Developed Countries

Highlights Fed: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Nominal Treasuries: We project that Treasury securities will still deliver negative total returns, even if Fed liftoff is delayed until December 2022. Investors can protect returns by favoring the 2-year note (long 2yr over cash/10yr barbell) and 20-year bond (long 20yr over 10yr/30yr barbell). TIPS: Investors should short 2-year TIPS outright in anticipation of falling short-dated inflation expectations during the next 12 months. The Taper Is Done, Now Onto Liftoff The Fed announced a tapering of its asset purchases last week and the details of the tapering plan were consistent with what had already been signaled to the public. The Fed will purchase $70 billion of Treasuries this month (compared to $80 billion in October) and $35 billion of agency MBS (down from $40 billion in October). It will then reduce monthly Treasury and MBS purchases by $10 billion and $5 billion each month, respectively, until it reaches net zero asset purchases by June of next year (Chart 2). The Fed didn’t give specific guidance on what will happen with the balance sheet after June, but it’s highly likely that it will follow the pattern of the last tightening cycle and keep the balance sheet flat for a long time, until the fed funds rate is well above the zero bound. The Fed also gave itself the option to increase or decrease the pace of purchases if such changes are warranted by the economic outlook, but it would take a major shock to knock the Fed off its pre-set course. Chart 1The Market's Liftoff Expectations Chart 2Net Purchases Will Reach Zero By June With the tapering announcement out of the way, the Fed can now turn to the more important question of when to start lifting interest rates. Jay Powell made it clear at last week’s press conference that the committee hasn’t yet formally taken up the issue, but that didn’t stop reporters from pressing the Chairman to provide more details about when the Fed will hike. None of that should be too surprising. There’s intense market interest and a great deal of uncertainty about the timing of Fed liftoff. Two months ago, markets were pricing-in no rate hikes at all in 2022. Now, markets are looking for Fed liftoff at the September 2022 FOMC meeting and are discounting a 90% chance of 2 rate hikes by the end of next year (Chart 1). The Fed’s Thinking On Liftoff So, what did we learn from last week’s FOMC Statement and press conference about how the Fed is thinking about the liftoff date? First, we know from previous comments that the Fed would prefer to reduce net asset purchases to zero before it starts lifting rates. This means that the July 2022 FOMC meeting is the first “live meeting” where a rate hike could possibly occur, and the fed funds futures market is already pricing-in a 74% chance that liftoff will occur at that meeting (Chart 1). We aren’t so sure. In fact, we don’t see the Fed lifting rates until December 2022, and Chair Powell’s comments about inflation at last week’s press conference only increased our confidence in that view. On inflation, Powell echoed comments by Fed Governor Randal Quarles that we flagged in a recent report.1 Both Powell and Quarles put less emphasis on the length of time that inflation remains above the Fed’s target and more emphasis on the causes of that inflation and whether it’s appropriate for the Fed to lean against it. Here’s Powell from last week (emphasis added): Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself. Our tools cannot ease supply constraints. Like most forecasters, we continue to believe that our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline to levels much closer to our 2 percent longer-run goal. Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation. Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.2 Essentially, Powell is pointing out that it would be a mistake for the Fed to tighten policy to bring down inflation only to find out that the economy’s natural supply side response was about to do so anyways. The Fed would have dragged down aggregate demand for no reason. So what would cause the Fed to lift rates? We see two potential triggers. The first liftoff trigger would be an assessment by the FOMC that the labor market has reached “maximum employment”. This is the liftoff condition that the Fed has officially set for itself. The second liftoff trigger would be an uncomfortable increase in long-dated inflation expectations. A spike in long-dated inflation expectations would be worrying enough that the Fed would abandon its “maximum employment” goal and tighten earlier. The “Maximum Employment” Trigger Chart 3How Far From "Maximum Employment"? The concept of “maximum employment” brings a whole host of other issues along with it. How will the Fed know if the labor market is at “maximum employment”? We’ve discussed this topic at length ourselves and have come to a few helpful conclusions.3 First, we can infer from the most recent Summary of Economic Projections that the Fed views an unemployment rate of 3.8% as roughly consistent with “maximum employment”. It is therefore highly unlikely that the Fed will even consider declaring victory on its employment goal until the unemployment rate is in the vicinity of 3.8%, down from its current 4.6% (Chart 3). Second, there are good reasons to believe that the aging of the US population and the recent sharp increase in retirements will prevent the labor force participation rate from re-gaining its pre-pandemic level. However, FOMC participants seem to agree that the prime-age (25-54) labor force participation rate should be close to its February 2020 level for the “maximum employment” condition to be satisfied (Chart 3, bottom panel). Chair Powell even specifically referenced the prime-age participation rate at last week’s press conference. We think a declaration of “maximum employment” will only occur once the unemployment rate is near 3.8% and the prime-age (25-54) labor force participation rate is near its February 2020 level of 82.9%, up from its current 81.7%. It’s unlikely that these conditions will be met in time for a July 2022 rate hike. The Appendix to this report updates our scenarios for the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and participation rates by specific future dates. Our scenarios use the overall participation rate (not the prime-age one), but we think the scenarios derived from the New York Fed’s Surveys of Market Participants and Primary Dealers come close to capturing reasonable conditions for “maximum employment”. Based on those scenarios, we calculate that average monthly nonfarm payroll growth of 602k to 733k is required to reach “maximum employment” by June 2022. Conversely, average monthly payroll growth of only 379k to 455k is required to reach “maximum employment” by December 2022. We see the latter as easily achievable and the former as more of a stretch. On the topic of employment growth, it’s worth noting that both monthly nonfarm payroll growth and the prime-age labor force participation rate were dragged down by the spread of the Delta variant during the past few months (Chart 4). With new COVID cases falling, we should see stronger payroll growth and a higher prime-age part rate in the months ahead. Relatedly, falling COVID cases will also help alleviate some the constraints on labor supply as workers grow less fearful of the virus and more confident about re-entering the labor force. This will not only push prime-age participation higher, but it will also take some of the sting out of wage growth. Wage growth has been extremely high recently as the number of job openings has far outpaced the number of new hires (Chart 5). Fading COVID fears should increase the pace of hiring and slow wage growth. This will give the Fed even more confidence that it should stay the course. Chart 5Peak Wage Growth? The Inflation Expectations Trigger Chart 6Inflation Expectations Are Well-Anchored We noted above that the Fed would abandon its “maximum employment” liftoff condition if long-dated inflation expectations rose to uncomfortably high levels. Specifically, we like to track the 5-year/5-year forward TIPS breakeven inflation rate relative to a target range of 2.3% to 2.5% (Chart 6). As long as the 5-year/5-year breakeven rate stays within that range or below, the Fed will be guided by its “maximum employment” goal. However, if that rate were to break above 2.5% for a significant period of time, the Fed would be sufficiently worried about an expectations-driven inflationary spiral that it would abandon its “maximum employment” trigger and bring forward the liftoff date. We don’t expect to see a breakout above 2.5% in the 5-year/5-year forward TIPS breakeven inflation rate anytime soon. The rate has stayed well contained throughout the past few months even as inflation skyrocketed. It would be strange for it to suddenly spike after inflation has already peaked.4 Bottom Line: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Treasury Market Positioning For A December 2022 Liftoff To determine how we should position within the Treasury market, we translate our above views on the timing of Fed liftoff into fair value estimates for different segments of the Treasury curve. Specifically, we assume a scenario where the Fed starts hiking in December 2022 and then lifts rates at a pace of 100 bps per year until reaching a terminal rate of 2.08%. That 2.08% terminal rate is based on an expected target range of 2%-2.25% that is inferred from responses to the New York Fed’s Surveys of Market Participants and Primary Dealers. We assume that the effective fed funds rate will trade 8 bps above the lower-bound of its target range, as it does currently. Table 1 shows expected 12-month total returns for each Treasury maturity, assuming the market moves to fully price-in our expected funds rate path during the next year. Table 1Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.08% Terminal Rate The first observation that jumps out is that, except for the 2-year and 20-year maturities, expected Treasury returns are negative across the board. This justifies sticking with our recommended below-benchmark portfolio duration stance. Second, our expectation that liftoff will be delayed relative to current market expectations gives the 2-year note slightly better expected returns, particularly relative to the 10-year note. As a result, we advise investors to hold 2/10 yield curve steepeners. Specifically, investors should go long the 2-year note versus a duration-matched barbell consisting of the 10-year note and cash. Third, the 20-year bond looks to be priced cheaply on the curve. It offers expected 12-month returns of +79 bps while the 10-year note and 30-year bond are both projected to lose money. We recommend taking advantage of this situation by going long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This proposed trade offers positive carry of 20 bps (Chart 7). Further, the 10/20 slope is stuck in the middle of where it was on the 2015 and 2004 liftoff dates (Chart 7, panel 2). The 20/30 slope, meanwhile, is inverted and well below where it was on the 2015 and 2004 liftoff dates (Chart 7, bottom panel). Our 20 over 10/30 trade will profit as the 20/30 slope re-steepens, even if the 10/20 slope doesn’t move that much. Chart 7Buy 20s Versus 10s30s It could be argued that our recommend trades are all predicated on a fed funds rate scenario that embeds too low of a terminal rate. In fact, the median projection of FOMC participants would place the terminal rate closer to 2.5% than to 2%. If we alter our scenario by increasing the terminal rate assumption from 2.08% to 2.58%, it only improves the outlook for our recommended positions (Table 2). Table 2Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.58% Terminal Rate In the new scenario, expected Treasury returns are more negative – especially at the long-end. However, the 2-year note is still expected to earn a small profit. Our 20 over 10/30 trade performs slightly worse in this second scenario compared to the first one (+1.79% versus +1.95%), but it is still expected to make money.  TIPS Chart 8A Lot Of Upside In Short-Maturity Real Yields We have one final government bond recommendation based on our expectation that Fed liftoff will be delayed until December 2022. That trade is to go short 2-year TIPS. Alternatively, investors could enter 2/10 inflation curve steepeners or 2/10 real yield curve flatteners. Our base case economic outlook is that supply side constraints (both in global supply chains and in the labor market) will loosen during the next 12 months. This will push down short-dated inflation expectations while long-dated inflation expectations stay relatively close to the Fed’s target. If we assume that both the 2-year and 10-year TIPS breakeven inflation rates trend towards the middle of the Fed’s 2.3% to 2.5% target range during the next 12 months and that the nominal 2-year and 10-year yields follow the paths predicted by the fair value scenario presented in Table 1, then we see that the 2-year real yield has a lot of upside (Chart 8). This is true both in absolute terms and relative to the 10-year real yield. We advise investors to short 2-year TIPS outright. Alternatively, 2/10 inflation curve steepeners or 2/10 real yield curve flatteners will also perform well during the next 12 months. Bottom Line: We suggest four different ways that bond investors can profit from the Fed delaying liftoff until December 2022. Investors should keep portfolio duration low, enter 2/10 nominal curve steepeners, buy the 20-year T-bond versus a 10/30 barbell and short 2-year TIPS.  Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 62.7%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +455k in order to hit “maximum employment” by the end of 2022. Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. Chart A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 2 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf 3 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 4 For more details on our inflation outlook please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Rate Hikes Are Coming – O/W Banks And Small Caps: Rampant inflation is changing investor expectations on the timing and speed of rate hikes. At present, the market is pricing in three rate hikes in 2022. Overweight sectors that outperform in a rising rates environment. Shortages Of Goods – O/W Semis: Overweight industries which are upstream in the supply chain, such as semiconductor manufacturers. They enjoy strong pent-up demand and significant pricing power. Transportation Bottlenecks – O/W Airfreight, Road And Rail: While skyrocketing transportation costs are a boost for most, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Pent-Up Demand For Services – O/W Travel Complex: The ISM PMI Non-Manufacturing composite reading indicates that demand for services still exceeds demand for goods. Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services. Underweight Airlines for now. US Consumers Are Feeling Poorer – This Will Weight On Profits: Real wages are not keeping up with prices, erasing American consumer purchasing power, thus putting a lid on corporate pricing power. This will hurt profits in the Consumer Discretionary sector, in addition to causing broad-based margin compression. Fundamentals Are Strong For Now: Companies delivered blockbuster Q3 2021 earnings results and peak margins. However, an unusually high percentage of companies (52.6%) were guiding lower. Rising labor costs, reduced productivity, and loss of corporate pricing power will lead to margin compression as early as 2022. Strong Equity Inflows Into Year-End: Late-in-year catchup pension contributions translate into strong inflows into US equities after the early fall hiatus. Buying on dips still offers downward protection from a major market pullback. Buybacks vs Dividends: Share buybacks are on the rise, seemingly displacing dividends as a means of returning cash to shareholders. For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Reiterating Investment Positioning Overarching Macroeconomic Themes Rate Hikes Are Coming Taper Tantrum 2.0 rotation is running its course: Sectors and styles most adversely affected by rising rates, such as Consumer Staples, Communications, Services and Health Care have underperformed in October (Chart 1), while cyclicals, geared to rising rates, have outperformed. Growth/Technology has benefited from recent rate stabilization. Chart 2Market Is Pricing In Three Rate Hikes in 2022 Market now expects three rate hikes by the end of 2022: Rampant inflation is changing investor expectations on the timing and the speed of rate hikes. A month ago, the probability of two rate hikes in 2022 stood at around 55%. Now, the probability of three rate hikes is roughly 64% (Chart 2). The BCA house view is that the Fed will raise rates once in December 2022 – an outlook much more temperate than the market’s. Investment Implication: Banks, Small Caps and Cyclicals outperform in a rising rates environment (Table 1). Table 1Recent Performance Of Sectors In A Rising Rates Regime Shortages Of Goods   Shortages are ubiquitous. How do we make money from this theme? We choose industries that are positioned upstream in the supply chain; for example, we prefer Semis to Durable Goods (Chart 3). Manufacturers of chips face strong demand and significant pricing power, while durable goods manufacturers face shortages and have to pass higher input costs on to their customers, which constrains demand and sales growth. Of course, there is also another aspect contributing to the underperformance of durables: Purchases of goods have exceeded the pre-pandemic trend and turned. Over the past three months, semis outperformed the S&P 500 by nearly 5%, while durables underperformed by 12%. Investment Implication: Stay overweight Semiconductors and Semiconductor Equipment, underweight Durable Goods (Table 2). Chart 3Demand for Chips Is BoomingTable 2Sectors Affected By Shortage: Recent Performance Pent-Up Demand for Services The ISM Non-Manufacturing PMI for October has come in at a record 66.7 (62 expected) (Chart 4A), and new orders are soaring at 70. These readings exceed the ISM Manufacturing PMI (60.8), suggesting that demand for services still exceeds demand for goods. Furthermore, spending on services is still below pre-pandemic levels, and the rebound is running its course (Chart 4B). We conclude that our “pent-up demand for services” investment theme still has legs. Chart 4AISM Services Is Soaring Chart 4BStill Strong Pent-up Demand For Services Investment Implication: Stay overweight Hotels, Restaurants, Entertainment and Professional Business Services (Table 3). Stay away from Airlines for now. Table 3Travel Complex: Recent Performance Transportation Bottlenecks Shipping costs continue their ascent (Chart 5). Over 100 ships are currently anchored in LA/Long Beach ports compared to almost immediate unloading before the pandemic. While rising transportation costs are denting the profit margins of a wide range of companies, from retailers to manufacturers, they are a boon for ocean shipping lines, and US transport companies, such as truck lines and railways. Case in point: A.P. Moller-Maersk, the world’s largest boxship operator, delivered $5.44B in quarterly profits last week – doubling its entire 2020 income, on the heels of the unprofitable years of 2018 and 2019.1 Profits of other freight operators are also surging. Investors take notice: After a stretch of underperformance, the S&P 500 Transportation Index outperformed the S&P 500 by 6.55% in October. Chart 5Shipping Costs Still Exorbitant Investment Implication: Continue overweight of Transportation Services, specifically Air Freight and Logistics, and Road and Rail (Table 4). Table 4Transportation: Recent Performance US Consumers Are Feeling Poorer Consumers are right to worry about inflation: Nominal wages increased by 4.5% Year-on-Year in October, the highest reading over the past 40 years. However, real wage growth is negative, i.e. it is not keeping up with prices, erasing American consumers’ buying power (Chart 6). According to a Gallup survey, upticks in citations of the deficit and inflation are largely responsible for an increase in mentions of any economic issue – from 16% in September to 24% in October.2 According to the Conference Board survey, consumers expect prices to rise by 7% over the next 12 months. Loss of purchasing power is bound to dampen consumer demand, as we have seen with demand for Consumer Durables and Autos which has collapsed due to shortages and sky-high prices. Corporate pricing power is waning: As a result of pressures on consumer purchasing power, US producers are reporting that they find it harder to raise prices. Looking ahead, companies will have to absorb price increases (Chart 7). Chart 6Wage Increases Are Not Keeping Up With Inflation Chart 7Corporate Pricing Power Is Waning Investment Implication: Erosion of consumer pricing power will eventually harm the Consumer Discretionary sector and will lead to a broad-based margin compression. Fundamentals Peak margins are here: The confluence of rising wages, falling productivity, and reduced ability to raise prices translates into an impending margin squeeze. We forecast that the year-over-year margin change will be negative in 2022 (Chart 8). The Q3 2021 earnings season delivered blockbuster results so far with roughly two-thirds of the companies reporting, and results are striking. 83% of companies have beaten the street expectations with the average earnings surprise standing at 11% (Chart 9). Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25%, exceeding an expected 6% contraction. Compared to Q3 2019, EPS CAGR is 12%. These results indicate that street expectations were a low bar to clear. Forward guidance is concerning: Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. Most companies have navigated a challenging economic environment swimmingly so far. However, looking ahead, waning pricing power, falling productivity, and rising costs will weigh on profitability. These factors are the ubiquitous reasons for negative guidance: 52.6% of companies are guiding lower for Q4 2021 (compare that to 32.7% in the previous quarter). Investment Implication: It is likely that the Q4 2021 earnings season disappoints. Sentiment Strong inflows into US equities after early fall hiatus. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines, which many retail investors aim to park in US equities (Chart 10). Furthermore, historically, November and December have been characterized by robust equity inflows: Retail investors wait until the end of the year to reach clarity on their financial situation and to allocate funds to 401Ks, IRAs, and 529s. Investment Implication: Buying on dips still offers downward protection from a major market pullback. Chart 10Strong Inflows Into US Equities: Buying On Dip Is Still En Vogue Uses Of Cash Buybacks Replace Dividends: Share buybacks are on the rise again (Chart 11, Panel 1), seemingly displacing dividends as a means of returning cash to shareholders: The dividend payout ratio is flagging (Chart 11, Panel 2). From a corporate standpoint, dividends require a long-term commitment, while buybacks can be a “one-off,” lending more flexibility to corporate treasurers. Corporations also prefer buybacks as they reduce their share count and inflate earnings per share. Investment Implication: For cash yield, focus on sectors known for using buybacks to disburse cash to shareholders: Technology and Financials. Chart 11Buybacks Are Replacing Dividends   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     Small Vs Large Chart 23Macroeconomic Backdrop Chart 24Profitability   Chart 25Valuations and Technicals Chart 26Uses Of Cash       Footnotes 1     WSJ, Supply-Chain Pain Is Maersk’s Gain as $5.44 Billion Profit Dwarfs Amazon, UPS, November 2, 2021. 2     Job Market Ratings Set Record, but Economic Confidence Slides (gallup.com), October 27, 2021.   Recommended Allocation

We will be holding our quarterly webcasts next Monday, November 15th at 10:00 a.m. Eastern time and Tuesday, November 16th at 8:00 a.m. Hong Kong time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 22nd. Highlights Economy – Wages could be on the rise if workers are able to exploit the considerable leverage they now enjoy: The labor market currently has no slack. Workers’ ability to derive a lasting advantage from today’s shortages will determine if the extended decline in labor’s share of income will reverse. Markets – Lengthy agreements in labor’s favor could give inflation an additional impetus: Investors are not prepared for a shift in the balance of power from management to labor and a range of assets will have to reprice if workers can achieve some durable victories. Strategy – Keep an eye on labor agreements, which could hasten a shift to more defensive positioning: The current economic backdrop, along with accommodative monetary and fiscal policy, support risk-friendly portfolio positioning, but a labor revival could prompt the Fed to engage in a disruptive tightening cycle that would halt the bull markets in equities and credit and possibly also short-circuit the expansion. Feature At the end of 2019, tiring of the market debates du jour, we began haunting the New York Public Library, reading all we could about US labor relations history. Several books and rolls of microfilm later, we published a three-part Special Report on workers’ past, present and future. While we concluded that organized labor would not regain the influence it wielded in the fifties, sixties and seventies, we thought that investors were underestimating the potential for workers to reverse the grinding decline in their fortunes that began in the early eighties. Public opinion seemed to be shifting in workers’ favor, especially among the young; the coming election held promise for the Democrats; and the pendulum had swung so far, for so long, that there was little scope for management to gain any more ground. We looked forward to countering the view that organized labor was as dead as a doornail, only to have COVID-19 render the topic irrelevant. Nearly two years later, however, dislocations caused by the pandemic have pushed negotiations over wages and labor conditions to the fore. Amidst a recent flurry of strikes against S&P 500 constituents, clients have been asking what the labor future holds. We refresh the themes we identified in our initial analysis, noting how conditions have shifted since early 2020. The investment takeaway is that increasing labor muscle could stoke inflation and push long-run inflation expectations higher, forcing the Fed to tighten monetary policy more abruptly than markets expect. The 2020 Election Went Labor’s Way A review of the historical record makes it crystal clear that employees cannot gain ground if government sides with employers. The 2020 election, which delivered both the White House and the Senate to Democrats, put some unexpected wind in labor’s sails. They did not mark a revival of the New Deal, however, as Democrats’ legislative majorities are precariously thin and unlikely to survive the 2022 midterms, their control of the presidency may not extend beyond 2024, and the federal judiciary will be inclined to see things management’s way for some time thanks to past conservative appointments. At the state level, the executive and legislative branches remain firmly in Republican control. A friendly executive branch can do a lot to reset the scales nonetheless. The Biden Department of Labor, National Labor Relations Board (NLRB), Occupational Safety and Health Administration (OSHA) and Department of Justice are certain to enforce existing worker protection laws more vigorously than their recent predecessors, while more actively challenging business combinations. Joe Biden began his election campaign at a Pittsburgh union hall and returned to the Steel City to end it, promising to be “the most pro-union president you’ve ever seen.” Labor leaders have generally given him high marks since taking office for supporting legislation to make it easier for workers to organize and he publicly offered moral support to John Deere’s UAW workers when they went on strike last month, saying, “My message is they have a right to strike and they have a right to demand higher wages.” Public Opinion Has Continued To Shift Toward Labor We noted two years ago that young Democratic voters overwhelmingly favored Bernie Sanders’ and Elizabeth Warren’s candidacies, suggesting that solidarity with workers might be on the rise. It is no surprise that students would be the most avid supporters of progressive campaigns, but Millennials, born between 1981 and 1996, and Generation Z might be viewed as the Inequality Generations, having entered the workforce after China’s admittance to the WTO, which coincided with a peak in labor’s share of income (Chart 1). Their lives have spanned the September 11th attacks, the financial crisis, a once-in-a-century pandemic and three equity market crashes, and many of them started adulthood with onerous student debt burdens and dim earnings prospects. They might find the notion of a union buffer from market forces especially alluring and therefore view unions favorably. The 2019 Gallup poll found that public approval for unions had reached nearly 20-year highs; two years on, it’s up to levels last reached over 50 years ago (Chart 2). Chart 1Workers' Share Of The Pie Shrank For 15 Years Chart 2Extreme Makeover Public opinion is crucially important to the outcome of labor negotiations because for-profit employers will seek the most favorable terms they can get, to the extent that they are socially acceptable. In our schematic of the 1980s vicious circle that initiated unions’ 40-year decline, public opinion made it possible for the Reagan administration to take a hard line against the air traffic controllers’ union and emboldened private employers to take more aggressive measures as well (Figure 1). Beyond the private sector, elected officials reliably deliver what their constituents want, and the courts do, too, albeit with a longer lag. The median voter theory advanced by our geopolitical strategists doesn’t just predict future outcomes, it directly influences them. Striketober Another key takeaway from our original study was that successful strikes beget strikes. Strikes are the most potent weapon in workers’ arsenal – withholding their labor threatens to reduce their employer’s output and may halt it altogether – but they are fraught with risk for individual employees. Striking workers don’t get paid beyond the partial support that may be provided by their union strike fund and may find themselves entirely out of work if the strike fails. Workers should only strike when they have a good chance of winning or when their situation has become so intolerable that they have little to lose. Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative position, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. Viewing labor negotiations through a game theory lens, we posit a simple framework in which each side can hold any of five perceptions of its bargaining power, resulting in a total of 25 possible joint perceptions. Labor (L) can believe it is way stronger than Management (M), L >> M; stronger than Management, L > M; roughly equal, L ≈ M; weaker than Management, L < M; or way weaker than Management, L << M. Management also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure 2 displays only the outcomes consistent with labor’s belief that it has the upper hand. For completeness, the exhibit lists all of management’s potential perceptions, but we deem the three away from the extremes to be most likely. Record job openings and job quits rates (Chart 3) should disabuse even the most rabidly anti-union managements from thinking they hold all the cards. On the other hand, four consecutive decades of victories will make it hard for all but the most objective management negotiators to believe that the tables have completely turned and that labor is fully in control. Chart 3It's A Labor Seller's Market ... Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack Though we hold the view that labor force participation is likely to revive in coming months because inequality and a comparatively thin social safety net will compel many lower-income workers to return to the work force, no one knows for sure where the workers have gone or when they will return, if at all. It is abundantly clear from accelerating wage gains (Chart 4), the openings and quits rates, and small businesses’ historic inability to fill job openings (Chart 5) that the labor market is extremely tight right now. A difference of opinion about whether and how long the worker shortages will persist could make finding common ground in contract negotiations a challenge. Chart 4... As Rising Wages ... Chart 5... And Frantic Employers Confirm Economic Concentration We previously noted that the trend toward economic concentration has strengthened management’s hand in labor negotiations as it has made an increasing share of local labor markets tend toward monopsony. A monopsony is a market with a single buyer, the mirror image of a monopoly, which is a market with a single seller. Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. The trend toward economic concentration is well established and we think the probability that it will reverse is low – Congress may shake its fist at Big Tech and the Biden Justice Department will more vigorously contest mergers on anti-trust grounds, but there is an ocean of liquidity available to support acquisitions and robust CEO confidence suggests it will be deployed. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from statehouses, federal agencies and the courts, as union and labor protections have been under siege from all sides. But the regulatory and legal tide has been such a huge benefit for employers since the beginning of the Reagan administration that it simply cannot continue to maintain its pace. Furthermore, as our Global Investment Strategy colleagues have observed, the Republican party’s lurch toward populism may leave Big Business without a champion in Washington, DC. The regulatory and legal winds are shifting and management teams that have spent their entire careers in an environment in which labor has perpetually been on the back foot may be the last to know, leading to an uptick in the number and contentiousness of labor disputes. A change in Fed policy, as unveiled in the August 2020 revision to the FOMC’s statement on longer-run monetary policy goals, has also tilted the playing field in workers’ favor. The Fed has sworn off preemptively tightening monetary policy when the labor market appears to be getting tight. The new direction contrasts with 40-plus years of Fed policy that were predicated on taking away the punch bowl before upward wage pressures could build momentum. The tacit pledge in the revised statement on monetary policy implies that the Fed will prioritize its full employment mandate over its price stability mandate in the near term. That’s not an unalloyed positive for workers, who will only be better off if their nominal wage gains outpace inflation, but it will help give them more of a head start than they would have gotten if the FOMC had stuck with the proposition that tight labor markets stoke inflation. The Labor-Management Rubber Band Employees and employers have a deeply symbiotic relationship, and we like to think of labor and management as being linked by an elastic tether with a finite range. Since neither side can indefinitely thrive if the other is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. One does not have to be a card-carrying socialist to believe that the band is near its limit and that some sort of mean reversion is inevitable, given how badly real hourly wages have lagged gains in hourly output over the last 50 years (Chart 6). Chart 6Testing How Far The Labor-Management Rubber Band Can Stretch What Comes Next Steady concentration across industries and a persistently hospitable legal and regulatory climate has given management the upper hand for four decades. Going forward, however, labor should see its fortunes improve as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band becomes less stretched in management’s favor (Figure 3). The major uncertainty pertains to the ongoing level of slack in the labor market and how employment agreements should account for it. All parties recognize there is no slack right now and employers are duly offering generous inducements to attract workers. Sign-on bonuses for new employees in unskilled services positions are ubiquitous and negotiations with unionized employees include ratification bonuses for signing new contract packages. Because wages are sticky on the downside – it’s difficult to get employees to swallow outright pay cuts – employers prefer making one-time concessions like bonuses to increasing wage rates across the board, which is tantamount to locking in higher long-term input costs. The duration of concessions appears to be a sticking point in the negotiations to settle the current strikes. Over the last two decades, several large companies with unionized workforces have instituted a two-tier employment track distinguishing legacy employees from new hires. The legacy employees remain on their existing salary path and retain their retirement and health insurance benefits, while new employees are subject to a lower salary scale and are entitled to fewer benefits, if any. The result has been to bend the human resources cost curve lower in the future as natural attrition shrinks the share of employees on the more costly legacy path. The two-tier employment classification has proven to be an effective way for employers to bend the cost curve to their liking, as it protects the interests of a considerable majority of employee voters at the expense of a largely hypothetical future employee constituency. It is presumably difficult to empathize with workers who aren’t yet coming to the plant every day and legacy employees haven’t dwelled on their plight when participating in contract ratification votes. An interesting feature of the ongoing John Deere strike is that the UAW rejected what appeared to be a strikingly generous package partially in the interest of defending current and future employees who have no path to reach legacy employees’ all-in compensation level. The recent strikes against S&P 500 constituents have been concentrated in industries that faced demand spikes during the pandemic. The bakery worker’s union (BCTGM) representing Kellogg’s workers struck against Frito-Lay (owned by Pepsi) for three weeks in July and Nabisco (a unit of Mondelez) for five weeks in August and September. A significant motivation for the BCTGM workers’ actions seemed to be frustration over intense pandemic workloads. Their plants ramped up capacity to fill kitchen cabinets while consumers were cooped up at home and they are now seeking redress for the emergency hours they were asked to work. (All of the bakery workers who struck, as well as the John Deere workers, were considered essential workers.) Management, on the other hand, might take the view that their employees’ sacrifices are in the past, and are not likely to be repeated if product demand settles back into its pre-pandemic trend. Viewing ongoing negotiations from our game theory perspective, there is ample room for divergent perceptions of relative negotiating strength, based on differing opinions about the persistence of pandemic trends. The divergence might make for increasingly contentious labor negotiations going forward, with strikes exacerbating supply bottlenecks and ramping up near-term inflation pressures. If ongoing rounds of labor negotiations result in workers achieving longer-term victories, it will pressure corporate profit margins. Labor gains will also potentially feed into inflation if capacity is not poised to meet the ensuing increase in aggregate demand. We will keep close tabs on labor negotiations as the economy works its way back to a post-pandemic steady state.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Special Report

Highlights We introduce our rotation graphs to assess the evolution of the relative trend and momentum of various assets. US equities remain on firm footing, but their weakening relative momentum suggests that investors may soon begin to rotate away from this market in favor of the Eurozone and EM. Cyclicals continue to dominate defensives, globally and in Europe. European value stocks are experiencing improving momentum, which suggests that a rotation out of growth equities is afoot. While European small-cap equities sport attractive fundamentals, rotational dynamics indicate it is still too early to overweight them aggressively. The energy crisis is a dominant driver of the relative sector performance in Europe and resulted in a massive shift in leadership from industrials to energy. As long as oil and natural gas act as a drag, industrials will lag. Financials are well supported. Swedish stocks have borne the brunt of the energy price spike, while Norwegian equities have been its main beneficiaries. The improvement in momentum of German stocks suggests that their relative underperformance will soon end. Spanish shares look attractive from a tactical perspective. Swiss industrials will need a recovery in EUR/CHF to outperform other European industrials. UK industrials will continue to outperform their continental competitors, while Spanish industrials have a window through which to shine. A rotation into UK financials may soon begin as their momentum improves. The darkest days for German financials are ending, while Spanish, Italian, and Swedish financials may soon witness a wave of underperformance. Spanish consumer discretionary equities are becoming more attractive compared to their European counterparts. While Dutch names continue to outperform other European tech equities, their softening momentum suggests investors are beginning to rotate out of this country. Spanish and German tech names offer an attractive diversification opportunity within the industry. Feature Methodology The combination of excess liquidity, large pools of fast money, elevated valuations across most securities, and the existence of the near-term momentum reversal effect encourage investors to rotate from one asset to the next in the hope of rapid profits. Measures to assess where each market stands in this rotational pattern can be useful for investors to catch these swings. In this optic, we introduce our rotation screener focused on equities. It is a simple tool that looks at whether a sector or a country is strengthening relative to its benchmark and whether this strength is happening at a faster or slower momentum. To measure each dimension, we use proprietary indicators of relative strength and momentum. Once each asset’s relative strength and relative momentum are established, we can position them in quadrants. We follow traditional terminology. The upper right quadrant denotes “Leading” assets, or securities that are outperforming their benchmark with strengthening momentum. The bottom right quadrant denotes “Weakening” assets, or securities that are outperforming their benchmark but with a deteriorating momentum. The bottom left quadrant denotes “Lagging” assets, or securities that are underperforming with decreasing momentum. Finally, the top left quadrant indicates “Improving” assets, or securities that are underperforming but with increasing momentum. Investors should move to overweight assets that are in the Improving quadrants and to underweight assets that are inching toward the “Lagging” from the “Weakening” quadrants. This method is very flexible and can be applied to sectors, countries, styles, and so on, as long as a benchmark is available to generate comparisons. In this report, we will analyze the following from a rotational perspective: global national markets, global cyclicals vs global defensive’s, European cyclicals vs European defensives, European sectors, European national markets, European financials, European consumer discretionaries, and European tech stocks. Global National Markets US equities have moved from the Leading quadrant to the Weakening one as they continue to outperform the global benchmark but with a decelerating momentum (Chart 1). This locates the US market in a risky position that could herald a period of underperformance, especially if global economic surprises accelerate. From a rotational perspective, US stocks could still experience another wave of outperformance over the coming weeks, as momentum has been firming over the past four weeks.   The Euro Area benchmark has fully moved from the Weakening quadrant in August to the Lagging one today. Investors should monitor Europe’s relative momentum closely, because a pick-up from here would push the Eurozone into Improving territory, a warning of an imminent trend change in European relative stock prices. Emerging markets have exited the Lagging zone and moved into the Improving quadrant. The move is far from decisive and remains at risk with Chinese credit growth still decelerating. The recent decline in steel prices in China suggests that construction activity in that economy continues to slow. Thus, as long as Chinese credit flows deteriorate, EM stocks will have trouble moving into the Leading quadrant. Cyclicals Vs Defensives Global defensive equities tried to move into the Leading quadrant at the end of the summer, but, ultimately, they plunged back into Lagging territory as global stocks recovered in October (Chart 2). Meanwhile, global cyclicals moved in the opposite trajectory, shifting from the Lagging quadrant to the Leading one over the past three months. Cyclicals continue to benefit from the general uptrend in the market. Even the recent decline in yields is doing little to boost the performance of defensive equities. The biggest risk to these stocks remains the Chinese economic slowdown. For now, this deterioration has not been large enough to compensate for the general vigour in profits and consumption in advanced economies. However, if inflation worries do not abate, then the Chinese slowdown will become more problematic for global cyclicals as it will raise the spectre of stagflation.  The rotational pattern for European cyclicals vs defensive stocks mimics that of global equities (Chart 3). However, European cyclicals are somewhat softer than their global equivalents, hurt by Europe’s greater exposure to the Chinese business cycle compared to the US’s exposure. European Investment Styles Over the past three months, European investment styles have begun a major shift. Value has moved from the Lagging quadrant to the Improving one, which suggests that flows could push value into the Leading quadrant (Chart 4). Moreover, growth has moved from the Leading quadrant to the weakening one, which created a similar dynamic as the decline in performance of the quality factor. This confirms that the rise in yields is beginning to favour a shift in style from growth to value. Meanwhile, small-cap stocks have tumbled into the Lagging quarter. We do expect attractive returns for European small-cap names over an 18- to 24-month investment horizon. However, we have not moved yet to overweight this sector of the market and rotational patterns confirm it is too early to do so safely. European Sectors Sectors have begun to make some important shifts in European markets (Chart 5). Tech has moved from the Leading quadrant to the weakening one. While the sector continues to outperform, it is doing so with a declining momentum, and it could soon move to the Lagging quadrant. This deteriorating price action must be monitored closely. Consumer discretionary names, which were strong performers that have become increasingly weak, have moved from the Weakening quadrant to the lagging one. However, their momentum is not deteriorating as much as it did nine weeks ago, which suggests a move to the Improving quadrant could soon be in the offing. Financials have greatly enjoyed the uptick in global yields. After a short passage through the Lagging quadrant, they have shifted into the Leading one. This suggests that the winds remain behind this sector, which we continue to overweight. Industrials and energy have become mirror images of one another, highlighting the negative impact on European economic activity and profitability of the recent surge in energy prices. The industrials have moved from the Leading quadrant to the lagging one, as the energy sector experienced the opposite direction of travel. This suggests that industrials will only recover their shine once the energy crisis abates, which will also hurt energy stocks. European National Markets The rotational pattern exhibited by European national markets bears their respective sectoral footprints (Chart 6). The tech-heavy Dutch market has moved from the Leading quadrant to the Weakening one, the industrials-focused Swedish market has fallen into the Lagging quadrant from the Weakening one and the Norwegian market has leapt out of Lagging into Leading territory. Hence, if the rotation out of tech deepens, The Netherlands will tumble directly into the Lagging zone, while an easing in energy prices will force Norway and Sweden to switch places on the back of a rotation out of energy into industrials. Germany is of particular interest. It is a well-diversified market that has become oversold. Moreover, as we wrote in September, its relative performance exhibits a significant discount to relative earnings. From a rotational perspective, Germany is moving to leave the Lagging quadrant; a durable shift into the Improving quadrant will sufficiently assuage traders into buying this market. This process will support our overweight position in German equities. Spain is another market we like on a tactical basis. Over the course of the past three months, it moved out of Lagging territory into the Improving zone. This price action supports our thesis that the large country-discount embedded across Spanish equity sectors is excessive and should soon dissipate. The main risk to this view would be another down leg in bond yields, which would hurt financials—a major weight in this market. Italy, too, is in the process of executing a full rotation, having exited the Weakening quadrant and moved into the Lagging one. Italian stocks have tried to punch their way into the Improving zone but have failed to do so. They will require higher yields to move out into the Improving zone durably because of the heavy financials weighting of Italian stocks. European Industrials Within European industrials, a rotational pattern is also evident (Chart 7). Swiss industrials have moved out of the Leading quadrant into the Lagging one as the Swiss franc continues to appreciate against the euro. The rising CHF imparts deflationary pressures into Switzerland and the SNB continues to build up its reserves. As a result, EUR/CHF will appreciate once EUR/USD finds a firmer footing. Thus, while it is too early to overweight Swiss industrials relative to those of the Eurozone, their oversold nature suggests that a rotation in favour of Swiss manufacturing businesses will soon take place. At the current juncture, Spanish industrials look appealing. They have moved out of the Lagging quadrant into the Improving one as the momentum of their relative performance improves. Additionally, they are close to moving into the leading territory. This picture is consistent with a narrowing of the discount embedded in all Spanish sectors since the pandemic broke out. Swedish industrials are also trying to exit the Lagging territory; their elevated RoE, and heavy sensitivity to the DM capex cycle indicate that they should move into the Leading quadrant in the coming weeks. UK industrials have remained in the Leading zone for the past three months, but their relative momentum is softening, which risks them being placed in the Weakening zone. The recent deterioration in GBP/EUR could provide a breath of fresh air, as it will improve the competitiveness of UK industrials compared to continental firms. Even then, for now, rotational dynamics do not flag an imminent problem for UK industrials. European Financials The clearest rotational pattern within European financials may be found in Sweden and the UK (Chart 8). Over the past three months, Swedish financials have fallen out of the Leading quadrant into the Weakening one, and they are inching closer toward the Lagging zone. This suggests that they could soon begin to underperform. Meanwhile, UK financials offer a mirror image as they exited the Lagging quadrant and moved into the improving one. They have yet to enter Leading territory, but seem close to doing so. The pessimism toward the UK is overdone right now. BCA’s Global Fixed-Income Strategy team expects the UK yield curve to steepen anew. UK financials would be prime beneficiaries of this dynamic. Italian and Spanish financials are also exhibiting some concerning moves lately. Both were in the Leading quadrant, but they have since shifted to the lagging one as peripheral spreads widened. Meanwhile, money seems to be moving into German financials, which have advanced from the Lagging quadrant to the Improving quadrant. While they are not as close to the Leading quadrant as their UK competitors, this shift warrants monitoring. European Consumer Discretionary Within the consumer discretionary space, most European countries have remained in their quadrant (Chart 9). Nonetheless, Spanish CD stocks have moved out of the Lagging zone into the Leading quadrant, while their Italian counterparts have recently entered the Weakening quadrant where they have joined French CDs. While both these countries’ consumer discretionary firms are witnessing weakening momentum, they remain in an upward trend against their European competitors. It is therefore too early to sell these countries within this industry. German Consumer discretionary equities are still in the Lagging quadrant, but they are trying to move into the Improving one, where UK CD names have remained for the past three months. European Tech The European tech sector is very much a story about The Netherlands versus the rest, due to the large size of the Dutch tech sector (Chart 10). For now, rotational patterns remain in favour of Dutch names; they have exited the Leading quadrant, but, while their momentum is weakening somewhat, they remain in a pronounced relative uptrend. A few small markets offer some promise. Over the past three months, both Spanish and German tech names have shifted from the Lagging quadrant into the Improving one. Their elevated momentum measures suggest that a shift into the Leading quadrant is imminent. As such, investors should consider switching some of their tech holdings into these two countries to diversify away from the Dutch behemoth.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com