraging in recent years, the country’s overall corporate debt is still very elevated. Remarkably, Chinese corporate debt as a share of nominal GDP is the highest in the world, as shown in Chart 5. China’s households are reducing debt. Depressed household income growth and deflating home prices have curbed borrowing. Deleveraging by households heralds weaker consumption, which is negative for corporates revenues. Bottom Line: Rising labor compensation and declining efficiency of investments constitute formidable headwinds to the profitability of China’s industrial sector. Moreover, the secular outlook of corporates’ profitability is also vulnerable to lower productivity growth and weaker top-line growth due deleveraging among companies and households. The Cyclical Outlook In our report two weeks ago, we discussed how China’s business cycle recovery in the second half of this year will be more U rather than V shaped. Both sluggish domestic demand and contracting external demand for Chinese exports will curb the rebound of the industrial sector in 2H. Industrial earnings are set to disappoint.  Chart 15Non-Commodity Enterprises: No Profit Expansion For 12 Years Flat Profits For Non-Commodity Enterprises Flat Profits For Non-Commodity Enterprises Manufacturing producers have not been able to fully pass on higher input prices to consumers given weak demand. This weakness together with elevated commodity prices has led to a substantial profit divergence between upstream and mid- and downstream industries since late 2020 (Chart 15).  However, upstream commodity producers face the headwind of commodity price deflation. At the margin, weakening resource prices will benefit mid- and downstream industries that use commodities. However, their revenue growth will remain fragile due to subdued domestic and external demand and a lack of pricing power. The tight correlation between industrial profits and raw material prices reinforces the importance of commodity prices as a driver of China’s industrial profit cycles Therefore, if commodity prices drop meaningfully in the second half of this year, then overall industrial profits in China will suffer markedly. Chart 16The share of loss-making industrial enterprise ventures has Rocketed The Share of Loss-Making Industrial Enterprises Has Been Surging The Share of Loss-Making Industrial Enterprises Has Been Surging Furthermore, overcapacity and operational inefficiencies persist despite supply-side reforms and a capacity reduction campaign implemented by China’s authorities. Chart 16 demonstrates that the share of loss-making industrial enterprise ventures has soared to 24%, implying capital misallocation.  With a further rising share of enterprises making losses as commodity prices plunge, the ability of companies to service debt will deteriorate and hence banks will experience climbing non-performing loans. Bottom Line: China’s recovery in the second half of this year will be more U than V shaped. Corporate earnings are set to disappoint in 2H. Investment Strategy The gloomy outlook for corporate profitability does not bode well for the performance of Chinese stocks. Chinese A-shares are struggling to bottom on the back of shaky economic fundamentals, while investable stocks are cheap for a reason. We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. Lower profitability and return on equity have ramifications for the valuations of China’s industrial companies. Remarkably, China’s industrial profits have been flat in the past 12 years (Chart 15 above). That is a reason why many Chinese stocks have been de-rated. Among A-share industrial companies, sectors with higher profitability are coal, non-ferrous metals, auto, construction materials and food & beverage. However, coal, non-ferrous metals and construction materials are pro-cyclical sectors, and their profit growth is positively correlated with economic growth, which is facing downward pressure at least through the end of this year. In addition, resources and commodity plays are vulnerable in the next 6 to 12 months. We recommend to underweight these sectors.  Within the Chinese equity universe, we recommend overweighting autos, food & beverage, and utilities sectors. Food & beverage and utilities are interest rate-sensitive sectors, which will continue to benefit from lower onshore bond yields. In addition, utilities sector’s profit margin and earnings will improve as coal prices decline. The auto sector will gain an advantage from China’s stimulus for auto purchases, especially for new energy vehicles.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The DuPont analysis breaks down return on equity in three distinct elements: net profit margin, operational efficiency, and leverage. This analysis enables to identify how various drivers impact return on equity. 2Please see China Investment Strategy Special Report "Global Copper Market: No Bottom Yet," dated July 27, 2022, and Emerging Markets Strategy Report "A Cocktail Of Falling Oil Prices And Surging US Wages," dated July 21, 2022, available at bcaresearch.com Strategic Themes Cyclical Recommendations

Dear Client, On Monday August 8, I will be sending you an abbreviated version of our monthly Chart Pack. Our regular publication will resume on August 15. Kind regards, Irene Tunkel Executive Summary The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector In the following report we continue answering questions from our “Bear Market 2.0” webcast, by reviewing recent US legislative actions, and their effects on semiconductor and energy stocks. Semiconductors Bill: Over the long term, the recently passed CHIPS+ bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Semiconductors Overview: Semis are "growthy" and have surged on the back of falling yields. They are also highly cyclical, and slowing growth will become a headwind to performance. Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. We prefer more stable growth areas of the Technology sector and are overweight Software and Services as opposed to semis stocks. The bill is not enough to "move the needle". What To Do With Energy? The stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As a result, we downgrade the Exploration & Production segment, maintain our overweight in the Equipment & Services, and boost Storage & Transportation from underweight to neutral on the back of the upcoming new pipeline construction. Bottom Line: We remain underweight semis as the one-off boost from the CHIPS+ bill does not counterbalance demand headwinds. When it comes to Energy, the capex upswing will lower the price of oil which warrants an underweight stance in Exploration & Production names. Feature This week investors experienced a deluge of news and data, spanning the Fed rate decision, the Q2-2022 GDP estimate, and earnings reports from some of the largest US corporations, such as Apple, Amazon, and Facebook. To top it off, we had major developments on the legislation front after a multi-month hiatus. Two major bills, the Chips and Science Act of 2022 (aka CHIPS+) and the Inflation Reduction Act of 2022 (an incarnation of Build Back Better), are close to passage, after months and months of dithering. In this report, we will discuss the potential effects of these pieces of legislation on the two equity sectors most affected, Semiconductors and Energy. Since these sectors are also at the epicenter of recent market action, we hope that this report is timely and will help you make the right investment decisions. Sneak Preview: We maintain our underweight on Semiconductors, and downgrade Energy Exploration and Production to an underweight on the back of falling energy prices. Semiconductors: Is It Time To Close The Underweight? When it comes to semis stocks, the current bear market caused a deeper peak-to-trough correction (40%) than at the bottom of the pandemic, implying that, perhaps, much of the bad news was priced in. We have been underweight semis since early January and are up 14% relative to the S&P 500. With the industry bouncing 20% off its June lows, we question whether we have overstayed our welcome and it is time to close this underweight, especially in light of the imminent passage of the CHIPS+ bill. Let’s start by discussing the bill: Designed In The US, Made In Asia In a November 2021 “Semiconductors: Aren’t They Fab?!” Special Report, we highlighted that semiconductor production is divided among chip designers and manufacturers, a so-called “fabless model,” which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. The entire semiconductor industry depends on cooperation between two regions: North America, which houses global leaders in designing the most sophisticated chips, and Asia, which is home to companies that have the technology to manufacture them (Charts 1 & 2). As a result, the US share of chip manufacturing has been falling steadily for the past 30 years, from 37% to 10% (Chart 3). Recent, supply chain disruptions and heightening geopolitical tensions have underscored this country’s vulnerability due to outsourcing of chip manufacturing, which led to renewed calls for chip independence and onshoring. Chart 1Chips Are Designed In The US... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 2...And Manufactured In Asia What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Objective Of The CHIPS+ Bill Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. The bill will provide financial incentives for both US and non-US chip makers to open manufacturing plants in the US while restricting semiconductor companies’ activities “in specific countries that present a national security threat to the United States.” The provision ensures that China, which has also been recently striving for chip independence, will not be a beneficiary of US government funds. The bill also comes with strings attached: It states that it will not allow companies to use any of the funds to buy back stocks or issue dividends. Chart 3The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Cost Of The Bill Preliminary analysis from the Congressional Budget Office assesses that the bill will trigger roughly $79 billion in new spending over the coming decade. The key provision in the bill is the $52.7 billion for chip makers. Of those funds, $39 billion is earmarked to “build, expand, or modernize domestic facilities” for chip-making, while $11 billion is set aside for research and development. Funds will be spread over five years. The bill also adds $24 billion in tax incentives and other provisions for semiconductor manufacturing. In addition, $2 billion is allocated to translate laboratory advances into military and other applications. While $79 billion sounds like a lot of money, we need to keep things in perspective. As Barron’s pointed out: “According to IC Insights, total semiconductor industry capital spending is estimated to grow 24% this year, to $190 billion. Assuming some growth over the next several years, the bill would be a modest single digit percentage of the aggregate spending over the five-year time period.” Therefore, the financial benefits the bill provides are modest. Key Beneficiaries US chip makers with fab facilities, such as Intel (INTC), Micron Technology (MU), and Texas Instruments (TXN) will be the key beneficiaries of the bill as they are offered financial incentives for opening new plants. Foreign companies, such as TSMC, Samsung, and Global Foundries, might also qualify for financial incentives to open chip production facilities in the US. In fact, Intel, TSMC, and Global Foundries have already announced plans to build plants in the US contingent on the bill’s passing. Fabless chip designers, such as Nvidia (NVDA), AMD, and Qualcomm are unlikely to benefit from the package in a major way. Over the long term, the bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Demand For Chips Is Fading While the bill will have some positive effect on chip manufacturing, there is a lurking danger that production is being ramped up globally just at a time when, after prolonged shortages, demand for chips is starting to fade. Historically, this highly cyclical industry has gone through boom and boost cycles every three to four years. During the Q2 earnings call, TSMC Chief Executive Mr. Wei said that the broader industry is dealing with an “inventory correction” that has led customers to cut orders from some of its peers. After two years of pandemic-driven demand, “our expectation is for the excess inventory in the semiconductor supply chain to take a few quarters to rebalance to a healthier level.” This is not surprising. Semiconductors are highly economically sensitive with sales declining in lockstep with slowing global growth (Chart 4), while inventory levels are picking up (Chart 5). Chart 4Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Chart 5Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Demand for two of the industry’s key markets, computers and mobile phones, which account for 50% of the overall chip demand, seems to be deteriorating rapidly amid the slowing global economy. Demand for consumer electronics is fading after a pandemic surge of buying, when consumers pulled forward their spending on phones and computers. Most of these items don’t need to be upgraded or replaced for years. COVID-related lockdowns in China, meanwhile, have also weighed on consumer demand. According to IDC, worldwide shipments of personal computers fell 15% in the June quarter from a year earlier, due to “macroeconomic headwinds.” IDC has also lowered its forecast for 2022 expecting computer shipments to retreat by 8.2%. Canalys said global shipments for mobile phones fell 9% year over year, following economic headwinds, sluggish demand, and inventory pile-up. Memory chips represent 28% of the industry, and DRAM accounts represent three-fifths of memory sales. DRAM prices are falling (Chart 6). According to TrendForce, the average contract price for a DRAM, used widely in consumer items ranging from cars to phones to fridges, fell by 10.6% during the second quarter, compared to a year ago, the first such decline in two years. DRAM prices are expected to slide by 21% in Q3-2022. Companies are telling us similar stories: Micron, the No. 3 player in memory, recently issued revenue guidance well below analysts’ estimates. Chief Executive Sanjay Mehrotra warned that “the industry demand environment has weakened,” with PC and smartphone sales declining. Lisa Su, Chief Executive of AMD, expects computer demand to be roughly flat. Nvidia is bracing for a slowdown in the crypto space and game consoles. Intel has reported disappointing results: PC customers are reducing inventory levels at a rate not seen in a decade, Chief Executive Pat Gelsinger said in a call with analysts. PC makers typically reduce inventory levels of chips when they are expecting lower sales. Chart 6DRAM Prices Are Falling DRAM Prices Are Falling DRAM Prices Are Falling Of course, there is significant variability in demand for chips across sectors: While demand for phones and computers is fading, there is still pent-up demand for auto chips, and servers (Chart 7). According to Ms. Su, demand remains hot for chips used in high-performance computers and servers. TSMC, which has Apple and Nvidia among its clients, seconds this notion: Quarterly revenue for high-performance computers, increased 13% from the previous quarter and was greater than the revenue from smartphones, which rose 3%. There are also significant shortages of less-advanced auto chips (Chart 8). In a recent Q2 earnings call, GM reported that it carries 95,000 unfinished cars in its inventory due to the auto chip shortage. According to Mr. Wei of TSMC, the company will continue investing in auto chips, a product that historically it didn’t emphasize as much as its cutting-edge chips, in response to strong demand. Texas Instruments, which reported stellar results, also said that while it saw strength in the auto and industrial segments, demand from the consumer electronics market remained weak in both the second quarter and the current quarter. Chart 7Demand For Servers Is Still Strong Demand For Servers Is Still Strong Demand For Servers Is Still Strong Chart 8More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. Pricing power is also fading. However, there are still areas immune to the downturn, such as chips for servers, high-performance computers, and less advanced auto chips. Valuations and Fundamentals Earnings growth expectations have also come down significantly off their peak, and are currently at 5% for the next 12 months, which indicates negative real growth (Chart 9). Chart 9Earnings Growth Is Slowing Earnings Growth Is Slowing Earnings Growth Is Slowing Chart 10Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Semi valuations have pulled back from a 33x trailing multiple to 17x over the course of six months, only to bounce back another 3x since June 16, currently trading at 20x multiple. While valuations certainly moderated, they are still above the pre-pandemic trough in 2019 when the global economy was also slowing. The BCA Valuation Indicator, an amalgamation of various valuation metrics, indicates that semiconductors trade at fair value (Chart 10 & Chart 11). The rebound rally was fast and furious; at nearly 20% off market lows, it feels like much of the recovery from severely oversold conditions has run its course. Chart 11Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Semis Investment Implications Semiconductors are somewhat unique in that they are both cyclical and “growthy” (Chart 12). Since semis are “growthy,” the past six-week rebound may be attributed to falling rates, which have led to multiple expansion of most growth sectors. However, we need to keep in mind that rates have stabilized because of signs of global slowdown, and that the cyclical nature of semis will get in the way of further outperformance. While we also believe that the CHIPS+ bill is a modest tailwind, it is hard to commit to an industry in the early innings of contraction. For investors who would like to top up their allocations to semis, we recommend companies most exposed to demand from industrial sectors (autos, servers, high performance computers), and staying away from companies most exposed to consumer electronics. Much of the performance of companies that have reported so far hinged on their product mix. Chart 12Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Bottom Line We are reluctant to add to semis after the sector gained nearly 20% in just six weeks. Economic challenges remain – demand for chips is slowing, and the process of clearing inventory build-up may take several quarters. CHIPS+ is a positive but, in our opinion, is not enough to move the needle. We prefer more stable growth areas of the Technology sector and are overweight Software and Services. We also prefer semis most exposed to demand from non-consumer sectors. What To Do With Energy? We are currently equal-weight Energy. More specifically, we are overweight Energy Equipment and Services, equal weight Explorations and Production (we closed an overweight in March, booking a profit of 50%), and underweight Energy Transportation industry groups. With Brent down 18% and GSCI down 15%, and economic growth slowing, it is essential to review what is in store for the sector. Further, the Inflation Reduction Act, which is now on President Biden desk expecting his signature, has quite a few provisions relevant to the sector. Inflation Reduction Act And Its Effects On The Fossil Fuels Industry This bill is a true marvel of political negotiation and gives all parties something to be happy about and something to complain about. While the bill earmarks $370 billion for clean energy spending at the insistence of Senator Manchin (D, WV), the legislative package provides support for traditional sources of energy like oil, gas, and coal. Broadly speaking, the bill is a positive for expanding domestic energy production and supporting its nascent Capex cycle, which we called for in the “Energy: After Seven Lean Years” Special Report. Development of new wells has already picked up over the past few months (Chart 13). Chart 13New Energy CAPEX Cycle New Energy CAPEX Cycle New Energy CAPEX Cycle Here are a few important rules stipulated by the bill, highlighted by the Wall Street Journal: Expanding offshore wind and solar power development on federal land will now require the federal government to offer more access for drilling on federal territory. Under the bill, the Interior Department would be required to offer up at least two million acres of federal land and 60 million acres of offshore acreage to oil and gas producers every year for the next decade. It would be the first-ever required minimum acreage for offshore oil and gas leasing and would significantly increase the acreage requirements for onshore leasing. The bill would also effectively reinstate an 80-million-acre sale of the Gulf of Mexico to the oil drillers last year that a federal judge had invalidated. The bill is also a major positive for the natural gas industry, providing an accelerated timeline for building the pipelines and terminals needed to increase production and export of fossil fuels. In exchange for access to more federal territory, oil and gas companies would also have to pay higher royalty rates for drilling there. It would also require them to pay royalties on methane they burn off or let intentionally escape from their operations on federal lands. The bill aims to increase the supply of oil, gas, and coal, and return the US towards energy independence. Over the medium term, it should lead to a normalization of the price of energy. Demand Vs. Supply Naturally, the price of oil is all about supply and demand. And the performance of the energy sector is inextricably linked to the price of oil (Chart 14). Supply: According to our EM Strategist, Arthur Budaghyan, “fears that sanctions on Russia will considerably reduce global oil supply have not yet materialized.” According to International Energy Agency (IEA) estimates, Russia’s shipments of crude and oil products have declined by only about 5% since January (Chart 15). Clearly, despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. Chart 14Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Chart 15Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Demand: Meanwhile, global commodities and energy demand is downshifting in response to both high fuel prices and weakening global growth. US consumption of gasoline and other motor fuel has marginally contracted (Chart 16, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 16, bottom panel). In the rest of EM (excluding China), a strong dollar and high oil prices are leading to demand destruction. Chart 16US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak Prices Are To Trend Down: Hence, the supply of energy and commodities is stable, but demand is flagging, which does not bode well for the prices of energy and materials. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. In addition, as the market anticipates a turn in inflation, there is a pronounced rotation away from Energy and Materials towards Technology and other growth pockets of the market (Charts 17 & 18). With a supply of energy staying steady or even expanding, while demand is slowing on the back of the global slowdown, we expect the price of energy to trend down. Chart 17Energy And Materials Were Biggest Winners In the "Inflation High And Rising" Regime... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 18...But They Gave Back Their Gains In "Inflation High But Falling" Regime What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Energy Investment Implications It appears that the stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As production is expanded and prices fall, the profitability of the Oil Exploration and Production industry (upstream) will decline. In addition, inflation is about to turn, and a change in market leadership has already ensued. We downgrade Exploration and Production to an underweight. In the meantime, the Equipment and Services industry will benefit from contracts to develop new wells and will thrive. We maintain an overweight. We are currently underweight the Energy Storage and Transportation industry (mid-stream) as historically, this industry was marred in multiple regulations and most expansion projects faced obstacles, especially if running through public land. However, under the provisions of the Inflation Act, midstream will benefit from rising production volumes and expedited construction the pipelines and terminals needed to increase production and exports of fossil fuels. We upgrade Storage and Transportation to an equal weight. Bottom Line The Inflation Reduction Act will create conditions favorable for expanding the production of fossil fuels and will support US energy independence. As supply grows while demand is slowing, the price of energy is likely to turn – while a boon for US consumers, this is a headwind to the performance of the Energy sector.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Feature Clean energy names rallied yesterday on the back of the news that a reconciliation deal was struck to support Biden’s fiscal package. The deal, which was dubbed the “Inflation Reduction Act Of 2022”, includes approximately $370 billion in clean energy spending as well as EV tax credits for both new and used cars.  The bill has been sent to President Biden for his signature. The bill is a boon to two of our long-term investment themes: “EV Revolution” and “Is It Time To Invest Green And Clean?”. In both reports, we argued that both themes were to benefit from the favorable legislative tailwinds thanks to this administration’s focus on climate change prevention policies. Since its inception in June 2021, the EV theme has outperformed the S&P 500 by 15%, while the “Green and Clean” theme is up 14% since the April 2022 inauguration report. When it comes to investing in green technology and EV, we recommend investors continue to treat them as long-term thematic calls. Technological innovation themes are intrinsically risky: They are rarely immediately profitable and require both continuous investment and technological breakthroughs to succeed. As such, they are fickle over short term but pay off over a longer investment horizon. On a tactical basis both EV and clean energy stocks may be ripe for a pullback after a robust rally (Chart 2). Chart 1 On The Clean Energy Deal On The Clean Energy Deal Chart 2 On The Clean Energy Deal On The Clean Energy Deal     Thematic themes are best captured either via an ETF or a custom basket. Green energy ETFs are TAN, FAN, RNRG, CTEC, RAYS, and WNDY. Electric vehicle ETFs are ARKQ, IDRIV, DRIV, and KARS (See appendix for details). Bottom Line: We reiterate our structural preference for green technology and EV stocks on the back of strong legislative support and a continuous push for innovation and affordability. Appendix Table 1 On The Clean Energy Deal On The Clean Energy Deal Table 2 On The Clean Energy Deal On The Clean Energy Deal

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Image Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 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 9Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The 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 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 16The 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 17The 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 18A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 24The 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 25A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters 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