Developed Countries

Special Report

Highlights Below-Benchmark Portfolio Duration: Bond investors should keep portfolio duration low in 2022. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Own Treasury Curve Steepeners: The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Sell Short-Maturity TIPS: Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. We also recommend an outright short position in 2-year TIPS, as short-maturity real yields have a lot of upside in 2022. Overweight Corporate Bonds Versus Treasuries … For Now: We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. Overweight Emerging Market Bonds Versus US Corporates: EM bonds offer an attractive spread advantage versus US corporates, and a weakening US dollar will help boost returns in 2022. A Maximum Overweight Allocation To Municipal Bonds: Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. Underweight Agency MBS: Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. Feature BCA published its 2022 Outlook on December 1st. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer seven key US fixed income views for 2022. This report is limited to the seven key investment views, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2022” report that will delve into our outlook for the Fed next year. Outlook Summary First, a summary of the main economic views presented in BCA’s 2022 Outlook.1   On Economic Growth: The COVID-19 pandemic will recede in importance in 2022 allowing US economic growth to remain above trend. Sizeable household savings and wealth will support consumer spending, the composition of which will shift away from goods and towards services. Corporate capital expenditures also look set to surge. On Inflation: A transition in consumer spending from goods to services and an increase in labor supply will cause US inflation to fall in 2022, though it will remain above the Fed’s target. On Fed Policy: The first Fed rate hike will occur between June and December 2022, depending on the paths of inflation and inflation expectations during the next few months. Fed tightening will continue into 2023. On China and Emerging Markets: Further policy easing in H1 2022 will lead to a reacceleration in Chinese economic activity in the back half of the year. The BCA house view is negative on EM equities for now but will turn more bullish when clearer signs of Chinese policy easing emerge. Risks To The Outlook: The greatest risk to the outlook is that the spread of the Omicron variant leads to the re-imposition of public health measures that will weigh on economic activity. The effect of the Omicron variant remains uncertain, but increasingly widespread vaccination and the advent of anti-viral treatments should help mitigate any negative economic impacts. Key View #1: Below-Benchmark Portfolio Duration Bond investors should keep portfolio duration low in 2022, favoring the 2-year maturity over the 10-year. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Our recommendation to keep portfolio duration low in 2022 stems directly from our assessment of Federal Reserve policy. Without going into too much detail – we will do that in next week’s “Fed In 2022” report – the Fed appears to have adopted a more hawkish reaction function during the past month. The Fed’s official forward guidance says that it will not lift rates until the labor market reaches “maximum employment”. However, Fed Chair Jay Powell weakened that commitment in recent Senate testimony. Powell said that persistently high inflation threatens the economic recovery and implied that to reach its maximum employment goal the Fed may need to act pre-emptively to tame inflation. To us, this means that the Fed’s “maximum employment” condition for lifting rates is no longer binding. The Fed will accelerate the pace of tapering when it meets this week and will start lifting rates between June and December of next year, depending on the interim trends in inflation and inflation expectations. After liftoff, Fed rate hikes will proceed at a predictable pace of 75-100 bps per year until economic growth slows significantly. We expect the fed funds rate to reach at least 2% before that occurs, consistent with survey estimates of the long-run neutral fed funds rate. Let’s compare our estimate of the future fed funds rate path with what is currently priced in the bond market (Chart 1). Chart 1The Market's Rate Expectations Liftoff The overnight index swap (OIS) curve is priced for Fed liftoff in May 2022. This is a tad early compared to our projections, but not by much. Pace After liftoff, the OIS curve is priced for the fed funds rate to rise 79 bps during the subsequent 12 months. Again, this is roughly consistent with our own expectations that the Fed will deliver three or four 25 basis point rate hikes per year. Terminal Rate It is the market’s pricing of the endpoint of the next tightening cycle – the terminal fed funds rate – that disagrees significantly with our forecast. The OIS curve is priced for the funds rate to reach 1.5% in 2024 and then stabilize. This is too low. It is too low compared to the last tightening cycle when the fed funds rate reached 2.45% in 2019. It is also too low compared to survey estimates from market participants and primary dealers. The median respondent to the New York Fed’s Survey of Market Participants estimates that the long-run neutral fed funds rate is 2%. The median response to the same question from the Survey of Primary Dealers is 2.25% and the median FOMC participant pegs the long-run neutral rate at 2.5%. Meanwhile, the 5-year/5-year forward Treasury yield – a rough proxy for the long-run neutral interest rate that’s priced in the Treasury market – sits at only 1.73%. Historically, the 5-year/5-year forward yield converges with survey estimates of the long-run neutral rate as the Fed moves toward tightening (Chart 2). This means the 5-year/5-year forward Treasury yield has at least 27-52 bps of upside in 2022. Chart 25y5y Has Room To Rise Treasury Yield Forecasts Chart 3Treasury Yield Forecasts Chart 3 shows the 2-year, 5-year and 10-year Treasury yields along with the expected paths that are discounted in the forward curve for the next 12 months. The shaded regions in each panel represent our fair value estimates of where those yields will trade if the market moves to price-in our expected future path for the fed funds rate. The upper bound of the fair value range represents the most hawkish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in June, that rate hikes proceed at a pace of 100 bps per year and that the fed funds rate levels-off at a terminal rate of 2.08% (8 bps above the lower-end of a 2%-2.25% target range). The lower bound of the fair value range represents the most dovish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in December 2022, that rate hikes proceed at a pace of 75 bps per year and that the fed funds rate levels-of at a terminal rate of 2.08%. Chart 3 shows that the 10-year Treasury yield is well below even the lower-end of our fair value range. The 5-year Treasury yield is a bit too low compared to our target range and the 2-year yield is consistent with our fair value range, though at the very upper-end. The investment conclusions are obvious. Bond investors should keep portfolio duration low in 2022. They should avoid the 10-year maturity and allocate most funds to shorter maturities like the 2-year. It should be noted that we used a conservative 2.08% terminal rate estimate in the scenarios presented in Chart 3. This is at the low-end of most survey estimates. What’s more, the BCA Outlook makes a strong case that those survey estimates will be revised higher once it becomes apparent that interest rates will have to rise to well above 2% to contain inflation. We agree that survey estimates of the long-run fed funds rate are probably too low, but we don’t expect them to be revised higher in 2022. Upward terminal rate revisions are probably a story for 2023 or 2024, sometime after the Fed has delivered a few rate hikes and it becomes apparent that more will be needed to slow an overheating economy. Appendix A at the end of this report translates different fed funds rate scenarios into 12-month expected returns for every Treasury maturity. We show scenarios where the liftoff date varies between June 2022 and December 2022, where the pace of rate hikes varies between 75 bps and 100 bps per year and where the terminal fed funds rate varies between 2.08% and 2.58%. The 10-year Treasury note is projected to deliver negative returns in every scenario we tested. Meanwhile, the 2-year Treasury note is projected to deliver a small positive return in every single scenario. These results support our conclusion from Chart 3. Investors should maintain below-benchmark portfolio duration and favor short maturities over long maturities. Risks To The View The first risk to our bearish view on US Treasuries is a resurgence of the pandemic. The 10-year Treasury yield continues to track the “pandemic trade” in the stock market. That is, the 10-year yield rises when a basket of equities that benefit from economic re-opening outperforms a basket of equities that benefit from lockdowns, and vice-versa (Chart 4). So far, the news about the virulence of the Omicron COVID variant has been encouraging, and our base case scenario assumes a further easing of pandemic concerns over the course of 2022. The second risk to our view is that the Fed moves too aggressively toward rate hikes causing an abrupt tightening of financial conditions that weighs on economic growth and sends long-dated bond yields lower. The shaded region in Chart 5 shows that this exact dynamic played out in 2018. Fed rate hikes started to pressure the dollar higher and weigh on equities. This led to tighter financial conditions and slower economic growth. The impact of tighter financial conditions was not immediately evident in the bond market, but slower growth eventually caused the Fed to back away from rate hikes leading to a late-2018 peak in the 10-year yield. Chart 410yr Tracks The "Pandemic Trade" Chart 5Watch Financial Conditions In 2022 Compared to the 2018 scenario, we see less risk of Fed over-tightening in 2022 mainly because the fed funds rate is starting out at a much lower level. However, it will be important to track financial conditions as the Fed moves toward liftoff. Undue tightening would cause us to reverse our positioning. Key View #2: Own Treasury Curve Steepeners The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. We also recommend buying the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond as an attractive duration-neutral carry trade. The scenarios presented in the prior section show that the 2-year Treasury yield is priced within the bounds of our estimated fair value range while the 10-year Treasury yield looks too low. Logically, it makes sense to position for a steepening of the 2/10 Treasury curve to profit from this divergence. Chart 6 illustrates the implications of the prior section’s fair value estimates for different Treasury slopes. Our fair value range projects that the 2/10 Treasury slope will be between 38 bps and 89 bps in 12 months, above the 37 bps that is currently priced into the forward curve. The forward curve is also priced for too much flattening in the 2/5 Treasury slope, while the 5/10 slope is consistent with the lower end of our fair value range.   The conclusion is that investors should implement 2/10 Treasury curve steepeners in 2022 on the expectation that the 2/10 slope will flatten by less than what is currently discounted in the forward curve. A comparison of the 5-year/5-year forward Treasury yield with a target range based on survey estimates of the long-run neutral fed funds rate also supports the case for 2/10 steepeners. Historically, an increase in the 5-year/5-year forward yield towards its target range corresponds with a steepening of the 2/10 slope (Chart 7). Bear-flattening moves in the 2/10 slope only occur when the 5-year/5-year forward is within its target band, as was the case in 2017/18. Given that the 5-year/5-year forward yield is currently well below its survey-derived target range, there is room for some 2/10 steepening as yields rise. Chart 6Treasury Slope Forecasts Chart 7A Rising 5y5y Will Steepen The Curve One way to position for a steeper 2/10 curve is to go long the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Presently, this trade looks very attractive. The 2/5/10 butterfly spread shows a significant yield advantage in the 5-year bullet over the 2/10 barbell, both in absolute terms and relative to our fair value model (Chart 8). While we view this as a good trade, we don’t think it’s the best way to position for 2/10 steepening. We prefer a position long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. This trade gives you long exposure at the 2-year maturity instead of the 5-year maturity which will boost returns if the 2/5 slope steepens, as we anticipate it will (Chart 6, panel 2). Chart 8Curve Steepeners Are Cheap In addition to our recommended 2/10 steepener, we advise clients to favor the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. While we’d expect some flattening of the 10/30 slope in 2022, this trade should still perform well because of its huge carry advantage. The tables in Appendix A show that the 20-year bond earns a massive 12-month carry (income plus rolldown return) of 3.05% compared to 1.85% for the 10-year note and 1.80% for the 30-year bond. Key View #3: Sell Short-Maturity TIPS Chart 9TIPS Breakevens Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Other attractive positions include: an outright short position in 2-year TIPS, an inflation curve steepener (short 2yr TIPS/long 2yr nominal/long 10yr TIPS/short 10yr nominal), and a TIPS curve flattener (short 2yr TIPS/long 10yr TIPS). As noted at the beginning of this report, we see inflation trending down in 2022. Inflation will remain high enough for the Fed to feel comfortable lifting rates, but it won’t match the elevated readings that are currently discounted in TIPS. Interestingly, long-maturity TIPS breakeven inflation rates are roughly consistent with the Fed’s 2.3%-2.5% target range (Chart 9). The 5-year/5-year forward TIPS breakeven inflation rate is a bit too low, at 2.13%, and the 10-year TIPS breakeven inflation rate is currently 2.47%. With long-dated TIPS breakevens so close to the Fed’s target, we recommend a neutral allocation to long-maturity TIPS versus long-maturity nominal Treasuries heading into 2022. In our view, the mispricing in TIPS lies at the front-end of the curve. The 2-year TIPS breakeven inflation rate has risen to 3.23%, well above the Fed’s 2.3%-2.5% target range. This year’s surge in short-maturity TIPS breakevens has also resulted in a deeply inverted inflation slope (Chart 9, bottom panel). Table 1Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) Short-maturity inflation expectations are highly sensitive to changes in CPI inflation, much more so than long-maturity expectations. In fact, monthly changes in the 2-year CPI swap rate are more than twice as sensitive to headline inflation than are monthly changes in the 10-year CPI swap rate (Table 1). This means that the cost of short-maturity inflation compensation will decline as inflation moderates in 2022. We recommend an underweight allocation to short-maturity TIPS versus short-maturity nominal Treasuries. We also think an outright short position in 2-year TIPS will be highly profitable in 2022. If we assume that the 2-year TIPS breakeven inflation rate falls to the middle of the Fed’s target range during the next 12 months, and additionally that the 2-year nominal Treasury yield converges with our fair value estimate using the scenario of a September Fed liftoff, 100 bps per year hike pace and 2.08% terminal rate, then we calculate that the 2-year TIPS yield will rise from its current -2.56% to -0.98% during the next 12 months (Chart 10). Chart 10A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS Chart 10 also shows that the anticipated rise in the 2-year TIPS yield greatly outpaces the modest expected increase in the 10-year TIPS yield. This means that a position in 2/10 TIPS curve flatteners will turn a profit in 2022 (Chart 10, bottom panel). Key View #4: Overweight Corporate Bonds Versus Treasuries … For Now We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. A key pillar of our corporate bond investment process is to split the economic cycle into three phases based on the slope of the yield curve (Chart 11). Phase 1 of the cycle is defined as the period from the end of the last recession until the 3-year/10-year Treasury slope breaks below 50 bps. Phase 2 of the cycle spans the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Chart 11The Three Phases Of The Economic Cycle Our historical analysis shows that excess corporate bond returns versus duration-matched Treasuries tend to be strongest in Phase 1. They are usually positive, but much lower, in Phase 2 and are often negative in Phase 3 (Table 2). Table 2Corporate Bond Returns Across The Three Phases Of The Cycle We have been firmly in Phase 1 since April 2020 and, as we would expect, excess corporate bond returns have been strong. However, we will not remain in Phase 1 much longer. The 3-year/10-year Treasury slope is currently 50 bps, right on the precipice between Phase 1 and Phase 2. We recommend an overweight allocation to corporate bonds versus Treasuries for now, but we will adopt a more defensive posture toward corporates once we transition into Phase 2. We expect this will happen sometime in the first half of 2022. Why Are We Not In Phase 2 Already? Chart 12Curve Flattening Is Overdone The 3-year/10-year Treasury slope is hovering right around 50 bps. However, as is noted earlier in this report, we think that recent yield curve flattening is overdone and expect it to reverse somewhat in the coming months. Chart 12 shows the 3-year/10-year slope along with an expected fair value range. This range is based on a 100 bps Fed rate hike pace, a 2.08% terminal rate and varying the liftoff date between June 2022 and December 2022. This fair value range only breaks below 50 bps between March and September of next year. Given our yield curve view, we are positioned for one last period of strong corporate bond outperformance during the next few months. But we will turn more defensive once we judge that we have sustainably transitioned into a Phase 2 environment. Why Turn More Defensive In Phase 2? Chart 13IG Corporate Valuations It’s correct to point out that excess corporate bond returns are still generally positive in Phase 2 environments, so ideally, we would remain overweight corporate bonds versus Treasuries throughout Phase 2. This makes sense theoretically, but strategically we think it will be wise to adopt a different approach this cycle. The main reason to err on the side of caution is that corporate bond valuations are extremely stretched. The 12-month breakeven spread for the investment grade corporate bond index is at its 6th percentile since 1995. This means that the investment grade corporate bond index has only been more expensive than today 6% of the time since 1995 (Chart 13). Tight spreads mean that expected returns will be modest, even in a favorable cyclical environment. In other words, we are not sacrificing much expected return by reducing exposure early in the cycle. Given that we can’t predict the start of the next Phase 3 period with exact precision, we think it makes sense to be more defensive this cycle. We will sacrifice some modest expected returns to ensure that we are well positioned for the next period of significant spread widening. Our corporate bond strategy is supported by an empirical study of historical returns. Table 3A shows average 12-month excess returns for the investment grade corporate bond index after certain combinations of the 3/10 Treasury slope and average index option-adjusted spread (OAS) are observed. Table 3B shows 90% confidence intervals for the averages presented in Table 3A. The tables show that a strategy of remaining overweight corporate bonds versus Treasuries after the yield curve transitions into Phase 2 only works when the corporate index OAS is above 100 bps. A transition into Phase 2 portends negative excess corporate bond returns when the OAS is below 100 bps, as it is today. Favor High-Yield Over Investment Grade Chart 14HY Corporate Valuations While investment grade corporate bonds look extremely expensive compared to history, high-yield corporate bonds look somewhat expensive, but much less so. The average High-Yield index OAS is 1 bp below its pre-COVID low, but investors still get a nice spread pickup for moving out of the Baa-rated credit tier and into the Ba-rated tier (Chart 14). Our prior research has shown that high-yield corporates tend to outperform duration-matched Treasuries when the excess index spread after accounting for default losses is above 100 bps.2 If we assume a minimum required excess spread of 100 bps and a 40% recovery rate on defaulted debt, we can calculate that the junk index is priced for a default rate of 3.4% during the next 12 months (Chart 14, bottom panel). All available evidence suggests that the default rate will come in below 3.4% during the next 12 months, leading to positive excess returns for high-yield corporate bonds. The default rate came in at 1.8% for the 12-month period ending in November and it has been dropping like a stone, consistent with the reading from our Default Rate Model (Chart 15). We also recently wrote about the exceptionally good health of corporate balance sheets.3 We expect the default rate will be in the mid-2% range in 2022, below what is priced into the junk index. Chart 15Corporate Defaults Will Stay Low In 2022 Junk’s valuation advantage leads us to recommend that investors maintain a preference for high-yield corporates over investment grade. We will turn more defensive on both investment grade and high-yield corporates once we transition into a Phase 2 environment, but we may still retain our preference for high-yield over investment grade at that time, as long as junk stays relatively cheap. Key View #5: Overweight Emerging Market Bonds Versus US Corporates Investment grade USD-denominated Emerging Market bonds (both sovereigns and corporates) will outperform US corporate bonds with the same credit rating and duration in 2022. EM bonds offer an attractive spread advantage versus US corporates, and 2022 returns will be boosted by a weakening US dollar. We see an opportunity in Emerging Market (EM) bonds for US investors in 2022. Note that we are only referring to investment grade EM bonds denominated in US dollars. We consider both investment grade USD-denominated EM sovereign bonds and investment grade USD-denominated EM corporate & quasi-sovereign bonds. EM Sovereigns Chart 16EM Sovereigns EM sovereigns have modestly outperformed Treasuries so far this year (see Appendix B for a complete breakdown of year-to-date performance for different corporate bond sectors), and yet the sector remains attractively valued in the sense that the average index OAS has still not recovered its pre-COVID low (Chart 16). A look at recent performance trends shows that EM sovereigns outperformed credit rating and duration-matched US corporates in H2 2020 when the sector benefited from a huge yield advantage and a rapidly depreciating US dollar.4 This year, EM sovereigns lagged US corporates as the dollar strengthened. Looking ahead to 2022, we think that the recent bout of dollar strength is close to its end as the bond market has already moved to price-in an extremely hawkish Fed outlook at the front-end of the curve. A flat or depreciating dollar will benefit EM bonds in 2022, as will the yield advantage in EM sovereigns versus credit rating and duration-matched US corporates (Chart 16, panel 4). This yield advantage will only look more attractive as the Treasury curve flattens and the outlook for US corporate spreads deteriorates. At the country level, we see the best EM sovereign opportunities in Mexico, Russia, Chile, UAE, Qatar and Saudi Arabia. The bonds of all these countries outperformed credit rating and duration-matched US corporate bonds during the past 12 months, and they continue to offer a sizeable spread advantage (Chart 17). EM Corporates & Quasi-Sovereigns The investment grade USD-denominated EM Corporate & Quasi-Sovereign index shows a similar relative return pattern to the EM Sovereign index, though overall performance has been better (Chart 18). We see that the index outperformed credit rating and duration-matched US corporates dramatically in H2 2020 when the dollar was under pressure. Relative returns have been more stable this year as the dollar has strengthened. Chart 18EM Corporates & Quasi-Sovereigns EM corporates & quasi-sovereigns should continue to outperform credit rating and duration-matched US corporates in 2022. A weaker dollar will certainly help, but the main driver of outperformance will be the very attractive yield advantage (Chart 18, panel 4). Key View #6: A Maximum Overweight Allocation To Municipal Bonds Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. US bond investors should favor tax-exempt municipal bonds relative to both Treasuries and equivalently-rated corporate bonds. Long-maturity tax-exempt municipal bonds continue to be one the most attractively priced assets in the US fixed income space. As we discussed in a recent report, one big reason for the attractive valuation is that municipal bonds tend to pay premium coupon rates.5 This significantly reduces the duration risk in long-dated munis. The first two columns of Table 4 show the yield ratios and breakeven tax rates between different municipal bond sectors and duration-matched Treasury securities. We see that the breakeven tax rate – the tax rate that equalizes after-tax yields between the two sectors – is a mere 11% for 12-17 year general obligation munis. The breakeven tax rate between 12-17 year revenue munis and duration-matched Treasuries is only 3%, and the longest-maturity munis actually offer a before-tax yield advantage versus Treasuries! Table 4Muni/Treasury And Muni/Credit Yield Ratios Table 4 shows that munis also offer excellent value compared to corporate bonds with the same credit rating and duration, especially at the long-end of the curve. Breakeven tax rates between munis and corporate credit range from 3% to 21% for maturities longer than 12 years. What’s even more impressive about municipal bonds is that their attractive valuations are buttressed by extremely high credit quality. State & local government balance sheets have received a huge boost from federal stimulus during the past two years, and this has sent net state & local government savings (revenues minus expenditures) surging into positive territory (Chart 19). But it’s not just federal stimulus that has aided state & local governments. Even if we exclude transfer payments altogether, we find that the difference between tax receipts and consumption expenditures is rising sharply relative to interest expense (Chart 19, panel 2). Ratings agencies have noticed the improvement in state & local government budgets and ratings upgrades have far outpaced downgrades during the past year (Chart 19, bottom panel). Chart 19State & Local Balance Sheets In Good Shape Key View #7: Underweight Agency MBS Chart 20Poor MBS Performance Will Continue Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. We noted in a recent report that Agency Mortgage-Backed Securities have performed poorly in 2021.6 The main reason for the poor performance is that the compensation for prepayment risk embedded in MBS spreads (aka option cost) started the year at a very low level, but mortgage refinancing activity has been much higher than expected (Chart 20). The conventional 30-year MBS option cost has been rising, but it is still only back to where it was in 2019 (Chart 20, panel 2). This is not sufficiently attractive for us to advocate buying MBS. While rising bond yields will be a tailwind for refi activity in 2022, we still expect the pace of refinancings to be relatively strong because the rapid run-up in home prices has made it extremely enticing for households to tap the equity in their homes through cash-out refis. Within a recommended underweight allocation to MBS, we recommend that investors favor higher coupon securities over lower coupon ones. Higher-coupon MBS carry less duration than lower-coupon MBS and also wider OAS and greater convexity. This means that high-coupon MBS will outperform low-coupon MBS if bond yields rise in 2022, as we expect they will. Appendix A: Treasury Return Forecasts   Appendix B: US Bond Sector Year-To-Date Performance Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2022: Peak Inflation – Or Just Getting Started?”, dated December 1, 2021. 2 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020. 3 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4 A weaker dollar tends to benefit USD-denominated EM bonds because it makes it easier for foreign issuers to service their dollar denominated debts. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 6 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it. Economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. Corporate profitability will return to trend. The likely deceleration in earnings growth and margin contraction will be driven by a combination of factors: A slowdown in top-line growth, a decline in corporate pricing power, and increases in labor and input costs. The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle, and volatility is heightened. We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation as in the middle single digits. Overweight Small vs. Large for the following reasons: First, Small is expected to outperform in an environment of rising rates - A BCA view for 2022. Second, Small is cheap. Third, the profitability of Small has improved dramatically which attests to the ability of smaller companies to efficiently manage their operations even under duress. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double of Large, 20% vs. 10%. We are neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. Overweight Cyclicals vs. Defensives as the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives. Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. Further, rising rates is an environment favorable for Cyclicals at the expense of Defensives. Within Cyclicals, we prefer the following sectors and themes: Consumers are flush with cash and there is strong pent-up demand for services and selected consumer goods like services: Overweight Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Also, overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. New Capex Cycle: Businesses bring their supply chains back to the US and excess consumer demand has driven the need for expanded capacity. Capex intentions are on the rise. Overweight Construction and Engineering, Building Materials, and Capital Goods. New Credit Cycle: Early signs that both consumer and business lending is picking up. Rising rates will also lend a helping hand to Banks – overweight Overweight Energy as demand for oil is robust on the back of global recovery and chronic underinvestment in Capex. Underweight resource stocks, which are exposed to a slowdown in China. The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. Overweight Real Estate and Homebuilders Multi-year structural themes are Millennials, Generation Z, EV revolution, and Cybersecurity. 2022 will be a big year for the new technology themes. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports. Feature House Views Last Week, BCA published its annual outlook, a transcript of our yearly discussion with the firm’s long-time clients, Mr. X and his daughter, Ms. X. In this document, we discussed the major themes for 2022. Below are some of the main conclusions: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. We expect actual inflation will come in lower next year than what short-maturity inflation expectations currently suggest. Economic growth in advanced economies will be above trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the latter half of next year rather than in the coming six months. Stocks will outperform bonds in 2022, but equity market returns will be in the single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may increase in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields—which will not threaten economic activity or cause a major decline in equity multiples. Equity investors should favor small-cap over large-cap stocks in 2022. Small-cap stocks tend to outperform when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year but stretched relative performance versus defensives means that we expect to rotate away from cyclicals at some point over the coming year. A window exists for value outperformance versus growth in 2022, in response to higher long-maturity government bond yields. We do recommend the former over the latter. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. In this report, we will explore the implications of the above views for US Equities. 2022 Is A Year Of Normalization If 2021 passed under the banner of recovery, 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it, variants and all, and it will become less disruptive to the economy and our personal lives. As such, economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. US Economic Growth And Corporate Profitability Will Return To Trend The economy is expected to grow at a robust pace next year (7.3% nominal GDP growth), albeit slower than this year (Chart 1). After a growth surge on the back of the post-COVID recovery, the economy has entered the slowdown phase of the business cycle. Economic growth is poised to shift closer to its long-term trend in 2022. Corporate profitability is also expected to trend lower next year (Chart 2). While corporate earnings in 2021 have been impressive, this performance is unlikely to be repeated, as the unique circumstances of the pandemic and the recovery are giving way to more ordinary business conditions. Amid the pandemic and during the early innings of recovery, companies have cut costs aggressively, improved productivity, while lower interest rates have reduced debt servicing burdens, and a weaker dollar has boosted overseas earnings. As the economy restarted, sales growth surged, and corporate pricing power was on the rise thanks to significant pent-up demand for goods and services and consumers being flush with cash. Chart 1Economic Growth Will Return To Trend Chart 2Sales Growth Is Poised To Slow   In 2022, earnings growth will return to trend (Chart 3). The likely deceleration in earnings growth and margin contraction (Chart 4) next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth, a decline in corporate pricing power, i.e., the ability of companies to raise prices, which has been diminished by consumers’ income increasing slower than inflation. Chart 4Profit Margins Are Set To Compress In the meantime, the tight labor market is putting upward pressure on wage growth (Chart 5). Labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items. Input costs are also on the rise with PPI soaring, cutting into corporate profitability (although we do expect PPI to decelerate) (Chart 6). Chart 5Wage Growth Is Accelerating Chart 6Corporate Pricing Power Has Been Waning In addition, there are a few minor expenses that are set to rise in 2022: Capex recovery will push up depreciation expense, interest expense is set to go up because of rising rates and corporate re-leveraging, and taxes are projected to increase, especially for the US multinationals exposed to the international minimum tax. And of course, there is also an appreciating dollar, diminishing the translated value of overseas profits. While each of these line items is minor, in concert they will have a noticeable adverse effect on corporate profitability. We provide analysis of the S&P 500 margins in Marginally Worse and Sector Margin Scorecard reports. 2022: Pedestrian Returns And Higher Volatility The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle (Chart 7). Slowdowns are also usually accompanied by heightened volatility. The TINA trade is still on – there are few inexpensive asset classes, and yield is hard to come by. With rates expected to rise, equities are still a more attractive alternative to bonds (Chart 8). Equities are real assets that do a good job protecting investments from rising prices (that is until inflation triggers tighter monetary policy). With rate hikes still a few quarters away, the party is continuing. There is still a lot of liquidity sloshing around looking for attractive corners of the market. This is manifested in positive equity inflows and a “buy-on-dips” mentality, which, so far, has precluded any major market corrections. Buybacks are on the rise – many corporations have had bumper profits and are returning cash to shareholders (Chart 9). This trend is exacerbated by the current administration’s hostility to M&A activity. Chart 9Buybacks Are Reverting To The Pre-pandemic Level   Returns: Multiple Expansion Passes Baton To Earnings Growth Multiple expansion was a key driver of returns in 2020. In 2021, the baton was passed to earnings growth, which contributed 40% to realized returns this year (Chart 10). 2022 will be more like 2021 than 2020. Multiple expansion is highly unlikely as it tends to be a driver of returns during the recovery stage of the business cycle when the market anticipates economic rejuvenation. Furthermore, valuations are already elevated. When the S&P 500 is trading at over 21x forward earnings, the probability of negative returns over the next 12 months has historically been around 65% (Chart 11). While we believe that there are many factors supporting equities delivering positive returns next year, it is hard to be overly optimistic. Hence, it will be earnings growth again that will rule the day in 2022, with a little help from dividends and buybacks. However, while earnings growth is a key driver of returns, it is expected to slow from the current levels, returning to its historical trend (Chart 12). The blockbuster returns of 2021 will be in the rear-view mirror. Chart 12Earnings Growth Is Slowing Total Return Estimate: Mid-To-High Single Digits Above-trend economic growth and consumer price inflation point to revenue growth in the high single digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, margins are expected to compress in 2022, and earnings growth to decelerate. We proxy sales growth to nominal GDP growth of 7.6%. With margins expected to contract, the best scenario for the degree of operating leverage for the S&P 500 is a historical average of 0.96, translating sales growth into earnings growth of 7.3% (Table 1). For reference, sell-side analysts expect S&P 500 earnings to grow by 8% in 2022 (Chart 13). S&P 500 PE NTM stands at 20.5 which, historically, on average, is about three points below realized PE LTM in 12 months. We assume that PE LTM at the end of 2022 will be 25.6, or a 1.6% contraction from the 25.2 multiple today. Table 12022 S&P 500 Price Target And Total Return Estimate With an average historical dividend yield of 2.2%, we get: (1+7.3%)*(1-1.6%)*(1+2.2%) = 7.9% - Total Return Estimate 4,591*(1+7.3%)*(1-1.6%) =~ 4,850 - Price Target We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation in the middle single digits. The rate of multiple contraction, earnings growth, and dividend yield in 2022 are just educated guesses. Sector And Styles Key Views Small Vs. Large Cap: It Is Finally A Small World 2021 was a tumultuous year for small caps. After a strong outperformance at the beginning of the year on the back of a recovery trade, this asset class has been languishing since March, with each new attempt for a prolonged rally failing (Chart 14). Over the year, small caps have become extremely 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. So why was Small so unloved considering two blockbuster reporting seasons with earnings growth of more than 200%? Even on an annualized basis, since 2019 Small has delivered 47% annualized growth compared to 14% from Large (Chart 15). Moreover, smaller companies have been successful in repairing their balance sheets, which now look much healthier. Chart 14Small Had A Tumultuous Year Small was out of favor as investors fretted about an economic slowdown (Chart 16), the Delta variant (along with the other Greeks), razor-thin margins, and the ability of smaller companies to navigate the economy, plagued with supply bottlenecks and labor shortages. Yet, we went overweight Small vs. Large back in October and are still sticking to our guns. First, Small, which has higher allocations to Cyclicals, such as Financials and Industrials, is expected to outperform in the environment of rising rates (Chart 17) - A BCA view for 2022. Second, in a market where most asset classes are exuberantly expensive, Small is cheap. Third, the profitability of Small has improved dramatically, which attests to the ability of smaller companies to efficiently manage their operations even under duress, as well as to pass costs on to their customers. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double that of Large, 20% vs. 10%. The froth in expectations for the earnings growth of Small has also come down from its peak at 88% and now appears to be a low bar to clear. Chart 16Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Chart 17Small Is Expected To Outperform In The Environment Of Rising Rates What are the risks to this call? If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take. Growth Vs. Value: Be Nimble The story of Growth vs. Value is similar to that of Large vs. Small. Value had a fantastic run as the pandemic started to recede, but then as worries about the Delta variant emerged, Growth took over yet again. Over the past year, Growth outperformed Value by 11%, and by 18% 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 a 80% premium to Value (which is trading at 16x). The Growth/Value BCA Valuation indicator is nearly 3 standard deviations above average, and from a statistical perspective, is 99% likely to mean revert. What makes this valuation discrepancy absurd is that both asset classes are bound to deliver roughly the same earnings growth over the next year, i.e., 10%. What is the deal? Just like Small vs. Large, this year, Value vs. Growth has been strongly linked to the 30-year Treasury yield (Chart 18). This has not always been the case in the past, but since the onset of the pandemic, very long-maturity bond yields have done a good job at explaining the relative performance of these asset classes. Growth is overweight Technology, which has been a star of the “work from home” theme. Further, falling long rates inflate the present value of cash flows and earnings of the growth stocks. In the meantime, Value is highly exposed to Financials, which have a hard time maintaining their profitability during times of falling rates and flattening yield curves. Apart from sector composition, Growth as an asset class has also become synonymous with quality, which comes to the rescue at times of heightened risk aversion and uncertainty. This is usually accompanied by falling rates. Indeed, profit margins for Growth are 7% higher than for Value. Since 2019, the annualized earnings growth of Growth is 14.4% compared to 9.8% for Value. The difference is even more dramatic for Sales growth: 6.5% for Growth vs. -1.1% for Value (Chart 19). Chart 18US Value Versus Growth Is Strongly Correlated With Interest Rates However, while we observe that Growth is more reliable for churning out strong numbers, falling sales of Value indicate substantial pent-up demand for products and services. Value also thrives in the environment of robust economic growth and the steepening yield curve. We are currently neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. We have also retained some exposure to Growth by staying with our overweights to Technology and Pharma, as a means of protecting our portfolio from the kind of volatility we have experienced because of the Omicron scare and the Fed’s policy adjustments. Growth Is Robust And COVID Is Receding: Overweight Cyclicals Cyclical sectors have significantly outperformed Defensives this year (by 12%), benefiting from economic reopening and ubiquitous pent-up demand both from businesses and consumers. Despite a strong run and exceeding the pre-pandemic peak (Chart 20), Cyclicals have room to move higher when compared with the prevailing levels in 2010-2011, but that period reflected resource price levels that we are unlikely to see in the coming year. Yet, we expect further outperformance of Cyclicals in 2022. Chart 20Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Chart 21Cyclicals Rally When COVID Fears Reced We do hope that the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives (Chart 21). Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. For many cyclical sectors, such as Consumer Discretionary, Financials, Real Estate, and Industrials, annualized sales growth from 2019 to 2021 is below historical levels, suggesting that there is room for catchup growth (Chart 22). One of the cornerstones of the BCA outlook is that rates will rise. This is an environment favorable for Cyclicals. Defensive sectors tend to underperform when bond yields are rising, as many of them are heavily indebted and have somewhat fixed cash flows because of regulations (Utilities, Telecoms) or strong competition from cheaper substitutes (Pharma amid challenges from generics and biosimilars). Cyclicals are not that much more expensive than Defensives (22x vs. 19x forward earnings) and are trading with a 13% premium. The Cyclical/Defensive Valuations Indicator has come down from three to two standard deviations (Chart 23). Despite a modest valuations premium, earnings of Cyclical sectors are expected to grow at 25% while Defensives will only grow at 6% over the next 12 months. In short, Cyclicals are more attractive than Defensives as a group, but we prefer a granular approach and handpick cyclical sectors that we expect to thrive in the current macroeconomic environment and have favorable sales and earnings growth prospects. Later in the report, we will discuss some of our cyclical sector picks. Chart 23Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Despite Worries About Inflation, Consumers Still Have Money To Spend: Overweight Consumer Services The US government has supported consumers during the lockdowns with a series of helicopter cash drops to all Americans, enumerated in trillions of dollars. As a result, even nine months after the last cash disbursement, consumers are sitting on $2.3 trillion in excess savings (Chart 24). Extremely loose fiscal and monetary policy have lifted household net worth by 128% of GDP (Chart 25). And while consumers do indeed worry about inflation, expecting it to rise to 7.5% in 12 months, there is still plenty of dry powder sitting in their bank accounts. Chart 24Consumers And Businesses Have A Lot Of Dry Powder Chart 25Household Wealth Has Soared Consumer spending on goods has been above the pre-pandemic trend for months and has recently turned. In the meantime, spending on services is still below pre-pandemic levels, suggesting that there is plenty of pent-up demand (Chart 26). Specifically, spending on sports clubs, public transportation, personal care, medical services, and professional services are still below pre-pandemic levels. Pent-up demand will boost Consumer Services, and we recommend overweights to Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Further, while pent-up demand for goods has generally been met, there are still pockets of demand out there due to shortages, such as for automobiles and selected consumer durables. We are also overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. Chart 26Spending On Services Is Still Below The Pre-pandemic Trend New Capex Cycle: Overweight Industrials Industrials is another cyclical sector that we favor. Supply chain disruptions have demonstrated for many businesses that they need to bring their supply chains back to the US, launching the US Manufacturing Renaissance. Also, excess consumer demand has driven the need for expanded capacity. For months now, manufacturers have been inundated with orders (Chart 27). The industrial sector is also exposed to the restocking of inventories and is poised to benefit from the Infrastructure Bill. Therefore, Industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders. Capex intentions have been on the rise as well (Chart 28). Chart 27Producers Inundated With Orders And Need More Capacity To profit from this emerging trend, we are overweight Construction and Engineering, Building Materials, and Capital Goods. Chart 28Surge In Capital Expenditure Will Benefit Industrials New Credit Cycle: Overweight Banks 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. Both businesses and consumers have repaired their balance sheets, and the re-leveraging cycle is set to commence to finance Capex and higher price tag purchases like autos. There are early signs that lending is likely to pick up next year (Chart 29). According to JPM: “The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again.” Credit card spending is recovering (Chart 30). Chart 29Early Innings Of A New Credit Cycle Chart 30Consumers Are Borrowing Again While sell-side analysts anticipate that margins will decline, we believe that they may surprise on the upside: High operating leverage, improving pricing power, and growing demand for loans will contribute to strong profitability. Further, the BCA house view is 10-year rates rising to 2.0 – 2.25% in 2022, which will support net interest margins. Energy Sector Vs. Materials Energy profit margins are linked to underlying commodity prices. The BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate Capex. Although the price of oil has risen above the break-even level, energy companies are reluctant to invest in Capex due to pressure from shareholder activists and newly found financial discipline (Chart 31). As a result, prices are likely to remain high until “high prices cure high prices.” In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yields. Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Chart 31Chronic Underinvestment Is Driving Up Price Of Oil Chart 32A Slowdown In China Is Hurting Demand For Raw Materials Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently – our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year (Chart 32). US Housing Rally Still Has Legs To Run On The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since the GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. The data is also reflective of the supply/demand mismatch with inventories of new and existing homes for sale, and the homeowner vacancy rate at all-time lows, and housing prices exploding higher. At the same time, US building permits are still below the two million SAAR print that historically marked previous housing cycle peaks (Chart 33). The implication is that the current housing boom still has room to go further, benefiting US homebuilders as they monetize the supply/demand mismatch. Homebuilder sentiment rose to a six-month high in November. Tack on the 80bps sell-off in the 30-year US Treasury yield that translates into more affordable mortgage rates for consumers, and there is little that can undercut the US housing market throughout 2022. We are bullish on both the Real Estate and Homebuilders sectors. However, we would be remiss not to mention risks to this call: The performance of the real estate market is highly dependent on the direction of the rates. If long rates rise substantially, this sector will be in the crosscurrents of housing shortages and less affordable mortgages. However, the 2-2.25% 10-year yield that BCA anticipates by end -2022 should not put a significant dent into house ownership affordability. Chart 33Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Risks To The Outlook Rising rates are a key condition for our sector and style calls to pan out. However, if supply chain bottlenecks do not clear soon, inflation will not slow down meaningfully, and the US economy will enter a rising price-wage spiral. The Fed will realize that it is behind the curve and will start hiking rates aggressively, i.e., faster than the pace currently anticipated by the market. As a result, economic growth will disappoint, and the unemployment rate will rise. The yield curve will continue flattening with long rates staying range-bound or moving lower. In this scenario, Growth and Defensives will outperform, while Small, Value and Cyclicals will underperform. Multi-Year Structural Themes To finish, we want to remind clients of our long-term themes, which we expect to continue to pan out next year. Millennials Are Not Coming Of Age; They Are Already Here According to the US Census Bureau, millennials (born 1982 to 2000), are the US's largest living generation and represent more than one-quarter of the US population. This is a generation that is highly educated, and relatively unburdened by debt. While in the past, this generation was perceived as “forever young,” it is rapidly showing signs of maturing: Joining the labor force, starting families, and shopping for houses and cars, thereby pushing consumption up. However, millennials’ consumption basket is different, with an emphasis on new technology, homeownership, electric vehicles, and green energy. ETFs that capture the theme are MILN and GENY. Gen Z Is Coming Of Age And Has Money To Spend Generation Z in the US includes 62 million people born between 1997 and 2012. With $143B in buying power in the US alone, making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. We have created a Gen Z basket with stocks representing fintech, investing and crypto, online gaming, quality-over-price, and some others. There are no ETFs just yet that capture this emerging theme. Cybersecurity Is A Must-Have Global digital transformation as well as rising geopolitical tensions create fertile ground for attacks by both cybercriminals and malicious state actors. The cyber defenses of most private and public companies are still ill-prepared, and the space is poised for robust growth since cybersecurity is a “must-have” for survival. This growing market has attracted a plethora of new cybersecurity players who provide cloud-based SaaS solutions and are well-versed in deploying AI and ML to counter cyber threats. While many of these companies are still young with relatively small capitalization, their potential is enormous. We recommend tactical and structural overweights to the theme. The following ETFs provide exposure to the theme: BUG, CIBR, and HACK. EV Revolution The auto industry is undergoing a major technological disruption. This process is expensive and perilous yet presents an enormous future earnings growth opportunity. And all the ingredients for success are in place: The proliferation of new technologies, government support, changing consumer preferences, and a surging US economy. This tide will lift all boats: Legacy and EV-only auto manufacturers and suppliers as well as EV ecosystem players. We are bullish on the sector on a 12-month investment horizon. ETFs are DRIV, IDRIV, KARS, BATT, and LIT. What We Are Researching For 2022 2022 will be a big year for the new technology themes. Some are brand new, while others have been around for a while. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation