Equities

Highlights Chinese stocks are currently trading close to their fair value in absolute terms. When equity valuations are neutral, the direction of the next move in stocks depends on the profit outlook. Chinese corporate earnings are set to contract in the next six months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Historically, share prices lagged the turning points in China’s money/credit impulses by several months. Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in the coming months at a lower level. Relative to EM and global stocks, Chinese equities offer value. Hence, their relative performance will likely enter a rollercoaster phase. The secular outlook for corporate profitability among listed Chinese companies remains uninspiring. Hence, a structural re-rating of China stock indexes is unlikely. Feature With Chinese share prices down considerably in the past 12 months, a pertinent question is whether they offer an attractive entry point. Dissecting both valuations and the corporate earnings outlook are the key to getting the cyclical view right. This report aims to do this for both the MSCI Investable and MSCI A-share equity indexes. Our conclusion is as follows: in absolute terms, the Chinese MSCI Investable and A-share indexes have neutral valuations. Yet, the risk window for share prices remains open because corporate profits are set to contract. Also, bottoms and peaks in the money/credit cycle lead share prices by several months as illustrated in Chart 1. Hence, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Valuations Chinese equity valuations are by and large neutral. Specifically: 1. According to our aggregate composite valuation indicators, onshore A shares are fairly valued while the MSCI Investable index is slightly above its historical mean (Chart 2). This aggregate composite valuation indicator for both equity indexes is composed of three components: based on (1) median multiples; (2) 20% trimmed-mean multiples; and (3) equal-weighted multiples. The latter uses equal weights rather than market cap weights for sub-sectors in the calculation. In turn, each component is constructed using the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and the bottom 10% of sub-sectors, i.e., it removes outliers. 2. We have also calculated a cyclically adjusted P/E (CAPE) ratio for both A shares and MSCI Investable stocks. The CAPE ratio for A shares is slightly below its historical mean (Chart 3), and the one for the MSCI Investable index is one standard deviation below its mean (Chart 4). The idea behind the CAPE model is to remove the cyclicality of corporate profits when computing the P/E ratio. The CAPE model gauges stock valuations under the assumption that real (inflation-adjusted) EPS converges to its trend line. Importantly, the CAPE ratio is a structural valuation model, i.e., it works over the long run. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions. Below, we discuss the risks to Chinese corporate profits from both cyclical and structural viewpoints. We contend that a low CAPE ratio might not be unreasonable for listed Chinese companies, as their profitability has deteriorated over the past 10-12 years and their secular profit outlook is very uncertain. 3. The equity risk premium incorporates interest rates into valuations. We computed the equity risk premium by subtracting Chinese onshore government bond yields in real terms (deflated by headline CPI) from the trailing earnings yield of stocks. Chart 5 demonstrates that the equity risk premiums for A shares and investable stocks are near their historical mean, signifying neutral Chinese equity valuations at present. Relative to DM and EM equities, Chinese valuations appear to be attractive as Chinese share prices have massively underperformed their EM and DM peers in the past 12 months (Chart 6). Bottom Line: Chinese equity valuations are by and large neutral in absolute terms. When equity valuations are neutral, the next move in share prices depends on the profit outlook. If profits expand/contract, stocks will rally/sell off. Corporate Earnings: The Cyclical Outlook Chinese corporate profits are set to contract in this downturn. Chart 7 shows that Chinese aggregate industrial profits will shrink by single digits in the next nine months from a year ago. This model is based on a regression of aggregate industrial profits on China’s credit impulse. A similar model that regresses A-share non-financial companies’ net profits on narrow money (M1) growth is also pointing to a roughly 5% corporate earnings contraction in the months ahead (Chart 8). Is government stimulus sufficient to produce a recovery in the business cycle and in company earnings? So far, government stimulus has been insufficient to produce a meaningful recovery in H1 2022. In particular, the changes in the excess reserve ratio lead the credit impulse by six months, and the latter signifies only a stabilization, but not a meaningful improvement in the credit impulse prior to May 2022 (Chart 9). Given that the credit impulse leads industrial companies’ earnings by about nine months (please refer to Chart 7 above), odds are that corporate profits will not bottom until H2 2022. As for service industries, online retail sales of goods and services remain weak, reflecting sluggish household income growth (Chart 10). There has also been another factor weighing on China’s business cycle – a declining marginal propensity to spend among both households and companies (Chart 11). The marginal propensity to spend depends on sentiment and confidence among consumers and companies. A declining propensity to spend will dampen the positive effects from government stimulus. Notably, there has been a dramatic profit divergence in industrial sectors. Commodity-producing sectors – metals and mining, steel, energy and coal – have posted an earnings windfall. In contrast, industries consuming commodities – machinery, construction materials, autos, IT and food/beverages – have seen their profits plunge (Chart 12).           The reason for this industrial earnings dichotomy is that commodity prices have not fallen despite the weakness in China’s business cycle and its commodity imports (Chart 13). Critically, commodity users have not been able to pass on higher input costs to their customers due to weak demand. Consequently, commodity users have experienced a drastic profit margin squeeze and their earnings have plummeted. If commodity prices drop meaningfully, the profit divergence between these two groups of industrial enterprises will narrow. Yet, it will not improve the level of overall industrial profits in China. The rationale is that in the past six months, industrial profits of commodity users have accounted for 20% of aggregate industrial profits, while those of commodity producers have accounted for 80%. This reinforces the importance of commodity prices in driving China’s industrial profit cycles. Our view on commodity prices is as follows: Commodity prices have so far ignored China’s slowdown. However, the Fed’s tightening and the US dollar’s persistent strength amid the lack of a meaningful recovery in the Chinese business cycle will eventually produce a drawdown in resource prices in the coming months, as we discussed in last week’s report. Bottom Line: As policy stimulus gets more aggressive, China’s growth and corporate earnings will recover in H2. Yet, in H1 corporate profits are set to disappoint. This implies that Chinese share prices will remain in a risk window for now. Corporate Profitability: The Structural Outlook Investors reward companies with high or rising return on equity by bidding up their equity multiples, and vice versa. One of the main reasons why the structural valuation measures for Chinese equity indexes (like the CAPE ratio) have declined in the past 10 years is worsening corporate profitability. Specifically, the return on assets (RoA) and the return on equity (RoE) for non-financial companies included in the MSCI A-share and Investable indexes have been falling since 2011 (Chart 14, top and middle panels). Periodic government stimulus improved corporate profitability temporarily. Yet, as stimulus waned, corporate profitability deteriorated. Consistently, Chinese investable non-TMT stocks have produced zero price appreciation in absolute terms since 2011 (Chart 14, bottom panel). In the past 10 years, there has been a structural deterioration in the financial performance metrics of industrial companies. Their RoE and RoA have fallen as have turnover in account assets (sales/assets), inventory (sales/inventory) and account receivables (sales/account receivables) (Chart 15). It is unclear if this secular trend of deteriorating corporate financial performance will reverse if authorities repeatedly rescue the economy by unleashing large stimulus. As for technology/internet/platform companies, we maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity and low multiples. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, many US institutional investors will likely offload their holdings of these companies. Finally, Chinese bank stocks are cheap for a reason. They have not recognized a massive amount of non-performing loans and have not provisioned for them. Going forward, another roadblock to shareholders of Chinese stocks is the common prosperity policies that the Chinese government has championed. These policies will redistribute income away from shareholders to the general population. Chart 16 illustrates the share of labor compensation has been rising since 2011 while the share of profits has been declining. Not surprisingly, Chinese investable non-TMT stocks have been doing very poorly since 2011 (Chart 14, bottom panel). The common prosperity policies will only reinforce the existing trend of a rising share of labor compensation at the expense of shareholders in the coming years. This bodes ill for structural profitability and justifies low equity multiples. In short, a low CAPE ratio for Chinese stocks might not be out of line with such a downbeat secular outlook. Bottom Line: Even if there have been – and still will be – great companies in China that deliver phenomenal performance, their shareholders might not be in a position to reap the benefits of such solid performance. In short, the structural outlook for profitability among listed companies remains uncertain. Investment Recommendations Chinese stocks, especially investable ones, are oversold and might rebound in the very near term in absolute terms. However, the three-to-six-month outlook for absolute performance remains poor. Relative to EM and global stocks, Chinese equities are very oversold and offer value. Hence, their relative performance will likely enter a rollercoaster phase. Onshore Chinese stocks will underperform onshore government bonds. Within the Chinese equity universe, we have been recommending the following strategies and they remain intact: Long A shares/short MSCI Investable index since March 4, 2021 (Chart 17, top panel). This relative ratio is overbought and will likely pull back in the near term. However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Short Chinese investable value stocks/long global value stocks since November 26, 2020 (Chart 17, middle panel). This strategy remains intact. Short onshore and investable property stocks versus their respective benchmarks since May 9, 2019 (Chart 17, bottom panel). The woes of property developers are not over. Please refer to our Special Report on the Chinese property market. Long large banks/short medium and small listed banks since October 2016. Small and medium banks are exposed to the continuous woes in the property market much more than the large ones. Also, their profitability will be more negatively affected by the retrenchment in shadow banking activities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company.

Special Report

Highlights Chinese stocks are currently trading close to their fair value in absolute terms. When equity valuations are neutral, the direction of the next move in stocks depends on the profit outlook. Chinese corporate earnings are set to contract in the next six months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Historically, share prices lagged the turning points in China’s money/credit impulses by several months. Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in the coming months at a lower level. Relative to EM and global stocks, Chinese equities offer value. Hence, their relative performance will likely enter a rollercoaster phase. The secular outlook for corporate profitability among listed Chinese companies remains uninspiring. Hence, a structural re-rating of China stock indexes is unlikely. Feature With Chinese share prices down considerably in the past 12 months, a pertinent question is whether they offer an attractive entry point. Dissecting both valuations and the corporate earnings outlook are the key to getting the cyclical view right. This report aims to do this for both the MSCI Investable and MSCI A-share equity indexes. Our conclusion is as follows: in absolute terms, the Chinese MSCI Investable and A-share indexes have neutral valuations. Yet, the risk window for share prices remains open because corporate profits are set to contract. Also, bottoms and peaks in the money/credit cycle lead share prices by several months as illustrated in Chart 1. Hence, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Chart 1China: Lead-Lag Relationship Between Share Prices And Money/Credit Cycles Varies Valuations Chart 2Chinese Equity Valuation in Absolute Terms Chinese equity valuations are by and large neutral. Specifically: 1. According to our aggregate composite valuation indicators, onshore A shares are fairly valued while the MSCI Investable index is slightly above its historical mean (Chart 2). This aggregate composite valuation indicator for both equity indexes is composed of three components: based on (1) median multiples; (2) 20% trimmed-mean multiples; and (3) equal-weighted multiples. The latter uses equal weights rather than market cap weights for sub-sectors in the calculation. In turn, each component is constructed using the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and the bottom 10% of sub-sectors, i.e., it removes outliers. 2. We have also calculated a cyclically adjusted P/E (CAPE) ratio for both A shares and MSCI Investable stocks. The CAPE ratio for A shares is slightly below its historical mean (Chart 3), and the one for the MSCI Investable index is one standard deviation below its mean (Chart 4). Chart 3China A-Shares: CAPE Ratio Chart 4Chinese MSCI Investable Stocks: CAPE Ratio The idea behind the CAPE model is to remove the cyclicality of corporate profits when computing the P/E ratio. The CAPE model gauges stock valuations under the assumption that real (inflation-adjusted) EPS converges to its trend line. Importantly, the CAPE ratio is a structural valuation model, i.e., it works over the long run. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions. Below, we discuss the risks to Chinese corporate profits from both cyclical and structural viewpoints. We contend that a low CAPE ratio might not be unreasonable for listed Chinese companies, as their profitability has deteriorated over the past 10-12 years and their secular profit outlook is very uncertain. 3. The equity risk premium incorporates interest rates into valuations. We computed the equity risk premium by subtracting Chinese onshore government bond yields in real terms (deflated by headline CPI) from the trailing earnings yield of stocks. Chart 5 demonstrates that the equity risk premiums for A shares and investable stocks are near their historical mean, signifying neutral Chinese equity valuations at present. Relative to DM and EM equities, Chinese valuations appear to be attractive as Chinese share prices have massively underperformed their EM and DM peers in the past 12 months (Chart 6). Chart 5Equity Risk Premium For China Chart 6Chinese Equity Valuations Relative To EM And DM Bottom Line: Chinese equity valuations are by and large neutral in absolute terms. When equity valuations are neutral, the next move in share prices depends on the profit outlook. If profits expand/contract, stocks will rally/sell off. Corporate Earnings: The Cyclical Outlook Chinese corporate profits are set to contract in this downturn. Chart 7 shows that Chinese aggregate industrial profits will shrink by single digits in the next nine months from a year ago. This model is based on a regression of aggregate industrial profits on China’s credit impulse. A similar model that regresses A-share non-financial companies’ net profits on narrow money (M1) growth is also pointing to a roughly 5% corporate earnings contraction in the months ahead (Chart 8). Chart 7China: Industrial Profits Will Post A Single Digit Contraction Chart 8Chinese A-Share Profits Will Shrink In Mid-2022 Is government stimulus sufficient to produce a recovery in the business cycle and in company earnings? So far, government stimulus has been insufficient to produce a meaningful recovery in H1 2022. In particular, the changes in the excess reserve ratio lead the credit impulse by six months, and the latter signifies only a stabilization, but not a meaningful improvement in the credit impulse prior to May 2022 (Chart 9). Given that the credit impulse leads industrial companies’ earnings by about nine months (please refer to Chart 7 above), odds are that corporate profits will not bottom until H2 2022. As for service industries, online retail sales of goods and services remain weak, reflecting sluggish household income growth (Chart 10). Chart 9Liquidity Is Pointing To Stabilization But Not A Surge in The Credit Impulse Chart 10China: Internet Sales Are Disappointing There has also been another factor weighing on China’s business cycle – a declining marginal propensity to spend among both households and companies (Chart 11). The marginal propensity to spend depends on sentiment and confidence among consumers and companies. A declining propensity to spend will dampen the positive effects from government stimulus. Notably, there has been a dramatic profit divergence in industrial sectors. Commodity-producing sectors – metals and mining, steel, energy and coal – have posted an earnings windfall. In contrast, industries consuming commodities – machinery, construction materials, autos, IT and food/beverages – have seen their profits plunge (Chart 12). Chart 12Dramatic Profit Divergence Between Commodity Producers And Users Chart 11China: The Marginal Propensity To Spend Is Declining       Chart 13Chinese Imports Of Key Commodities Have Shrunk Drastically     The reason for this industrial earnings dichotomy is that commodity prices have not fallen despite the weakness in China’s business cycle and its commodity imports (Chart 13). Critically, commodity users have not been able to pass on higher input costs to their customers due to weak demand. Consequently, commodity users have experienced a drastic profit margin squeeze and their earnings have plummeted. If commodity prices drop meaningfully, the profit divergence between these two groups of industrial enterprises will narrow. Yet, it will not improve the level of overall industrial profits in China. The rationale is that in the past six months, industrial profits of commodity users have accounted for 20% of aggregate industrial profits, while those of commodity producers have accounted for 80%. This reinforces the importance of commodity prices in driving China’s industrial profit cycles. Our view on commodity prices is as follows: Commodity prices have so far ignored China’s slowdown. However, the Fed’s tightening and the US dollar’s persistent strength amid the lack of a meaningful recovery in the Chinese business cycle will eventually produce a drawdown in resource prices in the coming months, as we discussed in last week’s report. Bottom Line: As policy stimulus gets more aggressive, China’s growth and corporate earnings will recover in H2. Yet, in H1 corporate profits are set to disappoint. This implies that Chinese share prices will remain in a risk window for now. Corporate Profitability: The Structural Outlook Investors reward companies with high or rising return on equity by bidding up their equity multiples, and vice versa. One of the main reasons why the structural valuation measures for Chinese equity indexes (like the CAPE ratio) have declined in the past 10 years is worsening corporate profitability. Specifically, the return on assets (RoA) and the return on equity (RoE) for non-financial companies included in the MSCI A-share and Investable indexes have been falling since 2011 (Chart 14, top and middle panels). Periodic government stimulus improved corporate profitability temporarily. Yet, as stimulus waned, corporate profitability deteriorated. Consistently, Chinese investable non-TMT stocks have produced zero price appreciation in absolute terms since 2011 (Chart 14, bottom panel). In the past 10 years, there has been a structural deterioration in the financial performance metrics of industrial companies. Their RoE and RoA have fallen as have turnover in account assets (sales/assets), inventory (sales/inventory) and account receivables (sales/account receivables) (Chart 15). It is unclear if this secular trend of deteriorating corporate financial performance will reverse if authorities repeatedly rescue the economy by unleashing large stimulus. Chart 14Worsening Profitability Has Been Behind Poor Equity Returns in China Chart 15Chinese Industrial Companies: Structural Deterioration in Financial Performance As for technology/internet/platform companies, we maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity and low multiples. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, many US institutional investors will likely offload their holdings of these companies. Finally, Chinese bank stocks are cheap for a reason. They have not recognized a massive amount of non-performing loans and have not provisioned for them. Going forward, another roadblock to shareholders of Chinese stocks is the common prosperity policies that the Chinese government has championed. These policies will redistribute income away from shareholders to the general population. Chart 16 illustrates the share of labor compensation has been rising since 2011 while the share of profits has been declining. Not surprisingly, Chinese investable non-TMT stocks have been doing very poorly since 2011 (Chart 14, bottom panel). Chart 16National Income Composition: Labor’s Share Will Continue Rising The common prosperity policies will only reinforce the existing trend of a rising share of labor compensation at the expense of shareholders in the coming years. This bodes ill for structural profitability and justifies low equity multiples. In short, a low CAPE ratio for Chinese stocks might not be out of line with such a downbeat secular outlook. Bottom Line: Even if there have been – and still will be – great companies in China that deliver phenomenal performance, their shareholders might not be in a position to reap the benefits of such solid performance. In short, the structural outlook for profitability among listed companies remains uncertain. Investment Recommendations Chart 17Our Recommendations For Chinese Equity Investors Chinese stocks, especially investable ones, are oversold and might rebound in the very near term in absolute terms. However, the three-to-six-month outlook for absolute performance remains poor. Relative to EM and global stocks, Chinese equities are very oversold and offer value. Hence, their relative performance will likely enter a rollercoaster phase. Onshore Chinese stocks will underperform onshore government bonds. Within the Chinese equity universe, we have been recommending the following strategies and they remain intact: Long A shares/short MSCI Investable index since March 4, 2021 (Chart 17, top panel). This relative ratio is overbought and will likely pull back in the near term. However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Short Chinese investable value stocks/long global value stocks since November 26, 2020 (Chart 17, middle panel). This strategy remains intact. Short onshore and investable property stocks versus their respective benchmarks since May 9, 2019 (Chart 17, bottom panel). The woes of property developers are not over. Please refer to our Special Report on the Chinese property market. Long large banks/short medium and small listed banks since October 2016. Small and medium banks are exposed to the continuous woes in the property market much more than the large ones. Also, their profitability will be more negatively affected by the retrenchment in shadow banking activities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company.

Special Report

Highlights We introduce a novel concept called the ‘wealth impulse’, which describes the counterintuitive relationship between wealth and economic growth. To the extent that GDP growth is impacted by wealth, the impact comes not from the level of wealth or from the change in wealth, but from the change in the increase in wealth – which we define as the wealth impulse. The global wealth impulse has entered a downcycle, which tends to last 1-2 years. Previous downcycles in the wealth impulse in 2010-11, 2013-14, and 2018-19 all coincided with US economic growth falling to, or remaining at, below-trend. A similar pattern could emerge through 2022-23. Previous downcycles in the wealth impulse also coincided with strong down-legs in the 30-year T-bond yield. This supports our view that while the long bond yield could rise by a further 40-50 bps, the recent spike in yields is simply a tactical countertrend move within a broader structural downtrend, which remains intact. Fractal trading watchlist: Bitcoin, the euro, EUR/CZK, semiconductors, and Polish 10-year bonds. Feature Feature ChartThe 'Wealth Impulse' Has Peaked The post-pandemic synchronized boom in global house prices and global stock markets has caused an unprecedented windfall in household wealth. Albeit, it is a windfall that is highly concentrated in the top fraction of the world’s households. Many commentators claim that this unprecedented wealth windfall will boost economic growth in 2022-23 through the so-called ‘wealth effect’. However, these claims belie a basic misunderstanding about how wealth impacts economic growth. In this short Special Report, we introduce a novel concept called the ‘wealth impulse’, which describes the true relationship between wealth and economic growth. Using this concept of the wealth impulse we explain why, somewhat counterintuitively, wealth will be a headwind rather than a tailwind to growth in 2022-23 (Chart I-1). It Is The ‘Impulse’ Of Wealth That Drives Growth, And The Impulse Has Peaked In accounting terms, wealth is a stock. By contrast, GDP is a change in a stock, or flow, meaning that GDP growth is a change in a flow. It follows that, to the extent that GDP growth is impacted by wealth, it must also come from the change in the flow of wealth: in other words, not from the level of wealth and not from the change in wealth, but from the change in the increase in wealth. We define this as the ‘wealth impulse’ (Charts 1-2-Chart 1-5) Chart I-2The Level Of Real Estate Wealth Has Surged… Chart I-3…But The Impulse Is Fading Chart I-4The Level Of Stock Market Wealth Has Surged… Chart I-5...But The Impulse Is Fading To be clear, your stock of wealth will also generate a flow through dividends, rents, and interest income. And the higher the level of your wealth, the larger this flow will be – Bill Gate’s flow is much larger than Joe Sixpack’s flow. But given that these income flows are dwarfed by the capital gains flows, they will play second fiddle for all-important spending growth. If all of this sounds somewhat convoluted, let’s illuminate the concept with a simple example. Say that your starting wealth of $1000 increased by $100 in 2020, and by another $100 in 2021. In this case, you have effectively gained a constant additional ‘capital gain’ flow to your income flow. Let’s say you spent a constant tenth of these capital gain flows. What would be the growth in your spending? The counterintuitive answer is zero. As there is no change in these capital gain flows, the wealth impulse would be zero, and there would be no growth in your spending: it would be $10 in 2020 and $10 in 2021. To get economic growth from the wealth effect, the increase in your wealth in 2021 would have to be greater than the $100 increase in 2020. Let’s say the increase was $150. In this case, the wealth impulse would be 50 percent and your spending would grow from $10 to $15.1 Now let’s say that after this $150 increase in 2021, your wealth increased by $200 in 2022. Given that the 2022 increase was greater than the 2021 increase, the wealth impulse would be positive, and your spending would grow. But what about the rate of growth? The counterintuitive answer is that economic growth would slow, because the wealth impulse has declined to 33 percent (200/150) in 2022 from 50 percent (150/100) in 2021. To the extent that GDP growth is impacted by wealth, it must come from the change in the increase in wealth, which we define as the ‘wealth impulse’. Finally, let’s say that your wealth increased by a further $150 in 2023. In this case, the wealth impulse would turn negative, to -25 percent (150/200). The counterintuitive thing is that, despite an increase in wealth, your spending would contract. In fact, this is precisely what is happening in the real world. The wealth impulse peaked in the second half of 2021, and has entered a downcycle. Significantly, downcycles in the wealth impulse tend to last 1-2 years, and end up in deeply negative territory. Hence, contrary to what the commentators are claiming, the ‘wealth effect’ tailwind to growth is already fading, and is highly likely to become a headwind through 2022-23. Creating A Composite Wealth Impulse By far the largest component of household wealth is real estate, meaning the value of our homes. Significantly, through the past decade, global real estate prices have become highly synchronized and correlated. Hence, we can derive a real estate wealth impulse from a reliable monthly US house price index, such as the S&P/Case-Shiller Home Price Index. One rejoinder is that real estate wealth should be measured net of the mortgage debt that is owed on our homes. However, as the wealth impulse is a change of a change in wealth, and the mortgage debt changes very slowly, it does not really matter whether we calculate the impulse from gross or net real estate wealth. Either way, the impulse is fading. The wealth impulse peaked in the second half of 2021, and has entered a downcycle. The other significant component of household wealth comes from the exposure to equities. Hence, we can derive an equity wealth impulse using a broad equity index such as the MSCI All Country World. Significantly, the equity wealth impulse also peaked in 2021 and has already fallen to zero. We can then create a ‘composite’ wealth impulse which combines real estate and equities in the three to one proportion that households hold these two main assets. Unsurprisingly, this composite wealth impulse is also fading fast (Chart I-6). Chart I-6The Composite Wealth Impulse Has Peaked One final issue relates to the periodicity of calculating the wealth impulse. All the analysis so far has related to the 1-year impulse: that is, the 1-year change in the 1-year increase in wealth. This periodicity should match the time that it takes for wealth changes to impact household behaviour. Based on theoretical and empirical evidence, the optimal periodicity is indeed around a year – especially as we also assess the change in our incomes and taxes over a year. But what if households react faster to the change in their wealth? We can address this by looking at the 6-month wealth impulse: that is, the 6-month change in the 6-month increase in wealth. These 6-month impulses for both real estate wealth and composite wealth are already deeply in negative territory (Chart I-7 and Chart I-8). Chart I-7The 6-Month Real Estate Wealth Impulse Has Turned Negative Chart I-8The 6-Month Composite Wealth Impulse Has Turned Negative What Does A Wealth Impulse Downcycle Mean? There are several drivers of economic growth and the wealth impulse is a marginal player amongst these drivers. Still, while the wealth impulse may not be the overarching cause of growth, it does have the potential to amplify the growth cycle in either direction.  Downcycles in the wealth impulse have coincided with strong down-legs in the 30-year T-bond yield. In this regard, it is notable that in the post-GFC era, upcycles in the wealth impulse have coincided with accelerations in US economic growth. Whereas downcycles in the wealth impulse through 2010-11, 2013-14, and 2018-19 have all coincided with growth falling to, or remaining at, below-trend. A similar pattern could emerge through 2022-23, in stark contrast to what many commentators are predicting (Chart I-9). Chart I-9Wealth Impulse Downcycles Coincide With Fading Or Sub-Par Growth Unsurprisingly, the post-GFC downcycles in the wealth impulse have also coincided with strong down-legs in the 30-year T-bond yield. This supports our view that while the long bond yield could rise by a further 40-50 bps, the recent spike in yields is simply a tactical countertrend move. The broader structural downtrend in the long bond yield remains intact (Chart I-10). Chart I-10Wealth Impulse Downcycles Coincide With Down-Legs In The 30-Year T-Bond Yield Fractal Trading Watchlist From this week, we are pleased to introduce a new section: a fractal trading ‘watchlist’, which will highlight investments that are approaching, but not yet at, points of fractal fragility that presage upcoming turning points. This will help to prepare future trades. In the starting watchlist, we highlight potential upcoming buying opportunities for bitcoin, the trade-weighted euro, and EUR/CZK, and an upcoming selling opportunity for semiconductors versus technology. Catching our eye this week though is the very aggressive sell-off in Polish government bonds relative to their peers. Inflation has surged everywhere, including in Poland, but the inflation rate in Poland remains below that in the US. This means that the massive underperformance of Polish bonds seems overdone, confirmed by an extremely fragile 260-day fractal structure (Chart I-11). Chart I-11The Underperformance Of Polish Bonds Is Overdone Accordingly, the recommended trade would be to overweight Polish 10-year bonds versus US 10-year T-bond (or German 10-year bunds), setting the profit-target and symmetrical stop-loss at 8 percent. Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1  In practice, your income flow might also rise slightly. Assuming a yield of 2 percent on your $1000 initial wealth, and a 10 percent growth rate, your income flows would evolve from $20 to $22 (in 2020) to $24.2 (in 2021), equalling a $2.2 rise in 2021. But these would be dwarfed by the capital gain flows of $100 and $150, equalling a $50 rise in 2021. Admittedly, the propensity to spend income flows is higher than the propensity to spend capital gain flows, but assuming we spend half our income flow versus a tenth of our capital gain flow, the increase in the capital gain flow would still drive the growth in spending ($5 versus $1.1). Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - ##br##Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dear Client,In this special issue we present the first commentary for the BCA Research US High-Quality Stock Selection strategy, which represents the next evolution of the Equity Analyzer service.The strategy, constructed exclusively using the Equity Analyzer toolset, provides reliable exposure to high-quality US securities through the BCA Score factor model, while maintaining sector neutrality relative to the US market.Most importantly, the underlying portfolio is now offered through BCA Research Investment Solutions, which provides turn-key and directing-indexing implementations of our quantitative signals.  This solution marks the most accurate and practical implementation of our equity factor model to-date.For more information about the strategy, including historical performance metrics, or, to learn how to incorporate this service into your investment process, please contact investmentsolutions@bcaresearch.com.Performance RecapThe US equity market regained its composure in month of December 2021, with investors seeing through the rapidly spreading but seemingly less pathogenic Omicron variant. The US High-Quality strategy (USHQ), which closely tracks movement in the SPDR S&P 500 ETF (SPY, approx. 90% correlation since inception), also had a strong month, with an outperformance of 0.49% relative to SPY.1 Since last quarter, strategy performance has been mostly in line with the US market (Chart 1), with modest downside protection and lower daily return volatility (Table 1), which are typical characteristics of the strategy.Returning to the most recent month of trading (December 2021), we are reminded that tech and health care continue to have a major influence on total returns given their weight in the US market. The USHQ portfolio was able to gain ground against SPY through outperformance in 8 out of 11 GICS Level 1 sectors, namely in tech and health care (Chart 2). Within SPY, mega-cap symbols continued to provide strong contributions2 with AAPL, TSLA, FB, MA, and UNH leading the pack. Downside impact was muted, with ADBE being the top detractor. The USHQ strategy had solid breadth across constituents, with a few holdings standing out in tech and health care. The top/bottom 10 contributors for the month of December are shown in Table 2A and Table 2B. Table 12021Q4 Statistics* At the current juncture, US equities are experiencing increased volatility due in part to a hawkish tone from the Federal Reserve. The latest set of FOMC minutes point to a mid-march liftoff date. This comes amid sustained inflationary pressures and a move towards maximum employment in the US. Not surprisingly, the market has corrected slightly against this backdrop. As of end-of-day January 11, 2022, USHQ is down -0.3% MTD vs -1.7% for SPY.Factor BreakdownIn this section we examine the current factor landscape for the USHQ portfolio, SPY, and the broad US equity universe.The current factor exposure for the USHQ portfolio and SPY is shown in Chart 3. It is up to date as of the latest portfolio rebalance (Jan 3, 2021). The methodology is similar to that used by the Factor Analyzer widget on the Equity Analyzer (EA) platform. We define the composite factor exposure as the difference between the portfolio or fund-weighted average factor score and the average score of our stock universe. In this case the stock universe consists of the top 1000 US stocks according to market cap. Composite factor scores are obtained from the EA platform and range from 0% to 100%.The portfolio will tend to have a positive factor exposure on most factors as it holds the top ranking stocks in each sector according to the BCA Score.  The factor exposure of SPY will vary from month to month depending on the evolution of the market. In the ideal environment, the strategy should have positive BCA Score exposure relative to the market index. Practically speaking, this provides verification that the strategy is correctly tilted towards the factors we deem important for managing market risk.The values in Chart 4 can be interpreted as the difference between the dark green bars and light green bars in Chart 3. This month, we observe that the valuation gap between the portfolio and SPY has narrowed relative to last month. This was mainly due to a drop in the Value Score of USHQ, which can be explained by a significant price appreciation in the strategy's tech holdings. Increased exposure to Technicals for USHQ and SPY indicate that both are increasingly weighted towards firms with strong momentum over the past 12 months.When considering the broad US equity universe on an equal-weighted basis, it’s clear that the composite Value factor has experienced a resurgence over the past month (Chart 5). The BCA Score metric has remained robust over the same period, with the core model components outperforming on a long/short basis. The current factor landscape reflects a switch to an environment of rising interest rates, as seen by the movement of the 10-year Treasury yield. Based on a previous study of factor performance in different rate environments, the outlook for Quality factors remains strong, as we are currently in an environment of high3 and rising rates (Chart 6).Portfolio Constituents SummaryThis section provides information about the latest holdings in the portfolio as of last rebalance (Jan 3, 2021). The current sector composition is shown in Chart 7 with changes since last rebalance shown in parentheses. New positions in the portfolio are shown in Table 3A, and closed positions are shown in Table 3B. Movement of securities in and out of the portfolio is driven primarily by the level of the factor model ranking (BCA Score) at the time of rebalance.Specifically, positions are closed when the BCA Score drops below 70% and the Composite Macro Score is below 75%. The closed positions are replaced with high-ranking securities from the pool of top 1000 US stocks by market capitalization. Rebalancing occurs on the first trading day of each month. The number of securities in the portfolio currently sits at 55, with 5 stocks occupying each of the 11 GICS Level 1 sectors.Footnotes1   Calculated for the latest portfolio intra-rebalance period (2021-12-01 to 2022-01-03) using dividend-adjusted end-of-day pricing.2   Contribution defined as fund or portfolio-weighted return during the given month.3  As determined by our moving average (MA) cross indicators. Rates are considered “high” if the 3-month MA is above the 3-year MA. 

Highlights This week we highlight key charts for US Political Strategy themes and views in the New Year. For H1 2022, we maintain a pro-cyclical, risk-on approach. We favor industrials, energy, infrastructure, and cyclicals. Foreign supply kinks will persist due to Omicron. The US Congress will pass one more spending bill as Democrats try to save their skin ahead of the midterm election. Yet other trends are not so inflationary: Fed rate hikes, an 8% of GDP fiscal drag, and a looming return to congressional gridlock. Midterm elections usually see defensive and growth stocks outperform cyclical and value stocks. This is a risk to our view and may require adjustments later this year. Feature This week we offer our updated US Political Strategy chart pack for the new year. Inflation and stagflation are the top concerns. But the Federal Reserve is kicking into gear, with the market now expecting three-to-four interest rate hikes in 2022 alone. We doubt that will come to pass but it is possible and there is no question that a 12-month core PCE print of 4.7% is forcing the Fed to move. Since the mega-stimulus of March 2020, markets have seen a 91% rally in the S&P 500 and a 114% rally in the tech sector. Ultra-low interest rates and stay-at-home policies created a paradise for tech stocks. But the 10-year Treasury yield surged from 1.45% in December, when Omicron emerged and the Fed turned hawkish, to 1.76% today. An inflation-induced pullback and rotation out of tech stocks was to be expected and has been our most consistent sectoral view. Long-term inflation expectations have not taken off, however. Many investors see secular stagnation over the long run – and even in the short run the resilient dollar should work against inflation. Not only will the Fed wind down asset purchases by $30bn a month starting January 2022 and start hiking rates in March, but also the budget deficit is contracting, making for an 8% of GDP fiscal drag in 2022. In addition the market no longer has any confidence that Congress will pass President Biden’s “Build Back Better” plan. We still think a reconciliation bill will pass, albeit in watered down form. But ultimately the looming midterm election will paralyze Congress, as we argued in our 2022 outlook report, “Gridlock Begins Before The Midterms.” Gridlock will ensure that whatever passes only modestly expands the long-term deficit and then that fiscal taps will be turned off in 2023. In the context of Fed hikes, this should reduce fears of inflation later in 2022, though we still see inflation as a persistent long-term problem. If history is any guide, stocks and bond yields will be flattish for most of the year due to election uncertainty. The difference between this year and other midterm years is that the US consumer is in better financial shape and yet foreign supply kinks will persist due to Omicron. The takeaway is to prefer industrials, energy, small caps, and cyclicals, even though we may not maintain these recommendations for the whole year. We are hedging by staying long health care stocks. Omicron: Less Relevant At Home, More Relevant Abroad American economic growth is declining but will likely settle at or above trend (Chart 1A). Money growth, a proxy for stimulus, is also coming off its peaks while credit growth is rising moderately. The long deleveraging of the American consumer since 2008 appears to have come to an end. But it is too soon to say how aggressively Americans will lever back up and whether a new private sector “debt super cycle” will begin (Chart 1B). Chart 1AEconomic Growth Peaked, Will Slow To Trend Chart 1BEconomic Growth Peaked, Will Slow To Trend The Omicron variant of COVID-19 will have a modest negative impact early in the year. Hospitalizations are picking up in the wake of a surge in new cases following Christmas gatherings. Only 61% of Americans are fully vaccinated and only 23% have received the booster shot that is most effective against Omicron (Chart 2A & Chart 2B). Yet new deaths from the disease remain subdued and only about a fifth of those hospitalized go to the intensive care unit today. Chart 2BCOVID-19 Continues But Relevance Wanes Pharmaceuticals, both vaccines and anti-viral medications, are saving the day and Americans are becoming resigned to the likelihood of getting the virus at some point. Social mobility has dropped off since summer 2021 but will boom in the springtime and consumer confidence is already picking back up (Chart 3A & Chart 3B). The Biden administration is not likely to impose unpopular social restrictions during an election year unless a variant is deadlier, more contagious, and resistant to vaccines, which is not the case with Omicron. Chart 3AOmicron Not A Major Setback For Recovery The resilience of the US will come with persistent inflation in goods given that Omicron will still cause supply disruptions abroad. Not all countries have as effective vaccines when it comes to Omicron – if they maintain tighter social restrictions, prices of imported goods will continue to rise. The Fed cannot resolve foreign bottlenecks. While manufacturing surveys show bottlenecks easing from last year’s highs, foreign supply constraints will remain a problem throughout the year. Chart 3BOmicron Not A Major Setback For Recovery Buy The Rumor, Sell The News Of “Build Back Better” The Biden administration and Democratic Party are still likely to pass one last blast of fiscal spending – the “Build Back Better” budget reconciliation act, a social welfare bill. The output gap is virtually closed and the economy does not need new demand stimulus. However, the Democratic Party needs a legislative win ahead of the midterm election. Thin majorities in both chambers of Congress enable a single senator to derail the bill. But the bill’s provisions are popular among political independents and especially the Democratic Party’s base, which is lacking in enthusiasm about the election as things stand (Charts 4A & 4B). Moderate Democrats in the Senate are still negotiating: their goal is to chop the plan down to size and pass only the most popular provisions, rather than to sink the president and their own party. This means the bill’s top-line spending will be further reduced. The final size should fall from the earlier range of $2.5-$4.7 trillion to $2.3 trillion or less. Add a few tax hikes, like the minimum corporate tax, and the deficit impact will be around $600 billion (Table 1). Table 1"You’ve Gotta Pass It To See What’s In It" Ultimately we cannot have high conviction on the BBB plan because we cannot predict what a single senator will do. That is a matter of intelligence, not macro analysis. But subjectively we still give 65% odds that the Democratic Party will circle the wagons and pass the bill. The party views itself as surrounded by populism on both its right and left flanks – a failure to compromise will whet the appetites of both the Sanderistas (left-wing populists) and the Trumpists (right-wing populists) (Chart 5A). The Republicans still have a better position in the states, and the states have constitutional control of elections, so establishment Democrats are more terrified than usual of flopping in the midterm elections (Chart 5B). Otherwise the midterms – which are already likely to be bad for the Democrats – will deal a devastating blow. Republicans are recovering in party affiliation and tentatively surpassing Democrats among independent voters (Chart 6A). Biden and the Democrats lashed out at former President Trump and the Republican Party on the anniversary of the January 6, 2020 rebellion, but this tactic will not lift their popularity in polls. Their current polling is not much better than that of Republicans in 2018, when the latter suffered a bruising defeat in the midterms (Chart 6B). Chart 6ADemocrats Need A Win Before The Midterm Biden’s legislation would reduce the fiscal drag marginally in fiscal year 2023 but overall the budget deficit will shrink and then lie flat over 2022-24 regardless of what Congress does (Chart 7). New spending would be marginally inflationary over the long run since the budget deficit is expected to expand again beyond fiscal year 2024. Republicans will not be able to slash the budget until they control both Congress and the White House, but in that case they are likely to prove big spenders as in the past. Populism will persist on all sides: the political establishment will keep trying to use fiscal profligacy to peel voters away from populists, who are even more fiscally profligate. Only an inflation-induced recession will restore some fiscal discipline – and that is a way off. Ultimately the significance of the BBB bill is to verify whether establishment politicians – fiscal authorities – are capable of moderating their spending plans according to the threat of inflation, as Modern Monetary Theory maintains. Otherwise the implication is that polarization and populism will produce fiscal overshoots regardless of near-term inflation, even with the narrowest of possible majorities in Congress. The latter, a BBB fiscal overshoot, is what we expect. If it happens it will probably be received negatively by the equity market, fearing faster Fed rate hikes, and it would add credibility to long-term concerns about inflation, because it would reveal that fiscal authorities are not good at adjusting in real time. The former, a BBB failure and a halt to fiscal spending, would suggest that fiscal extravagance remains a crisis-era phenomenon and will be reined in by Congress after a crisis passes, which is probably positive for equities. It would at least suggest that fiscal authorities will adjust when the facts change. Of course, how investors respond to any legislative outcome will depend on a range of factors. But the takeaway is this: Inflation fears may or may not peak in the short run but they will persist over the long run. The Fed: Focus On The Framework In the wake of the Great Recession the Federal Reserve as an institution – both the Federal Open Market Committee and the Board of Governors – shifted in a more accommodative or dovish direction (Chart 8). The shift culminated in the review of monetary policy strategy in August 2020, which produced average inflation targeting. In practice the dovish policy shift is apparent in a real Fed funds rate at -4%, the lowest level since the inflationary 1970s under Fed Chair Arthur Burns. But what is more remarkable is the simultaneous surge in the budget deficit, unlike anything since World War II, and unlike anything in peacetime (Chart 9). Chart 9Inflation And Stagflation Risks The massive increase in federal debt, from 34% of GDP in 2000 to 75% before COVID-19 and 106% today, acts as a constraint on any future Fed hawkishness (Chart 10). A Fed chair who drives interest rates too high amid high debt levels will cause a recession and force the debt-to-GDP ratio up even higher. Yet the result of low rates is to stimulate indebtedness. While the private debt super cycle has subsided, a public debt super cycle is thriving. Chart 10A Major Check On Fed Hawkishness This brings us to today’s predicament. The Fed’s criteria for raising interest rates have mostly been met: 12-month core PCE inflation is running at 4.7% while the inflation breakeven rate in the Treasury market suggests that inflation is well anchored and likely to persist above the 2% inflation target for some time (Chart 11A). The economy is virtually at “maximum employment” (Table 2) – the Fed has set aside concerns about low labor force participation to focus on the collapsing unemployment rate, which is now within the range at which it will feed inflation (Chart 11B). Chart 11AThe Fed's Criteria For Liftoff Table 2The Fed’s Criteria For Liftoff Chart 11BThe Fed's Criteria For Liftoff The takeaway is that the Fed is suddenly restoring the credibility of its 2% inflation target, with headline PCE rapidly coming up on the trajectory established in the wake of the Great Recession (Chart 12), as our US bond strategist Ryan Swift has demonstrated. Chart 12Lo And Behold: Debt Monetization Generates Inflation The explosion of fiscal spending played a critical role in generating this new trajectory. The combination of monetary and fiscal accommodation has worked wonders. Assuming the BBB passes, Chairman Powell will face even greater pressure to prevent this correction of the inflation trajectory from overshooting and turning into a wage-price spiral. The unexpected risk would be if the BBB bill fails, the Fed hikes aggressively, global growth sputters, the dollar surges, and Republicans retake Congress — then Powell may yet see disinflationary challenges in his term in office. Our sense is that the BBB will pass, reinforcing Powell’s less dovish pivot, and yet the Fed’s framework will not permit too hawkish of a stance, resulting in persistent inflation risks over the long run. Three Strategic Themes In our annual strategic outlook, we highlighted three structural or strategic themes that are not beholden to the 12-month forecasting period: 1.   Rise Of Millennials And Generation Z: The sharp drop in labor force participation will gradually mend in the wake of the crisis but the aging of the population ensures that the general trend will decline over time as the dependency ratio rises (Chart 13A). Chart 13AStrategic Theme #1: Rise Of Millennials/Gen Z Politically the millennials and younger generations are gaining clout over time, although their partisan identity will also evolve as they mature and gain a greater stake in the economy and become asset owners (Chart 13B). 2.   Peak Polarization: US political polarization stands at historic highs and will likely remain so over the 2022-24 political cycle (Chart 14A). Polarization coincides with the transformation of society amid falling bond yields and technological revolution (Chart 14B). Chart 14AStrategic Theme #2: Peak Polarization Chart 14BStrategic Theme #2: Peak Polarization The pandemic era has been especially polarized due to the 2020 election and controversies over vaccination (Chart 15). Domestic terrorism of whatever stripe is possible (Chart 16). But any historic incidents will generate a majority opposed to political violence. Chart 16Risk Of Domestic Terrorism True, former President Trump is still likely to run on the Republican ticket, which will ensure that polarization remains elevated (Diagram 1). However, US elections hinge on structural factors, not individuals. Diagram 1GOP 2024 Is Up To Trump So far structural factors point to policy continuity: not only are Democrats still slated to retain the White House, but President Biden has coopted many of Trump’s key policies, including infrastructure, protectionism, and big budget deficits (Chart 17). If Democrats falter, Trump’s policies will be reaffirmed. The implication is that a new national policy consensus is taking shape beneath the surface. 3.   Limited “Big Government”: Americans have been turning away from “small government” and toward “big government” since the 1990s. Voters no longer worry so much about budget discipline and instead look for the “visible hand” of government to support the economy (Charts 18A & 18B). Both domestic populism and geopolitical challenges encourage this shift. Industrial policy and domestic manufacturing are making a comeback (Table 3). Table 3Strategic Theme #3: Limited “Big Government” With extremely robust fiscal policy, the US has avoided the policy mistake of the period after the Global Financial Crisis, when premature fiscal tightening undermined the economic recovery (Chart 19). Policy uncertainty will increase as gridlock returns to Congress and fiscal policy will be frozen. But investors need not fear a slide back into deflation. The Republican Party’s populist base may prevent more Democratic social spending but they will not be able to repeal what is done.  Chart 19Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Three Key Views For 2022 The key views for the 12-month period are connected with the above but of a more short-term or cyclical duration: 1.   From Single-Party Rule To Gridlock: Republicans are highly likely to win back control of the House of Representatives and likely the Senate (Charts 20A & 20B). President Biden’s approval rating suggests that Democrats could lose 40 seats in the House (Chart 21) and three in the Senate (Chart 22), whereas they only need to lose five and one to lose control. Our quantitative Senate election model shows an even split but the model’s trend favors Republicans, as does the political cycle and partisan enthusiasm (Chart 23). 2.   From Legislative To Executive Power: Biden may still pass one more spending bill but otherwise the legislature will be frozen. Democrats will not succeed in ramming legislation through by abolishing the Senate filibuster. Biden will turn to executive decree, where he is already on track to make a historic increase in regulation, which will increase concerns among small business (Chart 24A & Chart 24B). Anti-trust laws are unlikely to be overhauled and Democrats will struggle to bring back the tough anti-trust posture of the 1900s-1950s without new legislation, meaning that Big Tech faces a bigger threat from inflation than regulation (Table 4). The green transition will continue but primarily in the form of any subsidies passed in the reconciliation bill, rather than new taxes or any carbon pricing scheme (Chart 25A & Chart 25B). Chart 24AKey View #2: From Legislative To Executive Power Table 4Key View #2: From Legislative To Executive Power Chart 25BGreen Energy: Subsidies But No Carbon Tax   3.   From Domestic To Foreign Policy Risks: Biden faces a slew of foreign policy and external risks that could damage the Democrats in the midterms. The surge in illegal immigration on the southern border is truly historic and will have significant policy ramifications over the long run (Chart 26A & Chart 26B). The surge in inflation will force Biden to contend with foreign policy challenges with one hand tied behind his back, since energy supply disruptions could derail his party ahead of the midterm election (Chart 27). While Biden could ease some inflationary pressure via reduced trade tariffs, protectionist impulses will prevail during an election year (Chart 28). Chart 26AKey View #3: External Risks For Biden Chart 26BKey View #3: External Risks For Biden Chart 27Foreign Policy Could Hit Prices At Pump Chart 28Tariff Relief In 2022? Don't Bet On It Investment Takeaways The stock market tends to be flat, with risks skewed to the downside, during midterm election years due to policy uncertainty. The same is true for bond yields (Chart 29). Chart 29Stocks And Bond Yields Trend Lower Before Midterms ... When united or single-party governments approach midterms, stocks tend to perform worse than for divided governments in midterm years, while bond yields tend to be a bit higher (Chart 30). This trend is supercharged in 2022 due to the inflationary effects of the pandemic. Chart 30... But United Govts See Higher Bond Yields And Weaker Stocks ... Assuming Republicans regain at least the House, the US will transition from united to divided government (gridlock). In previous such transitions, stocks tend to perform in line with the average for a midterm election year, but bond yields skew higher – reinforcing the previous point (Chart 31). Chart 31... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise We will update our US Sector Political Risk Matrix to bring it better into line with our views, particularly in light of Table 5 below regarding sector relative performance during midterm election years. Normally defensives and growth stocks outperform in midterm years, Table 5ConDisc, Tech, Health Do Best During Midterms …But Waning Pandemic Makes An Exception while cyclicals and value stocks underperform, but 2022 looks to be different due to inflation. Still over the course of the year we would expect the historic trend to reassert itself. Investors should favor cyclicals even though they probably cannot outperform defensives for much longer (Chart 32A). We recommend health care stocks as a hedge given that the dollar should still be resilient this year, Fed hikes should moderate inflation expectations, and midterm policy uncertainty will eventually weigh on risk appetite (Chart 32B). Chart 32AFavor Cyclicals, Though They May Not Outperform Defensives Much Longer Chart 32BLong Health Care As Hedge Value stocks are forming a bottom relative to growth stocks, although this trend is less clear in the US, especially among US large caps, than it is abroad (Chart 33). We favor value over growth on a cyclical basis but midterm election uncertainties will pull the other way, making for a choppy bottom. Chart 33Favor Value And Small Caps, Though Bottom Formation Remains Choppy The same process is visible on a sector basis, where energy and materials continue to outperform tech (Chart 34A). We recommend staying long energy on a cyclical basis, though its outperformance against tech could abate later in 2022. Infrastructure stocks – such as building and construction materials – also continue to outperform. Since Biden’s honeymoon period ended, the outperformance is largely relative to tech rather than the S&P as a whole. We still favor infrastructure stocks as the fiscal policy theme will continue even beyond the current legislation, which will barely start to be implemented in 2022 (Chart 34B). Chart 34AFavor Energy, Materials, And Infrastructure Versus Tech Chart 34BFavor Energy, Materials, And Infrastructure Versus Tech   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”.  So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates, and violent and indiscriminate rotation out of the tech names. Companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rear-view window. Supply bottlenecks are easing, so is the ISM activity index, which we interpret as a normalization. When it comes to our style recommendations, we continue preferring small caps over large caps on the back of attractive valuations and favorable economic backdrop. Today, we also upgrade Value / Growth from neutral to OW - rising rates are a tailwind for Value. Recommended Allocation Feature December was a good month for equities (Chart 1). While the beginning of the month was marred by turbulence, induced by the arrival of Omicron, and the Fed shifting to a more hawkish stance, Santa Claus did deliver a rally to close the month, with the S&P 500 rising by 6% and lifting its 2021 gains to an impressive 27%. But 2021 was a wild year for active investors, as only 15% of funds and strategies outperformed the S&P 500. Hence, many investors had to watch the S&P 500 gains from the sidelines: The year was characterized by rotation across sectors and styles. December brought about a sell-off in the most speculative names in the equity market (EEM, IWM, ARKK, BTC, IPO), which has continued unabated into January: The Fed’s imminent monetary tightening is a culprit. Capital has also rotated away from Cyclicals and towards Defensives (the MSCI Cyclicals / Defensive ratio was down 7% in December). However, Cyclicals are starting to rebound from the Omicron slump. Overarching Macroeconomic Themes Omicron or “Omicold”? Either Way, The US Market Is Looking Past It… Little was known about the Omicron variant when it took us all by surprise at the end of November. Fortunately, an expectation that this variant is more contagious but less virulent has come to pass: While the number of cases has surged (nearly, every family I know in the tri-state area has had it by now), the number of hospitalizations has remained contained (Chart 2). The economic damage, at least in the US, has been minor, and mostly due to people being away from work sick or quarantined. It also appears that this COVID wave is close to a peak, which explains the recent outperformance of Cyclicals (Chart 3): The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. Chart 2Omicron Wave Is Close To A Peak... Chart 3...And Cyclicals Are Rebounding Inflation Is Forcing The Fed’s Hand Into An Aggressive Tightening Cycle Fed rate hikes are now all but certain: The market is pricing in four rate hikes in 2022 with a probability of nearly 90% (Chart 4), a noticeable increase from the three rate hikes expected in December 2021. The Fed’s December meeting minutes indicate that the first rate hike may come as soon as March. What is different this time is the inflation backdrop: In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”. The Fed is raising rates to squish growth to tame inflation, giving rate rises a different context: The Fed is behind the curve, and while in the past the stock market took rate hikes in its stride (after a short-lived slump in performance), now market reaction may be much more negative. So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates (Chart 5), and violent and indiscriminate rotation out of the tech names. Chart 4Market Is Expecting Four Hikes In 2022 Chart 5Rates Made A Vertical Move More Wage Raises Are On The Way – A Headwind To Corporate Profitability According to the NIPA, wages constitute about 50% of sales of US companies. Over the past year, nominal wages increased by 5.8% but still could not keep up with rising prices – real wage growth is running at -2.3% (Chart 6). Considering that in 2021 only a minor share of workers got raises – those rejoining the workforce, starting a new job, or members of a few labor unions, the majority of Americans have had no change in income and have been bewildered by prices in the supermarkets. As the new calendar year rolls on, many of these workers will negotiate their salaries to get inflation adjustments (Chart 7). In fact, according to the WSJ, companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rearview window. Chart 6Wages Are Not Keeping Up With Inflation Chart 7Wage-Price Spiral? Another concern is a wage-price spiral, leading to rampant inflation, making the Fed’s job harder, and calling for more aggressive monetary tightening, striking a blow to the stock market. Supply Bottlenecks Are Easing, So Is The ISM Activity Index The ISM Manufacturing index has turned from 64.7 to 58.7 (Chart 8A). Part of the decline in the top-line numbers is due to the resolution of supply-chain bottlenecks: The ISM Supplier Index has fallen from 78.6 to 64.9 (Chart 8B), indicating a reduction in delivery times. On the other hand, the New Orders index has also declined from 68 to 60.4, suggesting that bottlenecks are clearing thanks to the reduction in business activity, which we interpret as a normalization. Of course, zero-tolerance to COVID policy in China and other countries may lead to new production and shipping delays, and another leg up for the inflation readings. Chart 8AISM PMI Has Turned... Chart 8BAnd Not Only Because Of Shorter Delivery Times Styles Comments Small Vs. Large Cap: Sticking To Our Overweight In Small Valuations: Small caps are cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. Profitability: Since 2019, Small has delivered 47% annualized profit growth compared to 14% from Large. The small companies have demonstrated resilience and successfully navigated the economic landscape, plagued with supply bottlenecks, labor shortages, and surging prices (Chart 9A). Small-cap margins have exceeded the historical average and have likely peaked, just like the margins of their larger brethren. According to the NFIB Small Business Survey, a core concern is inflation, but 54% of small companies intend to raise prices, passing on costs to customers. Like all other American companies, they experience labor shortages and are planning to raise wages too. On balance, we believe that small caps will remain profitable and their earnings will continue to grow, albeit at a slower pace, i.e., at 15% (Chart 9B), which is significantly less than 88% in 2021, but more than the 10% growth expected of larger companies. Chart 9ASmall Businesses Are Worried About Inflation And Are Raising Prices Chart 9BEarnings Growth Expectations Have Normalized Macroeconomic Backdrop: Historically, small caps have outperformed large caps in the environment of rising rates (Chart 10), because of higher allocations to Cyclicals, such as Financials and Industrials. Also, while rising rates take the froth off the high-flying growth stocks, smaller companies are cheap and have moderate growth expectations. Overweight Small vs. Large: Attractive valuations and fundamentals, and a high likelihood to perform well when rates are rising, make overweighting Small vs Large an attractive proposition. Risks: While we stay with the call, there are a few caveats: Small caps’ margins are narrow, and continued cost pressures, especially surging labor costs, have the potential to dent their profitability. Further, while empirical analysis indicates that Small outperforms during the rate-hiking cycle, we are concerned that surging inflation may render this analysis less useful – can this time really be different? Growth Vs. Value: Shifting Towards Value Valuations: Over the course of 2021, Growth outperformed Value by 23% (trough to peak), and by 5% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is which is a 70% premium to Value (which is trading at 17x). The Growth/Value BCA Valuation Indicator corrected below the 2 standard deviation mark and is mean reverting. Profitability: Despite significant valuation discrepancy between Growth and Value, both asset classes are set to deliver roughly the same earnings growth over the next year, suggesting that the premium for Quality and Growth may be excessive (Chart 11A). Macroeconomic Backdrop: Since the beginning of the pandemic, performance of Value vs. Growth has been strongly linked to the direction of change in yields (Chart 11B). Growth is overweight long-duration Technology stocks, while Value is highly exposed to Financials, which appear to thrive in the environment of rising rates. Chart 11AGrowth Expectation Are Similar, But Value Is Cheaper Chart 11BRising Rates Are A Tailwind For Value Overweight Value: As we stated in our 2022 Outlook, “Our neutral position [in Growth vs. Value] will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates.” Now, with rate hikes drawing nearer and Omicron peaking, we are changing our neutral allocation to a cyclical overweight in Value, and underweight in Growth. Valuations and the macroeconomic backdrop are at the core of the call. Risks: We may be early with our presumption that Omicron is just an uber-contagious “Omicold” – hospitalizations may still surge, while global lockdowns may cause much economic damage. In that case, rates may remain range-bound, while the Fed may delay rate hikes. Then Growth would be bound to outperform Value.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuation And Technicals Chart 19Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Small Vs Large Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations and Technicals Chart 27Uses Of Cash Recommended Allocation Footnotes  .