BCA Indicators/Model

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Every Shock Is Always Supplanted By A New Shock Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The Economy Is Becoming Less Energy-Intensive The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform When Bond Yields Decline, Banks Underperform When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End The Recent Outperformance Of Banks May Soon End The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Alternative Electricity Is Rebounding From An Oversold Position Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Bitcoin's Support Is Holding Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks The Predictable Anatomy Of Shocks 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The recent market turmoil means that a 50 bps rate hike is off the table for the March FOMC meeting, but the Fed will proceed with a 25 bps rate hike this month and signal a further steady pace of tightening. As of Monday morning, the market is priced for close to 150 bps of tightening during the next 12 months. This is reasonable assuming that inflation moderates in the second half of the year and that long-dated inflation expectations remain well contained. A moderation of inflation in H2 remains our base case, but the war in Ukraine increases the risk that inflation will be sticky and that long-dated inflation expectations will move higher. The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Bottom Line: An ‘at benchmark’ portfolio duration stance makes sense for now, but the recent drop in Treasury yields could eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Stay tuned.   Feature The Russian invasion of Ukraine is ongoing and financial markets will surely remain volatile until a resolution is reached. For more details on how we see the crisis evolving please refer to last week’s BCA Special Report.1  As we go to press on Monday, the market is trying to digest the impact of sanctions that will block the access of some Russian banks to the SWIFT financial messaging system and freeze some Russian central bank reserves that are held abroad in USD and EUR. Taken together, the sanctions will impart a large stagflationary impulse to the Russian economy and, as would be expected, the Ruble is depreciating rapidly on Monday morning. The reaction in US bond markets is so far more muted. The 10-year Treasury yield is currently 1.86% - down from 1.99% last Wednesday – and the 2-year Treasury yield is 1.44% - down from 1.58% last Wednesday (Chart 1). Movements in the real and inflation components of US Treasury yields do show that the US market is pricing-in some stagflationary contagion. The real 10-year Treasury yield is down to -0.71% (from -0.54% last Wednesday) and the 10-year TIPS breakeven inflation rate is up to 2.57% (from 2.53% last Wednesday). The same divergence between a falling real yield and rising cost of inflation compensation is seen at the 2-year maturity point (Chart 1, bottom 2 panels). The market has also moved to price-in a shallower path for Fed rate hikes compared to last week (Chart 2). The market-implied odds of a 50 bps rate hike this month are now slim and the market is now looking for only 139 bps of cumulative tightening (just under six 25 basis point rate hikes) by the end of this year. Chart 2Fed Funds Rate Expectations Fed Funds Rate Expectations Fed Funds Rate Expectations Chart 1A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock We agree with the market that the heightened uncertainty and tightening of financial conditions takes a 50 bps rate hike off the board for the March FOMC meeting. A 25 bps rate hike this month remains the most likely scenario. However, we also think the market might be over-estimating the extent to which contagion from Russia will limit the pace of Fed tightening later in the year. In fact, we are inclined toward the view that the lasting impact of the crisis on the US economy might be more inflationary than deflationary. Chart 3Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen The inflationary risk is that a sustained upward shock to the oil price could keep headline inflation higher than it would otherwise be. This could also bleed through into other commodity prices and possibly even to inflation expectations. The textbook central bank response should be to ignore a commodity price shock and set policy based on trends in core inflation. However, in the current environment it will be difficult for the Fed to ignore yet another inflationary shock, especially if long-dated inflation expectations move higher. On the other hand, the economic fallout from a Russian recession will be much worse for Europe than for the United States. European Central Bank (ECB) Chief Economist Philip Lane recently estimated that the Ukrainian war could shave 0.3%-0.4% off Eurozone GDP this year.2 If the shock leads to a wider divergence between Fed and ECB policy expectations, then we would expect to see a widening of US yields versus European yields and upward pressure on the US dollar. Given that US bond yields can only diverge so far from yields in the rest of the world, a stronger dollar may cap any increase in US bond yields and eventually limit the extent of Fed tightening. So far, trends in the dollar and dollar sentiment have been supportive of rising US bond yields, but it will be important to watch this situation in the coming months to see if it changes (Chart 3). Investment Conclusions The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The Fed is likely to proceed with tightening policy at a steady pace, starting with a 25 bps rate hike this month. Trends in inflation and financial conditions will determine the pace of rate hikes in H2 2022. Right now, our sense is that the lasting impact of the Ukrainian crisis on the US economy will prove to be more inflationary than deflationary. With that in mind, the recent drop in Treasury yields may eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Checking In With Our Golden Rule Given the current market turmoil, we think it’s a good time to step back and check in with our Golden Rule of Bond Investing.3  The Golden Rule is a framework that investors can use to implement portfolio duration trades. It states that investors should determine the expected change in the fed funds rate that is priced into markets for the next 12 months and then decide whether the actual change in the funds rate will be greater or less than what is priced in the market. If you expect the fed funds rate to rise by more than what is priced in (a hawkish surprise), you should keep portfolio duration low. If you expect the fed funds rate to rise by less than what is priced in (a dovish surprise), you should keep portfolio duration high. It is admittedly a simple framework, but it does have a strong track record of performance. In general, hawkish surprises coincide with the Bloomberg Barclays Treasury index underperforming cash and dovish surprises coincide with the index outperforming cash (Chart 4). Chart 4The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing More specifically, if we look at rolling 12-month periods going back to 1990, we see that dovish surprises have coincided with positive excess Treasury returns versus cash 85% of the time for an average 12-month excess return of 4.0%. Conversely, hawkish surprises have coincided with negative excess Treasury returns 72% of the time for an average 12-month excess return of -1.5% (Chart 5 & Table 1). Table 112-Month Treasury Excess Returns And Fed Funds Rate Surprises (1990 - Present) Waiting For The Fog To Clear Waiting For The Fog To Clear Chart 5The Golden Rule’s Track Record Waiting For The Fog To Clear Waiting For The Fog To Clear As of today, the market is priced for 149 bps of Fed tightening during the next 12 months. That is very close to six 25 basis point rate hikes at the next eight FOMC meetings. Given our view that inflation will moderate in the second half of the year, this seems like a reasonable forecast that is consistent with our ‘at benchmark’ portfolio duration stance. However, as noted above, we believe the war in Ukraine could lead to an increase in inflationary pressures in the United States. Therefore, we see the balance of risks as tilted toward more rate hikes than are currently discounted rather than fewer. It will be vital to monitor long-dated inflation expectations during the next few months to assess how the pace of Fed rate hikes will evolve. Using The Golden Rule To Forecast Treasury Returns One more application of our Golden Rule framework is that we can use it to create forecasts for Treasury index returns. This is done by first looking at the historical correlation between the Fed Funds Surprise – the difference between the expected 12-month change in the fed funds rate and the realized change – and the change in the Treasury index yield (Chart 6). A regression between these two variables allows us to estimate the change in the Treasury index yield based on an assumed Fed Funds Surprise. Chart 6The Correlation Between Treasury Yields And Fed Funds Surprises Waiting For The Fog To Clear Waiting For The Fog To Clear Once we have an expected 12-month change in the Treasury index yield, we can translate that change into an expected return using the index’s average yield, duration and convexity. The result of this analysis is presented in Table 2. Table 2Using The Golden Rule To Forecast Treasury Returns Waiting For The Fog To Clear Waiting For The Fog To Clear Table 2 shows that we would expect the Treasury index to deliver a total return of 1.82% in a scenario where the Fed lifts rates by 150 bps during the next 12 months. This would equate to the Treasury index beating a position in cash by between 0.07% and 0.83%, depending on whether rate hikes are front-loaded or back-loaded. A pace of one 25 basis point rate hike per meeting (+200 bps during the next 12 months) would lead to the Treasury index underperforming cash by between -2.35% and -3.02%. Conversely, we can see that the index is expected to beat cash by between 3.25% and 3.92% if the Fed only lifts rates four times during the next 12 months. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see BCA Special Report, “Russia Takes Ukraine: What Next?”, dated February 24, 2022. 2 https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/ 3 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Waiting For The Fog To Clear Waiting For The Fog To Clear Other Recommendations Waiting For The Fog To Clear Waiting For The Fog To Clear

Executive Summary US biotech is trading at its greatest discount to the market. Ever. Much of biotech’s underperformance is due to transient factors: specifically, the sell-off in long-duration bonds; the focus on delivering a Covid vaccine; regulatory concerns; a drought in M&A; and a flood of IPOs. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. If, as we expect, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. Fractal trading watchlist: We focus on biotech, and add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. US Biotech Is Trading At Its Greatest Discount To The Market. Ever US Biotech Is Trading At Its Greatest Discount To The Market. Ever US Biotech Is Trading At Its Greatest Discount To The Market. Ever Bottom Line: Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. Feature Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. But before we go into the specifics of biotech, let’s quickly discuss the recent action in the broader market. The Past Year Has Been All About ‘Duration’ A good way to think of any investment is to compress all its cashflows into one future ‘lump-sum payment.’ The length of time to this lump-sum payment is the investment’s ‘duration.’ And the present value of the investment is just the discounted value of this lump-sum payment, where the discount factor will depend on the required return on the investment combined with its duration.1 It follows that, all else being equal, the present value of a long-duration stock must rise and fall in line with the present value of an equally long-duration bond – because their discount factors move in lockstep. And, as we have been banging on in recent weeks, this simple observation is all you need to explain market action over the past year. For the 30-year T-bond, 2.4-2.5 percent is an important resistance level. Given that long-duration indexes such as the Nasdaq, S&P 500 and MSCI Growth have the same duration as the 30-year T-bond, they have been tracking the 30-year T-bond price one-for-one (Chart I-1 and Chart I-2). Hence, when the long-duration bond rallied, these stock markets outperformed shorter-duration indexes such as the FTSE100 and MSCI Value; and when the long-duration bond sold off, they underperformed. Chart I-1The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One Chart I-2MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One The Russian invasion of Ukraine has catalysed a retreat in the 30-year T-bond yield from a ‘line in the sand’ at 2.4-2.5 percent, which we have previously highlighted as an important resistance level. If, as we argued in A Massive Economic Imbalance, Staring Us In The Face, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Over the longer term, the bigger driver of the stock price will not be the discount factor on the future lump-sum payment; the bigger driver will be the size of the lump-sum payment itself. For any company, industry, or stock market, this expected lump-sum payment will evolve in line with current profits multiplied by a ‘structural growth multiple.’ It turns out that while current profits are updated every quarter, the structural growth multiple does not change much from quarter to quarter, year to year, or even decade to decade. Yet occasionally, it can phase-shift violently downwards when an event, or realisation, shatters the market’s lofty hopes for structural growth. Occasionally, an event or realisation shatters the market’s lofty hopes for structural growth. For example, after the dot com bubble burst it became clear that the sky-high hopes for non-US tech companies were just pie in the sky. The result was that their structural growth multiple halved, which weighed down non-US tech stocks for the subsequent 10 years (Chart I-3). Chart I-3After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed More recently, the realisation that Facebook – or Meta Platforms as it is now known – is losing subscribers was the gestalt moment that shattered hopes for its structural growth. Note that while its 2022 profits are down slightly, the Meta share price has collapsed, indicating a big hit to the structural growth multiple (Chart I-4). Chart I-4Facebook's Structural Growth Multiple Has Collapsed Facebook's Structural Growth Multiple Has Collapsed Facebook's Structural Growth Multiple Has Collapsed Conversely, there are rare occasions when a phase-shift down in a structural growth multiple is unwarranted or has gone too far. Right now, a case in point is the biotech sector, especially the US biotech sector. Relative to the relationship of the 2010s decade, US biotech’s structural growth multiple has halved (Chart I-5). The result is that US biotech is trading at the greatest valuation discount to the market (-20 percent). Ever. It is also trading at its greatest valuation discount to the broader tech sector (-35 percent). Ever (Chart I-6 and Chart I-7). Chart I-5US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? Chart I-6US Biotech Is Trading At Its Greatest Ever Discount To The Market... US Biotech Is Trading At Its Greatest Ever Discount To The Market... US Biotech Is Trading At Its Greatest Ever Discount To The Market... Chart I-7...And Its Greatest Ever Discount To Big-Tech ...And Its Greatest Ever Discount To Big-Tech ...And Its Greatest Ever Discount To Big-Tech Another way of putting it is that in the post-pandemic era, while the structural growth multiple for the broader tech sector is largely unchanged, the structural growth multiple for biotech has collapsed by 40 percent (Charts I-8, I-11). Begging the question, is such a massive structural de-rating justified? Chart I-8US Tech's Structural Growth Multiple ##br##Is Unchanged... US Tech's Structural Growth Multiple Is Unchanged... US Tech's Structural Growth Multiple Is Unchanged... Chart I-9...But US Biotech's Structural Growth Multiple Has Collapsed ...But US Biotech's Structural Growth Multiple Has Collapsed ...But US Biotech's Structural Growth Multiple Has Collapsed Chart I-10Global Tech's Structural Growth Multiple##br## Is Unchanged... Global Tech's Structural Growth Multiple Is Unchanged... Global Tech's Structural Growth Multiple Is Unchanged... Chart I-11...But Global Biotech's Structural Growth Multiple Has Collapsed ...But Global Biotech's Structural Growth Multiple Has Collapsed ...But Global Biotech's Structural Growth Multiple Has Collapsed Much Of Biotech’s Underperformance Is Due To Transient Factors We have identified five culprits for biotech’s recent underperformance, but they are largely transient: The sell-off in long-duration bonds: Ironically, though the market has downgraded biotech’s structural growth, it has still behaved like a long-duration sector that has tracked the sell-off in the 30-year T-bond. Hence, if the long-duration bond rallies, it will boost biotech stocks. The focus on delivering a Covid vaccine: While biotech was developing a Covid vaccine, investors became enamoured with the sector, but once the vaccine was delivered, investors fell out of love with the sector. Yet there is more to biotech than a provider of vaccines, and as we show in the final section, the sell-off has gone too far. Regulatory concerns: In the US there has been some concern about the dilution of a biotech company’s intellectual property (IP) rights – known as March-In-Rights – if government funding or research has contributed to an innovation. In practice though, the sophistication of most innovations means that IP would remain with the innovator. There has also been concern about drug pricing reform, but as is normal in any negotiation, the opening extreme position is likely to get watered down. A drought in M&A: The focus on Covid, plus the uncertainty around regulation, has led to a drought in the M&A activity that is usually the mechanism to crystallize value. Still, for long-term investors, value is value, whether it is crystallized or not. Furthermore, the drought in M&A cannot last forever. A flood of IPOs: The more than 100 biotech IPOs in 2021 was double the usual rate, creating an oversupply and indigestion for specialist investors in the sector. But given the poor performance of the sector, the IPO flood is likely to recede through 2022-23 in a self-correction. So, we come back to the question: is it right to price a structural growth outlook for biotech worse than the overall market and much worse than for big-tech? If anything, it is big-tech that faces the much greater existential risk in the form of Web 3.0 – which will remove big-tech’s current ownership of the internet, thereby wiping out its very lucrative business model. Look out for our upcoming Special Report on this major theme. To repeat, the market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market, when most of the headwinds it faces are transient. All of which leads to two investment conclusions. The market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. Fractal Trading Watchlist This week’s analysis focusses on our main theme, biotech, and we add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. Reinforcing the arguments in the preceding sections, US biotech is deeply oversold versus broader tech, reaching a point of fractal fragility that signalled several significant turning-points through the past two decades (Chart I-12). Accordingly, this week’s recommended trade is to go long US biotech versus US tech, setting the profit target and symmetrical stop-loss at 17.5 percent. Chart I-12US Biotech Is Deeply Oversold Versus Broader Tech US Biotech Is Deeply Oversold Versus Broader Tech US Biotech Is Deeply Oversold Versus Broader Tech   US Banks Are At Risk Of Reversal US Banks Are At Risk Of Reversal US Banks Are At Risk Of Reversal Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Greece's Snapback At A Resistance Point Greece's Snapback At A Resistance Point Greece's Snapback At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined fully, the duration of an investment is the weighted-average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades Time To Buy Biotech Time To Buy Biotech Time To Buy Biotech Time To Buy Biotech 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Lots Of Pent-Up Demand Lots Of Pent-Up Demand Lots Of Pent-Up Demand The yen is unlikely to meaningfully appreciate until global bond yields stabilize. That said, very cheap valuations and a large net short position provide ample ammunition for an explosive rebound should macroeconomic conditions fall into place. The macro catalyst is likely to come from a domestic growth rebound. Unlike other developed economies, private consumption in Japan has been rather anemic on the back of cascading lockdowns. Inflation in Japan will remain contained in 2022, meaning the Bank of Japan will stay dovish. That said, the Japanese economy is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 104. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Recommendations Inception Level Inception Date Return Short CHF/JPY 125.05 2022-02-17 -   Bottom Line: Real rates are likely to remain quite attractive in Japan. While that has not been a key driver of the currency in the short term, it remains an anchor over a longer horizon. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns. Feature Chart 1Anemic Passenger Volumes Anemic Passenger Volumes Anemic Passenger Volumes The Japanese economy grew by 1.7% in 2021. For an economy with a potential growth rate of only 0.5%, this is an impressive feat. Even more remarkable is that this growth occurred within the context of very anemic domestic demand. The external sector in Japan has been benefiting from a global trade boom, while the domestic sector has been under siege from the pandemic. Anecdotally, the situation on the ground remains rather dire. Shinkansen passenger volumes are still down 35% this year after an even bigger collapse last year. According to Nikkei Asia, the waiting list to enter Japan continues to grow, as border restrictions are enforced. Of the 626,000 individuals approved for residence in Japan since January 2020, only 35% have filtered through. More broadly, at the peak, tourist arrivals (a meaningful source of demand) represented 25% of the overall Japanese population. Today, that number remains near zero (Chart 1). Amidst the gloom, pockets of Japanese financial markets are beginning to suggest a turnaround in economic conditions. The yield curve in Japan is steepening, usually a sign that monetary conditions remain very conducive to growth. Historically, that has been a bullish signal for the yen (Chart 2). Meanwhile, despite the surge in global bond yields, Japanese bank stocks are outperforming. The banking sector is usually one of the first to sniff out an improvement in economic fortunes (Chart 3). Chart 2The Yen And The Japanese Yield Curve The Yen And The Japanese Yield Curve The Yen And The Japanese Yield Curve Chart 3Japanese Banks Are Outperforming Japanese Banks Are Outperforming Japanese Banks Are Outperforming Outside financials, with inflation surging around the world, the Japanese economy is one of the best candidates for generating non-inflationary growth. This is bullish for the currency as real rates rise. Our bias is that while it might be too early to go long the yen today, conditions are gradually falling into place for a coiled spring rebound. The Case For Japanese Growth While the manufacturing PMI in Japan hit an 8-year high of 55.4 in January, the services PMI sits at 47.6, the lowest in the G10. The number of daily new COVID-19 cases breached 100,000 this month, the highest since the pandemic began two years ago. Hospitalizations and deaths are also rising acutely. However, there is rising evidence that Japan is beginning to put the worst of the pandemic behind it. 79.5% of the population is fully vaccinated, versus just about 50% six months ago. Booster shots are being ramped up quickly. The effective reproduction rate of the virus has dropped sharply, from 2.29 at the end of last year to 1.19 currently. According to government officials, there will be sufficient progress made on the virus front to begin relaxing border requirements and restrictions by next month. Optimism on the COVID-19 front will be a welcome fillip to much subdued consumer and business sentiment. Consumption outlays in Japan remain well below the pre-pandemic trend, especially towards services (Chart 4). As the economy reopens, and the labor market recovery continues, the war chest of Japanese savings that have been built in recent years should be modestly unwound. The job-to-applicants ratio is inflecting higher and workers’ propensity to consume has been improving (Chart 5). Chart 5A Labor Market Recovery Will Boost Spending A Labor Market Recovery Will Boost Spending A Labor Market Recovery Will Boost Spending Chart 4Lots Of Pent-Up Demand Lots Of Pent-Up Demand Lots Of Pent-Up Demand Wage increases remain very modest in Japan. Fumio Kishida, the Japanese prime minister has called for wage increases above 3%. His government also wants to raise the minimum wage from ¥930 to ¥1000, after a 3% increase last year. As the Shuntō (spring wage negotiations) begin, unions are likely to become more vocal in demanding wage increases. However, with a large share of temporary workers in Japan, and company preferences for one-time bonuses versus permanent pay increases, overall wage growth in Japan should remain in the 1-2% range, in line with BoJ forecasts. This puts Japan miles away from a wage inflation price spiral. From a contrarian perspective, it also means that falling unit labor costs are making the currency extremely competitive (Chart 6). Chart 6Japanese Workers Are Both Productive And Competitive Japanese Workers Are Both Productive And Competitive Japanese Workers Are Both Productive And Competitive Chart 7A Smaller Fiscal Drag In 2022 A Smaller Fiscal Drag In 2022 A Smaller Fiscal Drag In 2022 In a nutshell, Japan has had cascading shocks from the consumption tax hike in 2019 to six waves of COVID-19 over the last two years. These have led to a massive build in pent-up demand, which should be unleashed in the coming quarters. Government outlays will also go a long way towards boosting aggregate demand. A supplementary budget of ¥36tn was put together last year and approved for the fiscal year that ends this April. The even bigger 2022 budget of ¥107.6tn should also help ease the fiscal drag in 2022 (Chart 7). For a low-growth economy like Japan, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. The Export Machine Continues To Hum A boom in external demand has been a much welcome cushion for Japanese growth. Rising energy prices are hurting the nominal trade balance, but real net exports remain firm. Foreign machinery orders are still rising over 30% year on year, boosting industrial production in Japan (Chart 8). Demand from China has been an important component of foreign sales. As monetary policy is eased in Beijing, domestic demand should start to improve, preventing Japanese exports from collapsing. One of the most cyclical components of Japanese exports is machine tool orders, which remain firm (Chart 9).  Chart 9A Chinese Recovery Will Cushion Export Growth A Chinese Recovery Will Cushion Export Growth A Chinese Recovery Will Cushion Export Growth Chart 8Machinery Orders Remain Robust Machinery Orders Remain Robust Machinery Orders Remain Robust Monetary Policy And Inflation The Bank of Japan is unlikely to adjust monetary settings aggressively, amidst a recovery in demand. It could widen the target band for yield curve control, while bringing short rates back to zero, but this will require a vigorous rebound in demand and inflation. It could also scrap its 0% bank loan scheme but given these are targeted (especially towards renewable industries, and small/medium-sized firms), that is unlikely. Remarkably, the BoJ has not had to increase its holdings of government securities over the last year, as markets have viewed its policy as credible (Chart 10). Doing little is likely the best path of action for the BoJ in 2022. Chart 112% Inflation = Mission Impossible? 2% Inflation = Mission Impossible? 2% Inflation = Mission Impossible? Chart 10Not Much QE By The BoJ Not Much QE By The BoJ Not Much QE By The BoJ The key variable for the BoJ remains its 2% inflation target, which seems elusive for the time being. Inflation does not tend to accelerate in Japan until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ (Chart 11). Moreover, the decline in phone charges has been structural, even though it is usually touted as a one-off. A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 20% every year to generate 2% inflation in Japan (Chart 12). The pass-through is likely to be much higher for price-volatile items such as food and energy, which is likely to create angst among the rapidly ageing population. Chart 122% Inflation = 20% Yen Depreciation 2% Inflation = 20% Yen Depreciation 2% Inflation = 20% Yen Depreciation Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. The Yen And Portfolio Flows It will be very difficult for the yen to rally if global yields continue to rise aggressively (Chart 13). With yield curve control in Japan, the nominal spread with foreign yields has been narrowing. However, the cost of hedging those foreign yields has also risen dramatically, which has prevented Japanese investors from aggressively flocking to overseas fixed income markets (Chart 14). That said, the weakness in the yen also suggests speculators have been borrowing in JPY to bet on carry strategies. Chart 13Global Yields Need To Stabilize To Cushion The Yen Global Yields Need To Stabilize To Cushion The Yen Global Yields Need To Stabilize To Cushion The Yen Chart 14No Massive Outflows From Japan Yet No Massive Outflows From Japan Yet No Massive Outflows From Japan Yet The rise in Treasury yields has yet to hit exhaustion from a technical perspective. Our bond strategists expect the 10-year yield to reach 2.25%, which will also enter the zone where we have historically seen some consolidation. The J.P. Morgan survey shows that most of its clients are short duration, but speculators are only modestly short 10-year or 30-year Treasurys (Chart 15). Chart 16USD/JPY And DXY Tend To Move Together USD/JPY And DXY Tend To Move Together USD/JPY And DXY Tend To Move Together Chart 15Modest Upside In Treasury Yields? Modest Upside In Treasury Yields? Modest Upside In Treasury Yields? Once yields stabilize, and the dollar starts to weaken, the positive real rate spread between Japan and the US should attract yen inflows, or at least nudge speculators to start liquidating massive short positions. As a counter-cyclical currency, the yen usually weakens against other developed market currencies, but USD/JPY tends to fall, on broad dollar weakness (Chart 16). Finally, the recent turbulence in markets has seen the yen begin to shine as a safe haven, more so than the US dollar and the Swiss franc (Chart 17). In the near term, this is a catalyst for long yen positions. With US interest rates having risen significantly versus almost all G10 countries in recent quarters, the dollar has become a carry currency. It is difficult for any currency to act as both a safe haven and carry currency, due to opposing driving forces. A rise in volatility will be a boost for the yen. Chart 17The Yen Is The Better Hedge The Yen Is The Better Hedge The Yen Is The Better Hedge Valuations And A Trade Idea In a report titled “A Short Note On US Dollar Valuations,” we suggested that the yen was the most undervalued G10 currency. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns (Chart 18). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As a play on rising volatility, cheaper valuations, and a positive carry, we suggest investors short CHF/JPY today, with a stop at 127, and a target of 115. Historically, these currencies have tended to move together. However, more recently, CHF has risen substantially versus JPY, suggesting some mean reversion is due (Chart 19). Chart 18The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Chart 19Sell CHF/JPY Sell CHF/JPY Sell CHF/JPY Housekeeping We are closing our long AUD/NZD trade for a modest profit of 2.5%. We introduced this tactical trade over 6 months ago and are now cognizant of the negative carry as global yields rise. As a reminder we usually hold tactical trades for 6 months, and cyclical trades for 6-18 months.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Financials Versus Industrials Is Approaching A Turning-Point Image CAD/SEK At A Top CAD/SEK At A Top CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Image   Indicators To Watch - Interest Rate Expectations III A Massive Economic Imbalance, Staring Us In The Face A Massive Economic Imbalance, Staring Us In The Face Image    

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary We back-tested equity strategies based on our rotation framework. They deliver positive excess returns and lower volatility. We also introduce our Excess Returns Rotation Maps, a new investment tool with an impressive track record. Based on the current reading of our rotation graphs and the predictive ability of our Rotation Maps, we recommend investors favor both the Euro Area Volatility index over the Momentum index and Value over Growth over the next twelve months. Strategy Performance For Sectors The Great Rotation The Great Rotation Bottom Line: At the national level, favor Swedish equities over German ones, German equities over both Italian and French equities, and Dutch stocks over their Spanish counterparts. At the sector level, overweight Materials relative to Energy, Energy to Financials, and Tech stocks to Communication stocks. Feature 2022 started with a bang. Economic activity slowed because of the Omicron variant, but labor markets continue to improve. Meantime, yields rose and inflation has remained sticky, thus forcing the Fed—and even the European Central Bank (ECB)—into a hawkish pivot. Suddenly, the prospect of rising interest rates and tightening of financial conditions has dawned upon investors. And, if this were not enough, the potential for a major geopolitical event is rising because the tensions between Russia and Ukraine have flared, refueling the European energy crisis. Considering how elevated equity valuations already are, these developments have ultimately caused investment sentiment to deteriorate sharply. Net bullish sentiment hit its lowest level since April 2013 according to the latest American Association of Individual Investors (AAII) survey, followed shortly thereafter by an inversion of the VIX curve and a record volume for put options. In January, the S&P 500 and the Nasdaq fell, respectively, by 5.2% and 9%, while the Euro Area MSCI index fell by 3%. However, these exhaustion / worry signs are not harbingers of a recession. The yield curve—which provides an historically excellent leading indicator of recessions—has not inverted. Credit spreads are widening, but they do not yet flash major stress points. We remain bullish on a cyclical horizon, especially for European equities, even if the near-term market outlook continues to be tricky, which is why we recommend investors hold protections. Nonetheless, we expect economic growth to remain solid. The Chinese credit impulse is trying to bottom, the global capex cycle is firm, and European households are still flush with savings that they will ultimately spend. Finally, the ECB is unlikely to raise interest rates until year-end. Bouts of volatility such as the current one are common at the beginning of episodes of policy tightening. The rise in inflation forces investors to experience a rather painful rotation that moves them from the pain of rising rates, to the fear of a more severe market correction, and which ultimately shifts them away from the deflationary mindset of the last decade. Last November, we introduced our relative rotation graphs to identify where equities stood in their rotation and thereby to help investors navigate these dangerous waters.To obtain a visual representation of the rotation, we position different assets in quadrants1 based on proprietary indicators of their relative strength and relative momentum. In this follow-up report, we put the effectiveness of our rotation framework to the test by providing the backtest summary results of the relative equity returns associated with each quadrant over time, as well as the relative returns obtained by picking long/short equity pairs based on our Rotation Maps framework. Our Rotation Maps framework delivers positive excess returns and lower volatility. More importantly, an ex-ante investment strategy based their predictive ability yields strong results, in relation to its application to investment styles, at sector or national levels. Timing The Rotations The main assumption of the Rotation Maps framework is that, on average, equities follow the rotation pattern illustrated in Diagram 1. We do not expect it to operate like clockwork, but gathering more descriptive statistics about these patterns over time provides valuable information, from the amount of time spent in each of the quadrants to how much time it takes to complete a rotation. One does not want to assume equities have just stepped into the Leading quadrant when, in fact, they have been there for several weeks already, implying it is probably not a good entry point on a tactical basis. This is why we show the entire rotation trail and not only the last reading.  We have added these descriptive statistics in each quadrant on Diagram 1. Diagram 1Stylized Rotation Pattern The Great Rotation The Great Rotation Knowing that on average—and ignoring temporary moves—equities tend to remain between 15 and 16 weeks within one quadrant means that we can calculate what the expected returns over the next one to three months will be once equities come to occupy a specific quadrant. Unsurprisingly, the best (worst) expected returns are obtained when equities are in the Leading (Lagging) quadrant, notwithstanding the ones we look at (Table 1). Table 1Stepping Into A Quadrant: 1-Month & 3-Month Returns The Great Rotation The Great Rotation The results clearly show that you can identify both future winners and losers based on where they currently stand in their rotation and thus enter long/short pairs trades accordingly. Within a three-month time horizon, this observation generally means buying equities that are in the Leading quadrant and selling those that are in the Lagging quadrant. To do so beyond a three-month time horizon requires using the information we collected about each rotation to predict where equities will stand in their respective rotation patterns at a certain point in the future. Having done that, we can anticipate what the predicted excess returns2 will be for a given pair trade based on the current quadrants of each leg. Table 2 presents the Excess Returns Rotation Map for Euro Area Value / Growth equities over different time horizons. At present, Value equities are located in the Leading quadrant, whereas Growth equities are in the Lagging quadrant. In the past, when this was the case, Value outperformed Growth on a three-, six-, and twelve-month horizon by 0.8%, 1.1%, and 3.1%, respectively. Table 2Excess Return Rotation Map: Value Versus Growth The Great Rotation The Great Rotation For presentation purposes, we only display one example of Rotation Map in this report. The Excess Returns Rotation Maps for each European investment style, sector, and national market mentioned thereafter is available on demand. Rotation Maps… Or Treasure Maps? The true usefulness of Rotation Maps lies in looking at each rotation graph at any point in time and using its predictive ability to pick the best pair trades, thus generating alpha. We designed two investment strategies to see whether our Rotation Maps framework adds value to the investment process. Both strategies are purely mechanical and do not require any judgement. Chart 1Strategy Performance For Investment Styles The Great Rotation The Great Rotation In the first strategy, we picked a pair trade with the highest predicted returns over the next twelve months among all the rotation maps and held it over that timeframe, and then we repeated this process for every year. In the second investment strategy, rather than picking the best predicted pair trade, we selected a basket comprised of the top 10% The results of both strategies for European equity styles, sectors, and national bourses are shown in Charts 1, 2, and 3. These results are astounding. The main value of this framework seemingly comes from its ability not only to avoid major stock market corrections but also to deliver strong positive returns. Case in point: when the Euro Area MSCI index fell by 47% in 2008, our top 10% baskets had an average return of 18% (styles), 22% (sector level), and 13% (nation level). Chart 2Strategy Performance For Sectors The Great Rotation The Great Rotation Chart 3Strategy Performance For National Markets The Great Rotation The Great Rotation The two strategies do not consistently beat the market. However, used over a multi-year horizon, our framework achieves annual returns that are, on average, two to three times higher than those of the market. We are confident we can improve the overall effectiveness of our framework by applying it in conjunction with our own cyclical macro views. In future research, we will explore how to exploit the rotation framework under different macro environments, such as when yields or inflation are rising. Having said that, which equities are predicted to generate the most alpha over the next twelve months based on the current picture? European Investment Styles Over the past three months, many European investment styles have moved into the Lagging quadrant, notably growth stocks (Chart 4). Meanwhile value stocks are solidly in the Leading quadrant, supported by rising yields. Small-caps equities finally escaped the Lagging quadrant and should deliver positive relative returns over the next few months. Chart 4Relative Rotation Graph: European Investment Styles The Great Rotation The Great Rotation Our Rotation Maps framework suggests that going long volatility stocks relative to momentum ones as well as going long value versus growth are the two trades predicted to deliver the highest returns over the next twelve months. European Sectors The sector shifts in European markets mirror the general confusion in the market: ignore the volatility and keep chasing cyclical stocks or find shelter in defensive stocks (Chart 5)? It looks like they did both. Most defensive sectors have moved into either the Improving or Leading quadrants, except for Consumer Staples. In the meantime, Energy and Financials, two cyclical sectors, have been occupying the Leading quadrant for quite some time. Chart 5Relative Rotation Graph: European Sectors The Great Rotation The Great Rotation Our Rotation Maps framework indicates that the following trades are predicted to deliver the highest returns over the next twelve months: Materials over Energy Energy over Financials Tech over Communication Services Utilities over Tech Health Care over Industrials Industrials over Financials European National Markets As expected, the rotational pattern exhibited by European national bourses continues to reflect their respective sectoral biases (Chart 6). The tech-heavy Dutch market has finally moved into the Lagging quadrant. Until industrials do better, the Swedish market will linger in the Lagging quadrant. Chart 6Relative Rotation Graph: European National Markets The Great Rotation The Great Rotation Germany scarcely moved at all, mostly staying in the Improving quadrant. We take it that the rotation pattern will shift German stocks to the Leading quadrant over the next few months, which support an overweight position in German equities. Similarly, the rotation should shift Spanish equities to the Leading quadrant over the short run, especially if German yields keep rising. Italian equities appear to have already been raised by higher yields into the Leading quadrant. Our Rotation Maps indicates that the following trades are predicted to deliver the highest returns over the next twelve months: Swedish stocks over German ones German stocks over Italian ones German stocks over French ones Dutch stocks over Spanish ones   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com     Footnotes 1     The “Leading” (“Lagging”) quadrant denotes assets performing better (worse) than their benchmark, with strengthening (weakening) momentum. The “Improving” (“Weakening”) quadrant denotes assets that are performing worse (better) than the benchmark, with strengthening (weakening) momentum. 2     We define excess returns as the total returns of the long/short position based on the rotation in excess of the average returns observed in the past.

Dear client, In lieu of our weekly bulletin next week, I will be hosting a webcast on Friday, January 28 at 11:00 am EST, to discuss recent dollar trends. I hope you all tune in. Kind regards, Chester Ntonifor Highlights While not often discussed, it is well known that the dollar is expensive. It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually coincide with huge external imbalances, especially generated by an overvalued exchange rate. The US dollar could be stepping into such a paradigm - the DXY is 1.5 standard deviations above fair value, at the same time as the goods trade deficit is hitting record lows, and real interest rates are deeply negative. More importantly, there has been limited precedence to such a dollar configuration. Historically, it has required much higher real interest rates, or an improving balance of payments backdrop, to justify such lofty valuations. Our trading model shows that selling a currency when it is expensive and buying it when it is cheap generates excess returns over time. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade basis, the AUD stands out as a winner. Feature Chart 1High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented Valuations usually get little respect when it comes to medium-term currency movements. This has been especially the case over the last few years, where the macroeconomic environment has been by far the biggest driver of the US dollar. The bull market in the dollar from 2011 to 2020 coincided with higher real interest rates in the US, relative to the rest of the developed world. In fact, since 2008, no developed market central bank has been able to hike rates by more than 200bps, except for the US Federal Reserve. Our report last week focused on why aggressive interest rate increases by the Federal Reserve could be bullish for the US dollar in the short term, but eventually set the stage for depreciation. In this report, we argue that valuations will also become a more important factor for currency strategy over the next 1-2 years (Chart 1). The Dollar And The External Balance The framework to understand currencies and the external balance is straightforward - a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given ample pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar stands out as overvalued on a real effective exchange rate basis (Chart 2A and 2B). It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually occur with a shift in animal spirits, coinciding with huge external imbalances. Chart 2 Chart 2 In the US, these imbalances are already starting to trigger a shift. The US trade deficit is deteriorating, with the goods deficit hitting a record low of -$98bn in November. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasuries (Chart 3). Meanwhile, as we highlighted last week, substantial equity inflows over the last few years have started to roll over. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating at an accelerated pace (Chart 4). The US current account deficit for Q3 came in at -$214.8 billion, the widest in over a decade. This has reversed a lot of the improvement in the basic balance since the Global Financial Crisis. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. Chart 4Deteriorating Balance Of Payments Dynamics US Balance Of Payments Deteriorating Balance Of Payments Dynamics US Balance Of Payments Deteriorating Balance Of Payments Dynamics US Balance Of Payments Chart 3It Is Becoming Increasingly Difficult To Fund The Widening Deficit It Is Becoming Increasingly Difficult To Fund The Widening Deficit It Is Becoming Increasingly Difficult To Fund The Widening Deficit Fiscal policy is likely to become tighter in the next couple of years, easing the domestic spending constraint for the exchange rate. That said, fiscal policy will remain loose compared to pre-pandemic levels and relative to underlying employment conditions. This has historically led to a deterioration in the external balance and pulled the real effective exchange rate of the dollar down (Chart 5). Chart 5The Dollar And The Budget Deficit The Dollar And The Budget Deficit The Dollar And The Budget Deficit Real Interest Rates And The Dollar It is remarkable that at a time when real rates are the most negative in the US, the dollar is as overvalued as it has been in decades on a simple PPP model. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive (Chart 1). According to economic theory, a currency should adjust to equalize returns across countries. This is a no-arbitrage condition. In the early 80s, an overvalued dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. In fact, over the last decade, it has been an anomaly that the dollar is so strong despite relative real interest rates being so negative (Chart 6). Our view remains that the terminal interest rate for the US should be higher than what is currently discounted in the 10-year Treasury yield. According to the overnight index swap curve, the Fed will not hike interest rates past 1.75%. This is much lower than past cycles and will keep real interest rates low. This does not justify an expensive greenback. Our shorter-term interest rate model also shows the DXY as slightly expensive, even though short-term interest rates have moved in favor of the dollar over the past year (Chart 7). Chart 6The Level Of Relative Real Yields Also Matters The Level Of Relative Real Yields Also Matters The Level Of Relative Real Yields Also Matters Chart 7Our Timing Model Suggests ##br##A Pullback Our Timing Model Suggests A Pullback Our Timing Model Suggests A Pullback Other Considerations While real effective exchange rates and purchasing power parity models are among our favorite valuation gauges, they are not foolproof. Countries with structurally higher inflation (and so a higher real effective exchange rate), could also have higher productivity. According to the Balassa-Samuelson Hypothesis, competitiveness in the tradeable goods sector will boost wages across all sectors of the economy, leading to higher prices. This argument particularly resonates with proponents that suggest the US is a fast-growing economy, and so will tend to run a current account deficit, like Australia during the commodity boom of the early 2000s. Meanwhile, the US earns more on its overseas assets than it spends on its liabilities, suggesting that the funding gap will eventually close. Unfortunately, the overvaluation of the dollar has not been due to higher relative productivity in the US, especially when compared to other economies. Across a broad spectrum of developed and emerging market economies, the dollar is expensive according to our productivity models. The Chinese RMB (which is much overvalued on a PPP basis) is closer to fair value when productivity is taken into consideration (Chart 8). Chart 8 Meanwhile, the sizeable US deficit is not completely offset by its positive investment balance (Chart 9). This is occurring at a time when many faster growing countries (such as China for example) are generating current account surpluses (Chart 10A and 10B). In a nutshell, whether one looks at relative price levels, relative productivity trends, or relative real returns on government assets, the dollar is expensive. Chart 9The Positive Income Balance Has Not Helped The Us Investment Position The Positive Income Balance Has Not Helped The Us Investment Position The Positive Income Balance Has Not Helped The Us Investment Position Chart 10 Chart 10 Conclusion Last summer, we introduced a trading model for FX valuation enthusiasts. We used both our in-house purchasing power parity models (PPP) and our intermediate-term timing models as valuation tools. Since the 2000s, both valuation models have outperformed a buy-and-hold currency strategy with much lower volatility (Chart 11). Currency valuation tends to matter over the longer term, while the macro environment tends to dominate short-term currency trading. Given that the dollar has been overvalued for the last three to five years, the above analysis suggests we might be entering this “longer-term” tipping point where valuations will start to matter more going forward. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade and productivity basis, the AUD stands out as a winner. This is being reflected in a record-high basic balance surplus (Chart 12). In our trade tables, we went long AUD at 70 cents, and will upgrade this to a high conviction bet on signs that currency volatility is ebbing. Chart 11A Trading Rule Solely Based On Valuation A Trading Rule Solely Based On Valuation A Trading Rule Solely Based On Valuation Chart 12AUD And Balance Of Payments AUD And Balance Of Payments AUD And Balance Of Payments Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights Industrial commodity and ag markets will continue to pull widely followed inflation gauges higher, as global fuel and fertilizer prices remain well bid (Chart of the Week). Unplanned production outages in Libya, faltering supply growth within OPEC 2.0 and a bullish read-through on demand in the wake of relatively mild public-health effects due to the omicron variant will keep oil prices well supported over the short term. Base metals prices will be pulled higher by the ongoing energy crises in Europe and China, which are forcing refiners to shutter capacity as fuels are re-directed to human needs. This is compounded by lockdowns in China – home to ~ 50% of global refining capacity – due to its zero-tolerance COVID-19 policy. These energy crises also are pulling grains higher, as farmers deal with soaring fertilizer costs – driven by soaring natgas prices – this year. Longer term – 2024 and beyond – industrial-commodity production will be concentrated in the hands of a few large producers. More explicit carbon pricing and ESG-induced cost increases will have to be recovered in higher wholesale prices for oil and metals. Grains will remain subject to volatile input costs, and erratic weather. We continue to favor broad-based exposure to commodities vis the S&P GSCI and the COMT ETF. Feature Fundamental supply-demand conditions in commodity markets – largely out of the control of fiscal- and monetary-policymakers – will continue to pull inflation gauges higher this year and for the rest of the 2020s. Oil markets are tight and getting tighter, owing to a dearth of capex since the price collapse triggered by OPEC's market-share war in 2014 (Chart 2). The same is true for base metals, where capex also has languished.1 Chart of the WeekCommodities Continue To Contribute To Global Inflationary Pressures Commodities Continue To Contribute To Global Inflationary Pressures Commodities Continue To Contribute To Global Inflationary Pressures Chart 2 Ag markets are confronting massive cost increases brought about by natgas shortages that first surfaced in 2021 and will continue to dog European and Asian fertilizer markets this year (Chart 3). These tight conditions leave markets vulnerable to unexpected supply and demand shocks, no matter how short-lived they might be. This is easily seen in oil markets: A force majeure declaration by Libya's national oil company following unplanned production shutdowns and pipeline maintenance pulled output below 800k b/d, or 30% lower than November 2021 levels, and almost completely neutralized a supply increase agreed by OPEC 2.0 earlier this week. Combined with what appears to be a relatively sanguine read-through on the impact of surging omicron infections in major consuming markets, these developments took prompt Brent back above $80/bbl.2 Chart 3Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Oil Price Strength Will Persist Longer term – 2024 and beyond – OPEC 2.0's capacity to increase oil supply will be concentrated in the hands of a few large producers, while US shale-oil producers will face tougher ESG hurdles, which will raise their costs. More explicit carbon pricing also will raise costs. These cost increases will have to be recovered in higher prices. OPEC 2.0’s raison d'être at its inception in 2016 was to regain control over the level of global oil inventories. It has been remarkably successful in this endeavour, despite massive geopolitical uncertainty and a global pandemic (Chart 4). We do not expect any course changes over the coming years. What will change, however, are the fortunes of states in this coalition capable of increasing supply as global demand increases. At present, the Kingdom of Saudi Arabia (KSA) and Russia are the putative leaders of OPEC 2.0, and are two of the five states that can increase production at present (Iraq, the UAE and Kuwait also are in that group). By the end of this decade, the leadership of the coalition could come down to KSA and the UAE. While not certain, the US EIA expects Russia's output to level off and then gradually decline over the course of this decade. (Chart 5).3 Russia will remain a significant producer in the coalition, but it likely will be managing declining output as opposed to fighting for higher market share. Chart 4OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works Chart 5 Producers outside the OPEC 2.0 coalition – i.e., the price-taking cohort – have gone to great lengths to improve the attractiveness of their equity, and to maintain access to debt markets to fund their growth. These goals will not support any effort to increase production at the risk of reducing ROEs, as this would set efforts to regain investors' and lenders' favor back years. Going forward, capital markets, climate activists in board rooms and courtrooms, and an increasing load of ESG-related measures – most not yet even defined – will become central to the price-taking cohort's operations and returns. These will impose additional costs on the production of hydrocarbons, with explicit carbon pricing only one of many costs that will have to be recovered in higher prices. Base Metals Again Hit By Gas Shortages Shortages of natural gas continue to plague Europe: According to Gazprom, the Russian state-owned gas company, the continent has withdrawn more than 45% of total gas injected into storage this year, with peak winter in the Northern Hemisphere still to come.4 Just over 20% of power generation in Europe is gas-fired, which means tight gas markets drive gas prices and power prices higher. This power crunch is hitting the continent’s supply of refined aluminum and zinc particularly hard, which means global supplies also are being hit hard. Europe is responsible for ~ 12.5% and ~ 18% of global primary aluminum and zinc slab production, respectively. Low inventories at the start of winter, and cold weather is forcing European natgas to be directed to human needs at the expense of power generation. This has resulted in shutdowns of aluminum smelters in Europe – e.g., Aluminium Dunkerque Industries France was forced to curb production in the second half of December. Around the same time, Trafigura’s Nyrstar – which has the capacity to produce ~ 5.2% of global refined zinc – also announced plans to shut its zinc operations in France beginning January, citing high power prices. While power rationing has helped stabilize an earlier crisis in the world’s largest refined copper, aluminum, and zinc producer, the odds China’s power crisis will worsen has increased, following Indonesia's coal export ban in January to preserve the fuel for domestic energy security. China’s plans to curb air pollution ahead of the Winter Olympics next month will also dampen refining activity. Base metals also are contending with a new fundamental supply risk: Political uncertainty in the critically important producing states of Chile and Peru, the world’s largest producers of the red metal. Gabriel Boric, the new Chilean president, supports higher taxes on copper mining firms, as does his Peruvian counterpart Pedro Castillo. Boric’s election also signals more scrutiny on ore miners’ environmental practices – putting additional ESG-induced costs into wholesale copper prices. The uncertainty surrounding Peru’s constitutional rewrite, with the possibility for a change in mining rules to favor wealth redistribution and the environment will deter mining investments, according to Diego Hernandez, head of Sonami, the Chilean mining society. In Peru, the motion to and failure to impeach Castillo last month will increase political uncertainty, potentially reducing investors’ faith in the country’s mining sector. All of this has a chilling effect on investment in markets that are starved for capex.5 The lack of stable supply and low inventories have caused major price surges over the last year for industrial metals (Chart 6). We expect prices to rise and maintain higher levels over the course of this decade. Base metals production likely will fall short of demand as the world undertakes the green energy transition. Chart 6Copper Inventories Drawing Hard Copper Inventories Drawing Hard Copper Inventories Drawing Hard Investment Implications Industrial commodity markets are tightening over the short term and are on course to tighten further as the current decade progresses. This will raise the cost of the energy transition, as higher prices will be required to spur new supply investments in base metals, which are the sine qua non for this transition. This also will spur additional investment in oil and natgas supply, since these already have the infrastructure in place to move supply to market in order to meet the rising demand for energy we expect going forward. We will be exploring these themes throughout the year, particularly the implications for policy around the development of carbon-capture technologies – especially in natgas markets – and nuclear power, both of which may be the most "shovel ready" sources of incremental energy supply this decade.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish European natgas prices are once again rallying as inventories continue to be drawn down hard due to cold weather, reduced gas supplies from Russia, and higher demand generally (Chart 7). By the end of 2021, European natgas inventories were 57% full, vs the seasonal norm of 72%. At the end of December, close to 50 LNG tankers from the US were sailing to European destinations. As 2022 opens, the European TTF price for natural gas rose 30% to €94/MWh off their recent lows. Cargoes now will be bid in Asia, particularly in China, due to a halt in coal exports during January from Indonesia announced by the government at year end. China had replaced Australian coal imports with Indonesian-sourced material last year. Base Metals: Bullish MMG Ltd’s Las Bambas mine in Apurímac, Peru will restart operations after suspending production in late December. The mine's owner enacted the suspension following a month-long blockade at one of its key roads by the Chumbivilcas community. Prime Minister, Mirtha Vasquez travelled to the region to ensure the conflicting parties reached an agreement.  Las Bambas mine makes up ~2% of global mined copper supply and its tax payments are a significant source of government revenue. While an agreement was reached to lift the blockade, it did not address the Chumbivilcas’ primary concerns. The community wants the mine to employ more locals and provide higher cash contributions to support local infrastructure. This elevates the likelihood of further blockades and supply disruptions this year. Since it commenced operations in 2016, the Las Bambas mine has dealt with blockades over key roads on and off for over 400 days.  Ags/Softs:Neutral Global fertilizer markets will remain tight as natgas prices resume their rally and drive input costs higher. This will contribute to rising food price inflation and may result in global food shortages in 2022. High fertilizer prices might encourage farmers to delay planting this year, in the hope prices will fall. This risks increasing price volatility if too many farmers wait too long to apply fertilizers for their spring crops. Chart 7 Footnotes 1     Please see our most recent update on these factors in 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. It is available at ces.bcaresearch.com. 2     Please see Libyan crude output falls below 800,000 b/d published by argusmedia.com on January 4, 2022, and Oil futures: Prices steady after OPEC+ hike, Brent close to $80/b published by qcintel.com on January 5, 2022. 3    In its December 2021 assessment of Russia's oil-production potential, the US EIA noted: "… declining output from Russia’s more mature fields (primarily in Western Siberia, Russia’s largest oil producing region) may offset the production growth coming from greenfield development, which may result in Russia’s crude oil production declining by the end of the 2020s decade. In addition to greenfield development, companies are increasing drilling at some existing mature oil fields and are tying in smaller fields to existing infrastructure at larger fields to help increase recovery rates and mitigate some of the production decline. However, brownfield development efforts in Russia are unlikely to reverse the decline in production in the longer term." Please see Country Analysis Executive Summary: Russia, published by the EIA on December 13, 2021. 4    Please refer to Hoping for cheaper gas to come, Europe reverses Russian link to tap storage, published by Reuters on December 30, 2021. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021 for additional discussion   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

As 2021 draws to a close, we thank you for your ongoing readership and support. We wish you and your loved ones a happy holiday season and all the best for a healthy and prosperous 2022. Highlights Over the coming three months, the odds are high that the Omicron variant of COVID-19 will disrupt economic activity in advanced economies, but the magnitude of the disruption will be heavily determined by the variant’s capacity to produce severe illness. For now, we remain of the view that the pandemic will recede in importance over the course of the next year. Relative to the assessment that we published in our 2022 Outlook report, the Omicron variant of COVID-19 has modestly raised the odds of a stagflationary outcome next year. Our base case view of above-trend growth and above-target inflation remains the most likely scenario for 2022. We do not think that the actual risk of a recession has risen significantly since we published our annual outlook, but we can envision a scenario in which Fed tightening causes investors to become fearful of a recession. The true risk of a monetary policy-induced recession over the coming 12-18 months will only rise if long-dated inflation expectations break above the range that prevailed prior to the Global Financial Crisis. Beyond 2022, the main risk to financial markets is that investors raise their longer-term interest rate expectations closer to the trend rate of economic growth. This would not be bad news for real economic activity, but it would imply meaningfully lower prices for financial assets that have benefited from low interest rates. We continue to advise that investors position themselves in line with the investment recommendations that we presented in our Outlook report. Over the coming year, investors should watch for the following when deciding whether to reduce exposure to risky assets: a breakout in long-dated inflation expectations, a significant flattening in the yield curve, or a rise in 5-year, 5-year forward US Treasury yields above 2.5%. Feature Our recently published 2022 Outlook report laid out the main macroeconomic themes that we see driving markets next year, as well as our cyclical investment recommendations.1 In this month’s report, we discuss the most relevant risks to our base case view in more depth, and update our fixed-income view in the wake of the December FOMC meeting. The Near-Term Risks Chart I-1DM Policymakers Are Afraid That Omicron Will Overwhelm The Medical System DM Policymakers Are Afraid That Omicron Will Overwhelm The Medical System DM Policymakers Are Afraid That Omicron Will Overwhelm The Medical System Over the coming 0-3 months, the greatest risks to economic growth stem from the likely impact of the Omicron variant of COVID-19 on the medical system and the evolution of Europe’s energy crisis. News about the Omicron variant emerged just a few days prior to the publication of our annual outlook, and considerable uncertainty remains about its impact. Some early evidence suggests that the variant causes less severe disease, with a recent press release from South Africa’s largest private health insurance administrator suggesting that the risk of hospital admission was 29 percent lower for adults with the Omicron variant after adjusting for age, sex, underlying health conditions, and vaccine status. More recent studies from South Africa have suggested a much larger reduction in the severity of disease,2 but it is not yet clear whether these findings are applicable to advanced economies,given South Africa’s more recent vaccination campaign and higher proportion of a previously infected population. If Omicron turns out to result in 30 percent less hospitalizations, that only reduces the net impact on the medical system if the Omicron variant is no more than 1.5x as transmissible as the Delta variant. The sheer speed at which Omicron is spreading suggests it is far more contagious than this, the result in part to its ability to evade two-dose immunity. The potential for Omicron to quickly overwhelm available health system resources has alarmed authorities in several advanced economies, especially given that cases and hospitalizations have already trended higher in several countries even while Delta remained the dominant variant (Chart I-1). Additional restrictions on economic activity in the DM world appear to be likely over the coming weeks, and may be in effect until booster doses have been fully administered and/or Pfizer’s drug Paxlovid becomes widely available. For Europe, a worsening of the COVID situation has the potential to exacerbate the economic impact of the region’s ongoing energy crisis. Chart I-2 highlights that European natural gas prices have again exploded, reaching a new high that is fourteen times its pre-pandemic level. We noted in our Outlook report that European natural gas in storage is well below that of previous years, and Chart I-3 highlights that the gap in stored gas relative to previous years persists. This is occurring despite roughly average temperatures in central Europe over the past month (Chart I-4), underscoring that, barring atypically warmer temperatures, European natural gas prices are likely to remain elevated throughout the winter. Chart I-2Another Explosion In European Natural Gas Prices Another Explosion In European Natural Gas Prices Another Explosion In European Natural Gas Prices Chart I-3 Chart I-5For Europe, COVID Is More Of A Problem Than Natural Gas Prices For Europe, COVID Is More Of A Problem Than Natural Gas Prices For Europe, COVID Is More Of A Problem Than Natural Gas Prices Chart I-4   For now, it appears that the rise in COVID cases is having a more pronounced effect on the European economy than the energy price situation. Chart I-5 highlights that the flash December euro area manufacturing PMI fell only modestly, and that Germany’s manufacturing PMI actually rose in December. By contrast, the euro area services PMI fell over two points, reflecting the toll that recent pandemic control measures have taken on non-goods producing activity. Over the coming three months, the odds are high that the Omicron variant will disrupt economic activity in advanced economies to some degree, but the magnitude of the disruption will be heavily determined by the variant’s capacity to produce severe illness. Investors will have more information on hand in a few weeks by which to judge the extent of this risk. We will provide an update to our own assessment in our February report. Risks Over The Next Year In our Outlook report, we assigned a 60% chance to an above-trend growth and above-target inflation scenario next year, a 30% chance to a “stagflation-lite” scenario of growth at or below potential and inflation well above target, and a 10% chance of a recession. We present below our assessment of the risk that one of the latter two scenarios occurs in 2022. The Risk Of “Stagflation-Lite” Chart I-6Aside From Europe's Energy Crisis, Supply-Side Constraints Are Slowly Easing Aside From Europe's Energy Crisis, Supply-Side Constraints Are Slowly Easing Aside From Europe's Energy Crisis, Supply-Side Constraints Are Slowly Easing The Omicron variant of COVID-19 has modestly raised the odds of a stagflationary outcome next year. Over the past few months, supply-side pressures have been modestly improving outside of Europe. Chart I-6 presents our new BCA Supply-Side Pressure Indicator, which measures the impact of supply-side restrictions across four categories: energy prices, shipping costs, the semiconductor shortage impact on automobile production, and labor availability. When we include all eleven components, the index has been trending higher of late, but trending flat-to-down after excluding European natural gas prices. While Omicron has the potential to reduce energy price pressure outside of Europe, it has the strong potential to cause a further increase in global shipping costs and postpone US labor market normalization. On the shipping cost front, we noted in our Outlook report that supply-side effects have been a significant driver of higher costs this year. The large rise in China/US shipping costs since late-June has been seemingly caused by the one-month closure of the Port of Yantian that began in late-May. While China has made enormous progress in vaccinating its population over the course of the year, and has prioritized the vaccination of workers in key industries, recent reports suggest that the Sinovac vaccine provides essentially no protection against contracting the Omicron variant of COVID-19. It is possible that Sinovac will offer protection against severe illness, but in terms of preventing transmission of the disease, Omicron has essentially returned China’s vaccination campaign back to square one. Chart I-7Further Price Increases May Seriously Slow Goods Spending Further Price Increases May Seriously Slow Goods Spending Further Price Increases May Seriously Slow Goods Spending That fact alone makes it almost certain that China will maintain its zero-tolerance COVID policy for most of 2022, which significantly raises the risk of additional factory and port shutdowns – and thus even higher shipping costs and imported goods prices. One optimistic point is that these shutdowns are more likely to occur in mainland China than in Taiwan Province or Malaysia, two key semiconductor exporters. This is because these two regions have distributed doses of Pfizer’s vaccine, and thus presumably have the ability to provide three-dose mRNA protection to workers in crucial exporting industries (should policymakers choose to do so). Still, US consumer goods prices would clearly be impacted by even higher shipping costs, which would likely have the combined effect of slowing growth and raising prices. Chart I-7 highlights that the recent sharp deterioration in US households’ willingness to buy durable goods has been closely linked to higher goods prices, arguing that goods spending may slow meaningfully if prices rise further alongside renewed weakness in services spending. Omicron’s contagiousness may also exacerbate the ongoing US labor shortage. The shortage has occurred because of a surge in the number of retirees, difficult working conditions in several industries, and increased childcare requirements during the pandemic. The increase in the number of retirees has not happened for structural reasons; it has been driven by a sharp slowdown in the number of older Americans shifting from “retired” to “in the labor force”, which has occurred because of health concerns. None of these factors are likely to improve meaningfully while Omicron is raging, suggesting that services prices are likely to remain elevated or accelerate further even if services spending falls anew. Chart I-8 To conclude on this point, we estimate that the odds of a stagflation-lite scenario have risen to 35% (from 30%), and the odds of our base-case scenario of above-trend growth and above-target inflation have fallen to 55% (Chart I-8). Still, our base-case view remains the most probable outcome, given that we do not believe the odds of a recession next year have risen. The Risk Of Recession We do not think that the actual risk of a recession has risen significantly since we published our annual outlook, but we can envision a scenario in which Fed tightening causes investors to become fearful of a recession. Such a scenario would have a material impact on cyclical investment strategy, and thus warrants a discussion. Following the December FOMC meeting, BCA’s baseline expectation is that a first Fed hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. BCA’s house view on this question is now in line with the view of The Bank Credit Analyst service, which published in a September Special Report that the Fed could hit its maximum employment objective as early as next summer.3 The Fed’s shift implies that the 2-year yield should rise to 1.85%, and the 10-year yield to 2.35%, by the end of next year (Chart I-9).  Chart I-9A More Hawkish Fed Means A 2.35% 10-Year Yield Next Year A More Hawkish Fed Means A 2.35% 10-Year Yield Next Year A More Hawkish Fed Means A 2.35% 10-Year Yield Next Year We doubt that US monetary policy will become economically restrictive next year. If the Omicron variant of COVID-19 causes a serious slowdown in economic activity, the Fed will ramp down its expectations for rate hikes. And if the Fed meets our baseline expectations for hikes next year in the context of above-trend economic growth, we do not believe that a 2.35% 10-year Treasury yield will be, in any way, limiting for economic activity. However, investors do not agree with our view about the boundary between easy and tight monetary policy, and may begin to fear a recession in response to Fed tightening next year. We noted in our Outlook report that we believe the neutral rate of interest (“R-star”) is likely higher that investors believe, but the fact remains that the Fed and market participants have judged, with deep conviction, that the neutral rate remains very low relative to the potential growth rate of the economy. Chart I-10 presents the fair value path of the 2-year Treasury yield based on our expectations for the Fed funds rate, alongside the actual 10-year Treasury yield. The chart highlights that the 2/10 yield curve could flatten significantly or even invert in the second half of 2022 if long-maturity yields rise only modestly in response to Fed tightening, which could occur if investors focus on the view that the neutral rate of interest is low and that Fed rate hikes will not prove to be sustainable. Based on two different measures of the yield curve, fixed-income investors believe that the current economic expansion is already 50-60% complete (Chart I-11), implying a recession at some point in the first half of 2023. Chart I-10The US Yield Curve Could Invert Next Year If Long-Maturity Yields Rise Only Marginally The US Yield Curve Could Invert Next Year If Long-Maturity Yields Rise Only Marginally The US Yield Curve Could Invert Next Year If Long-Maturity Yields Rise Only Marginally Chart I-11More Than Half Of The Economic Expansion Has Already Occurred, According To The Yield Curve More Than Half Of The Economic Expansion Has Already Occurred, According To The Yield Curve More Than Half Of The Economic Expansion Has Already Occurred, According To The Yield Curve Chart I-12A Serious Flattening In The Yield Curve Could Unnerve Stocks A Serious Flattening In The Yield Curve Could Unnerve Stocks A Serious Flattening In The Yield Curve Could Unnerve Stocks If the yield curve were to flirt with inversion and investors began to price in the potential for a recession, it would cause significant financial market turmoil regardless of whether the risk of recession is real or not. Chart I-12 highlights that the S&P 500 fell 20% in late 2018 as the 2/10 yield curve flattened towards 20 basis points, in response to the economic impact of the China-US Trade War and the global impact of US tariffs on the auto industry. So it is possible that a “recessionary narrative” negatively impacts risky asset prices in the second half of 2022, even if an actual recession is ultimately avoided. Based on this, we would be much more inclined to reduce our recommended exposure to equities if the US 2/10 yield curve were to flatten below 30 basis points next year. In our view, the risk of a monetary policy-induced recession over the coming 12-18 months will only legitimately rise if long-dated inflation expectations break above the range that prevailed prior to the Global Financial Crisis. We noted in our Outlook report that this has not yet occurred for either household or market-based expectations, although it is a risk that cannot be ruled out. The odds of a breakout in long-dated inflation expectations will rise the longer that actual inflation remains elevated, and our inflation probability model suggests that core PCE inflation will remain well above 3% next year and potentially above 4% – although Chart I-13 highlights that the odds of the latter are falling. Chart I-13US Core Inflation Will Remain Well Above Target Next Year US Core Inflation Will Remain Well Above Target Next Year US Core Inflation Will Remain Well Above Target Next Year A dangerous breakout in inflation expectations would raise the risk of a recession because of the Fed’s awareness of the “sacrifice ratio”, a very important economic concept that has been mostly irrelevant for the past 25 years. The sacrifice ratio is an estimate of the amount of output or employment that must be given up in order to reduce inflation by one percentage point. Table I-1 highlights some academic estimates of the sacrifice ratio, which have typically varied between 2-4% in output terms. For comparison purposes, real GDP has typically fallen no more than 2% on a year-over-year basis during most post-war US recessions. Real GDP growth fell 4% year-over-year in 2009, highlighting that the cost of reducing the rate of inflation by 1 percentage point is effectively a severe recession. Chart I- In his Senate testimony in late-November, Fed Chair Jay Powell noted that persistently high inflation threatens the economic recovery. He also implied that to reach its maximum employment goal, the Fed may need to act pre-emptively to tame inflation. This was implicit recognition of the sacrifice ratio, and should be seen as an expression of the Fed’s desire to avoid a scenario in which persistently high inflation causes inflation expectations to become unanchored (to the upside), as it would force the Fed to sacrifice economic activity in order to ensure price stability. By acting earlier to normalize monetary policy, the Fed hopes to keep inflation expectations well contained. Chart I-14Long-Dated Market-Based Inflation Expectations Are Not Out Of Control Long-Dated Market-Based Inflation Expectations Are Not Out Of Control Long-Dated Market-Based Inflation Expectations Are Not Out Of Control For now, we see no signs that the Fed will fail to keep inflation expectations from rising dangerously. Chart I-14 highlights that long-dated market expectations for inflation have been falling over the past two months, and are essentially at the same level that they were on average in 2018. Given this, we maintain the 10% odds of recession that we presented in our Outlook report, although investors will need to monitor inflation expectations closely over the coming year to judge whether the risks of a monetary policy-induced recession are indeed rising. Risks Beyond The Next Year Beyond 2022, the main risk to risky asset prices is probably not overly tight monetary policy. Instead, the risk is that investors will come to the conclusion that the Fed funds rate will ultimately end up rising above what the Fed is currently projecting, and that the economy will be capable of tolerating interest rates that are closer to the prevailing rate of economic growth. This would not be bad news for real economic activity, but it would imply meaningfully lower prices for financial assets that have benefited from low interest rates. Chart I-15US Stocks Would Suffer Significant Losses If Interest Rates Rise Towards Potential Growth US Stocks Would Suffer Significant Losses If Interest Rates Rise Towards Potential Growth US Stocks Would Suffer Significant Losses If Interest Rates Rise Towards Potential Growth Chart I-15 drives the point home by comparing the current S&P 500 forward P/E ratio to a “justified” P/E. Here, we calculate the justified P/E using the average ex-ante equity risk premium (ERP) since 1980, and real potential GDP growth as a stand-in for the real risk-free rate of interest. The chart highlights that US stocks would experience a 30% contraction in equity multiples should real long-maturity bond yields approach 2%. A decline in the ERP could potentially reduce losses for equity holders in a higher interest rate scenario, but it is very likely that the net effect would still be negative for stocks. We detailed in our Outlook report why we believe that the neutral rate of interest is higher than most acknowledge. We agree that R-star fell in the US for a time following the Global Financial Crisis (GFC), but we strongly question that it is as low as the Fed and investors believe. The neutral rate of interest fell during the first half of the last economic cycle because of a persistent period of household deleveraging and balance-sheet repair, which was a multi-year consequence of the financial crisis and the insufficient fiscal response to the 2008-09 recession. We highlighted in our Outlook report that US household balance sheets have been repaired, and that the household debt service ratio has fallen to mid-1960s levels. However, Chart I-16 highlights that even the corporate sector, which has leveraged itself significantly over the past decade, has seen its debt service ratio plummet. In a scenario in which long-maturity Treasury yields were to rise to 4%, we estimate that the debt service burden of the nonfinancial corporate sector would rise to its 70th-80th percentile historically. Chart I-16The US Corporate Sector Debt Service Burden Has Room To Rise The US Corporate Sector Debt Service Burden Has Room To Rise The US Corporate Sector Debt Service Burden Has Room To Rise That would be a meaningful increase from current levels, but it would not be unprecedented, and thus would not render a 4% 10-year Treasury yield to be economically unsustainable. In addition, we strongly suspect that corporations would reduce their interest burden in such a scenario by issuing equity to retire debt. That would lower firms’ debt burden and reduce the economic impact of higher interest rates, although it would be additionally negative for equity investors given that this would dilute earnings per share. We argued in our Outlook report that a shift in investor expectations about the neutral rate of interest is unlikely to occur before the Fed begins to normalize monetary policy. Ryan Swift, BCA’s US Bond Strategist, presented further evidence of this perspective in a Special Report earlier this week.4 Ryan highlighted results from a recent academic paper, which showed that the entire decline in the 10-year Treasury yield since 1990 has occurred during three-day windows centered around FOMC meetings (Chart I-17). Ryan argued that this suggests investors change their neutral rate expectations in response to Fed interest rate decisions, rather than in response to independent macroeconomic factors that are distinct from monetary policy action. This argues that a shift in neutral rate expectations is unlikely before the Fed begins to lift interest rates in the middle of the year, and probably not until the Fed has raised rates a few times. We are thus unlikely to recommend that investors reduce their equity exposure in response to this risk until 5-year, 5-year forward Treasury yields break above 2.5% (the Fed’s long-run Fed funds rate projection), which is 80 basis points above current levels (Chart I-18). Chart I-17Fed Rate Decisions Drive Long-Maturity Bond Yields Fed Rate Decisions Drive Long-Maturity Bond Yields Fed Rate Decisions Drive Long-Maturity Bond Yields Chart I-18We Will Consider Selling Stocks If Market-Based Neutral Rate Estimates Exceed 2.5% We Will Consider Selling Stocks If Market-Based Neutral Rate Estimates Exceed 2.5% We Will Consider Selling Stocks If Market-Based Neutral Rate Estimates Exceed 2.5%   Investment Conclusions We continue to advise that investors position themselves in line with the investment recommendations that we presented in our Outlook report. Over the following 12-months, we expect the following: Global stocks to outperform bonds Short-duration fixed-income positions to outperform long High-yield corporate bonds to outperform within fixed-income portfolios Value stocks to outperform growth Non-resource cyclicals to outperform defensives Small caps to outperform large A modest rise in commodity prices led by oil A decline in the US dollar However, our discussion of the risks to our views has highlighted three things for investors to monitor next year when deciding whether to reduce exposure to stocks (and risky assets more generally): A breakout in long-dated inflation expectations, as that would likely cause the Fed to raise interest rates more aggressively than it currently projects. A significant flattening in the yield curve, as that would indicate that investors ultimately expect existing Fed rate hike projections to prove recessionary. A rise in 5-year, 5-year forward US Treasury yields above 2.5%, as that would indicate that investors may be upwardly shifting their expectations for the neutral rate of interest. Over the shorter-term, our discussion also underscored that the Omicron variant will likely disrupt economic activity to some degree over the coming three months, and that the risks of a stagflation-lite scenario next year have modestly increased because of the likely maintenance of China’s zero-tolerance COVID policy. We continue to expect that the widespread rollout of booster doses, as well as the progressive availability of effective and safe antiviral drugs, will limit Omicron’s impact on economic activity to the first half of 2022, and that the pandemic will recede in importance next year on average in comparison to 2021. As noted above, this assessment will be monitored continually in response to the release of new information, and we will provide an update in our February report. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst December 23, 2021 Next Report: January 27, 2022 II. Stock Buybacks – Much Ado About Nothing Dear Client, This month’s Special Report is a guest piece by Doug Peta, BCA Research’s Chief US Investment Strategist. Doug’s report examines the impact of US stock buybacks using a median bottom-up approach, and presents a different perspective of the value vs. growth distribution of buybacks than we did in our October Section 2. I trust you will find his report interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Elected officials’ antipathy for buybacks is unfounded, … : For the companies that are the primary drivers of buyback activity, returning cash to shareholders is more likely to have a positive impact on employment and investment than retaining it.  and the idea that they boost stock returns may be, as well, … : Over the last ten years, a cap-weighted bucket of large-cap stocks that most reduced their share counts underperformed the bucket that most increased their share counts by 2% annually.  especially within the Tech sector, which has most enthusiastically executed them: Despite the success of Apple, which has seen its market cap soar since embarking on a deliberate strategy to shrink its shares outstanding, a strategy buying Tech’s biggest net reducers and selling its biggest net issuers would have generated sizable negative alpha over the last ten years. The problem is the relative profile of net buyers and net issuers: In general, companies that consistently buy back their own stock are mature companies that cannot earn an accretive return by redeploying the capital their incumbent business generates. Net issuers, on the other hand, are often young companies seeking fresh capital to realize their abundant growth opportunities. The next year is likely to see a pickup of share buybacks nonetheless, … : Our US Equity Strategy service’s Cash Yield Prediction Model points to increased buyback activity in 2022. … as management teams are wedded to them and buying back stock is the best use of capital for the mature companies executing them: Better to return cash to shareholders than to enter new business lines beyond the company’s area of expertise or embark on dubious acquisitions, even in the face of a potential 1% surtax. In Capitol Hill’s current polarized state, stock buybacks are in select company with the tech giants and China as issues that unite solons on both sides of the aisle. They are also a hot-button issue for some investors, who see them as telltale signs of a market kept aloft by sleight of hand. Although we do not think they’re worth getting worked up over – they do not promote the misallocation of capital and they may not actually boost stock prices – they come up repeatedly in client discussions and are likely to remain a feature of the landscape even if they are eventually subjected to a modest federal surtax. We have therefore joined with the BCA Equity Analyzer team to pore over its bottom-up database for insights into the buyback phenomenon. After ranking nearly 600 stocks in our large-cap universe in order of their rolling 12-month percentage change in shares outstanding across the last ten years, we were surprised to discover that the companies that most reduced their share count underperformed the companies that most grew it. We were also surprised to find that Tech was by far the worst performer among the six sectors with negative net issuance. Ultimately, the performance story seemed to boil down to Growth stocks’ extended recent edge over Value stocks. We present the data, our interpretation of it, and some future investment implications in this Special Report. Buybacks’ Bad Rap From Capitol Hill to the White House, prominent Washington voices bemoan buybacks. In a February 2019 New York Times opinion piece,5 Senators Sanders (I-VT) and Schumer (D-NY) argued that equity buybacks divert resources from productive investment in the narrow interest of boosting share prices for the benefit of shareholders and corporate executives. To counter the increasing popularity of buybacks, they proposed legislation that would permit buybacks only after several preconditions for investing in workers and communities had been met. Echoing their concerns, the White House's framework for the Build Back Better bill included a 1% surcharge on stock buybacks, “which corporate executives too often use to enrich themselves rather than investing in workers and growing the economy.” Chart II-1The Smallest Companies Sell Stock; The Largest Buy It Back The Smallest Companies Sell Stock; The Largest Buy It Back The Smallest Companies Sell Stock; The Largest Buy It Back Buybacks’ opponents may mean well, but they seem to be missing an essential point: by and large, the companies that buy back their own stock lack enough attractive investment opportunities to absorb the cash their operations generate. Companies with more opportunities than cash don’t buy back stock; they issue it (and/or borrow) to get the capital to pursue them. The simple generalization that large, mature companies buy back shares while small, growing companies issue new ones is borne out by rolling 12-month percentage changes in shares outstanding by large-cap and small-cap companies (Chart II-1). On an equal-weighted basis, large-cap companies’ rolling share count was flat to modestly down for ten years before the pandemic drove net issuance. Adjusting for market cap, rolling net issuance has been uninterruptedly negative, shrinking by more than 2% per year, on average. The equally weighted small-cap population has been a net issuer to the tune of about 4% annually, with the biggest small-caps issuing even more, pushing the cap-weighted annual average to north of 6%. The bottom line is that large-cap companies in the aggregate have been modestly trimming their share counts, with the biggest companies retiring more than 2% of their shares each year, while small-cap companies are serial issuers, led by their largest (and presumably most bankable) constituents. We are investors serving investors, not policymakers, academics or editorial columnists charged with developing and evaluating public policy. Our mandate is bullish or bearish, not good or bad. We point out the flaws in the prevailing criticism of buybacks simply to make the point that buybacks are not an impediment to productive investment and that no one should therefore expect that productivity and income will rise if legislators or regulators restrict them. On the contrary, since we believe that buybacks represent an efficient allocation of capital, we would expect that successful attempts to limit them will hold back growth at the margin. The Buyback Calculus A company that buys back more of its shares than it issues reduces its share count. All else equal, a company with fewer shares outstanding will report greater earnings per share and a higher return on equity. Increased earnings per share (EPS) does not necessarily ensure a higher share price; if a company’s P/E multiple declines by more than EPS rises, its price will fall. Distributing retained earnings to shareholders reduces a company’s capital buffer against shocks and limits its ability to fund investment internally, but companies that embark on the most ambitious buyback campaigns likely face limited investment opportunities and have much more of a buffer than they could conceivably require. Revealed preferences suggest that management teams like buybacks. They have every interest in getting share prices higher to maximize the value of their own compensation, which typically contains an equity component that accounts for an increasing share of total compensation the more they rise in the company’s hierarchy. It is unclear, however, just how much their attachment to buybacks is founded on an expectation that buying back stock will boost its price. The opportunity to extend their tenure by pursuing a shareholder-friendly policy may well offer a stronger incentive. Do Buybacks Boost Share Prices? Returning cash to shareholders is widely perceived as good corporate governance. It increases the effective near-term yield on an equity investment and denies management the cash to pursue dubious expansion schemes or squander capital on lavish perquisites. It facilitates the reallocation of capital away from cash cows to more productive uses. Buybacks are squarely beneficial in theory, but are they good for investors in practice? (Please see the Box II-1 for a description of the methodology we followed to answer the empirical question.) Box II-1 Performance Calculation Methodology After separating stocks into large- and small-cap categories based on Standard & Poor’s market cap parameters for inclusion in the S&P 500 and the SmallCap 600 indexes, we ranked the constituents in each category in reverse order of their rolling 12-month percentage change in shares outstanding at the end of each month from 2011 through 2021. We then placed the top three deciles (the biggest reducers of their share counts) into the High Buybacks bucket and the bottom three deciles (the biggest net issuers) into the Low Buybacks bucket. We used the buckets to backtest a zero-net-exposure strategy of buying the stocks in the High bucket with the proceeds from shorting the stocks in the Low bucket, calling it the High-Minus-Low (“HML”) strategy. We computed two sets of HML results for the large-cap and small-cap universes. The first populated the buckets without regard for sector representation (“sector-agnostic”) and the second populated the buckets in line with the sector composition of the S&P 500 and SmallCap 600 Indexes (“sector-neutral”). We also track equal-weighted and cap-weighted versions of each HML bucket to gain a sense of performance differences between constituents by size. The experience of the last ten years fails to support the widely held view that stock buybacks boost share prices. Following a zero-net-exposure strategy of owning the top three deciles of large-cap companies ranked by the rolling 12-month percentage reduction of shares outstanding and shorting the bottom three deciles generated a modest positive annual return above 1% (Chart II-2). Small caps merely broke even, largely because their biggest share reducers sharply underperformed in Year 1 of the pandemic. On a cap-weighted basis, however, the large-cap strategy generated a negative annual return a little over 1% during the period, indicating that the largest companies pursuing buyback programs lagged their net issuer counterparts. For small caps, the cap-weighted strategy also lagged the equal-weighted strategy, albeit by a smaller margin. On a sector-neutral basis, the large-cap HML strategy roundly disappointed. The equal-weighted version was never able to do much more than break even, slipping into the red when COVID arrived, while the cap-weighted version continuously lagged it, shedding about 1.5% annually (Chart II-3). Though it was hit hard by the pandemic, the equal-weighted small-cap HML strategy managed to generate about 1% annually, and boasted a 3.5% annualized return for the eight years through 2019. Chart II-2Buybacks May Help A Company's Stock Price At The Margin ... Buybacks May Help A Company's Stock Price At The Margin ... Buybacks May Help A Company's Stock Price At The Margin ... Chart II-3... But They Are Not An Exploitable Factor ... But They Are Not An Exploitable Factor ... But They Are Not An Exploitable Factor   Drilling down to the sector level offers some additional insights. While changes in shares outstanding vary across large-cap sectors, with six sectors reducing their shares outstanding and five expanding them, every small-cap sector has been a net issuer in every single year, ex-Discretionaries and Industrials in 2019 (Chart II-4). Relative sector capital needs are largely consistent regardless of market cap, however, with REITs, which distribute all their income to preserve their tax-free status, unable to expand without raising cash in the capital markets, and Utilities, Energy and traditional Telecom Services being capital-intensive industries (Table II-1). Many Tech niches are capital-light, and established Industrials and Consumer businesses often throw off cash. Chart II-4 Chart II- There is less large- and small-cap commonality in HML relative sector performance than in relative sector issuance. Away from Real Estate, Tech and Discretionaries, small-cap HML sector strategies generated aggregate positive returns, led by Communication Services and Energy (Chart II-5). For the large caps, most HML sector strategies produced negative alpha, though the four winners and the one modest loser (Financials) are among the six sectors that have net retired shares outstanding since 2012. Tech is the conspicuous exception, with its HML strategy yielding annualized losses exceeding 3%, contrasting with the sector’s enthusiastic buyback embrace. Chart II-5 The Corporate Life Cycle Surprising as they may be on their face, negative cap-weighted ten-year HML returns do not mean that buybacks are counterproductive. We simply think they illustrate that net issuance activity follows from a company’s position in the corporate life cycle (Figure II-1). Investors have prized growth in the aftermath of the global financial crisis, and the companies with the best growth prospects are often younger companies just beginning to tap their addressable markets. They have a long pathway of market share capture ahead of them and need to raise capital to begin traveling it. Many of these strong growers populate the Low basket, especially in the Tech sector. Chart II- Chart II- Companies that return cash to their owners via share repurchases are often more mature. Their operations are comfortably profitable and generate more than enough cash to sustain them. They have already captured all the market share they’re likely to gain in their primary business and may not have an outlet for its proceeds in a space in which they have a plausible competitive advantage. Lacking a clear path to bettering the returns from their main operations, they have been steadily accumulating cash for a long time. Through the lens of the Boston Consulting Group’s (BCG) growth share matrix,6 a successful business in the Maturity stage of the business life cycle is known as a Cash Cow. Cash Cows have gained considerable market share in their industry, affording them a competitive advantage based on scale, brand and experience, but little scope for growth because they have saturated a market that is itself mature (Figure II-2). BCG advises management teams with a portfolio of business lines to milk Cash Cows for capital to reinvest in high-share, high-growth-potential Stars or low-share, high-growth-potential Question Marks that could be developed into Stars. In the public markets, a mature large-cap company that retains its excess capital impedes its owners’ ability to redeploy that capital to faster growing investments, subverting the overall economy’s ability to redirect capital to its best uses. Walmart, Twentieth-Century Growth Darling Chart II-6From Young Turk To Respected Elder From Young Turk To Respected Elder From Young Turk To Respected Elder Walmart fits the business life cycle framework to a T and has evolved into a textbook Cash Cow. It is a dominant player that executed its initial strategy so well that it has maxed out its share in the declining/stagnating brick-and-mortar retail industry. Its international attempts to replicate its domestic success have uniformly failed to gain traction, and it currently operates in fewer major countries than it's exited. Given Walmart’s star-crossed international experience and the dismal history of large corporate combinations, returning cash may be the optimal use of shareholder capital. Walmart began life as a public company in fiscal 1971 squarely in the Growth phase. It was profitable from the start and grew annual revenues by at least 25% for every one of its first 23 years of public ownership (Chart II-6, top panel). It was a modest issuer of shares during its Growth phase, conducting just one secondary common stock offering 12 years after its IPO and otherwise limiting growth in shares outstanding to acquisitions, management incentive awards and debt and preferred stock conversions. Once its revenue growth slipped into the low double-digits in the late nineties, it began retiring its shares at a deliberate pace (Table II-2). That retirement inaugurated a ramping up of Walmart’s annual payout ratio (Chart II-6, bottom panel) and cash yield (dividend yield plus buyback yield), underlining its transition from Growth to Maturity. Walmart’s 2010 admission into the S&P 500 Pure Value Index marked its ripening into full maturity, and it has been a Pure Value fixture since 2013. Today’s stolid icon is a far cry from the ambitious disruptor on display in its 1980 Annual Report: Chart II- Subsequent to year end, your Company’s directors authorized [a one-third] increase in the annual dividend[.] This continues your Company’s approach of distributing a portion of profits to our shareholders and utilizing the balance to fund our aggressive expansion program. [T]he decade of the ’70’s … has been a tremendous growth period for your Company. In January 1970, we … had 32 stores …, comprising less than a million square feet of retail space. In the next ten years, we added 258 … stores, … constructed and opened three new distribution facilities, and increased our retail space to 12.6 million square feet. During that same period of time, we increased our sales and earnings at an annual compounded rate well in excess of 40 percent. Reflecting upon the progress we have made in the ‘70’s makes it apparent that there is even more opportunity in the ‘80’s for your Company, and we are better positioned to maximize our opportunities … than ever before. The Exception That Proves The Rule Apple has shined so far in the twenty-first century much like Walmart did in the latter stages of the twentieth, growing its revenues and net income at compound annual rates exceeding 20% and 25%, respectively. Unlike Walmart, however, Apple hasn’t required a steady stream of capital to grow. While Walmart had to plow its earnings right back into the business to fund the acquisition and buildout of property to create stores, warehouses and distribution centers, Apple has simply had to make incremental improvements to its music players, phones and tablets while shoring up the moats around its virtual app and music marketplaces. As a result, cash and retained earnings began silting up on Apple’s balance sheet, lying fallow in short-term marketable securities and crimping a range of return metrics. Chart II- Beginning in its 2013 fiscal year, Apple embarked on a lengthy strategy of returning that cash to shareholders, buying back stock at a rate that has allowed it to reduce its shares outstanding by 37.5% in the space of nine years (Table II-3). It has reduced its retained earnings by more than $90 billion over that span and is on course to wipe them out completely in the fiscal year ending next September. Equity issuance in the form of incentive compensation augments Apple’s capital by about $5 billion per year, but if it continues to distribute more than 100% of its annual earnings in the form of dividends and repurchases, it could wipe out the rest of its recorded equity capital as well. Does this mean Apple is in danger of sliding into insolvency? Not in the least. The value of its assets dramatically exceeds the value of its liabilities, as evidenced by its nearly $3 trillion market cap and the top AAA credit rating Moody’s awarded it this week. Its reported book value is artificially suppressed by generally accepted accounting principles’ inability to value organically developed intellectual property (IP). Apple’s book value and that of other companies that generate similar IP, or benefit from internally generated moats, are dramatically undervalued. Takeaways For now, Apple is an anomaly when it comes to aggressively returning cash to shareholders while it is still in the Growth stage of its life cycle. Returning cash is typically the province of mature companies with steady operations that are unlikely to grow. It is generally good for the economy when those companies return excess cash to shareholders, freeing it up for more productive uses. If lawmakers or regulators manage to restrict the flow of capital from cash-cow companies to potential stars, we should expect activity to slow at the margin, not quicken. The experience of the last ten years suggests that companies that shrink their share counts do not outperform their counterparts that expand them. The trading strategy of shorting the biggest net share issuers to purchase the biggest net share reducers has produced negative returns. It is unclear if shareholders of companies who cannot redeploy their internally generated capital to augment the returns from their primary operations would be better served if their manager-agents retained the capital, though we suspect they would not. It seems inevitable that manager-agents with access to too much capital will eventually get into mischief. If buying back stock represents good corporate stewardship at mature companies, their shareholders should someday be rewarded for it. Given that the companies most suited to buying back stock tend to fit in the Value style box, the zero-net-exposure HML strategy may continue to accrue losses. Apple remains an outlier among Growth companies as an avid buyer of its stock; much more common are the S&P 500 Life and Multi-Line Insurer sub-industry groups, without which the S&P 500 Pure Value Index would have a hard time reaching a quorum (Table II-4). Their constituents have assiduously bought back their stock over the last ten years, albeit to no relative avail (Chart II-7). However, they should be better positioned once Value returns to favor and rising interest rates make investing their cash flow a more attractive proposition. Chart II- Chart II-7... But No One Else Seems To Want To ... But No One Else Seems To Want To ... But No One Else Seems To Want To   Doug Peta, CFA Chief US Investment Strategist III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to move in a tighter direction over the coming year, which is in line with the Fed’s recent hawkish shift. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises are rolling over, but there is no meaningful sign of waning forward earnings momentum. Bottom-up analyst earning expectations remain too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury Yield remains well below the fair value implied by a mid-2022 rate hike scenario, underscoring that a move higher over the coming year is quite likely. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, could weigh on commodity prices at some point over the coming 6 months. We expect stronger metals prices in the back half of 2022. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "OUTLOOK 2022: Peak Inflation – Or Just Getting Started?", dated December 1, 2021, available at bca.bcaresearch.com 2   Early assessment of the clinical severity of the SARS-CoV-2 Omicron variant in South Africa by Wolter et al., medRxiv preprint, December 21, 2021. 3  Please see The Bank Credit Analyst “The Return To Maximum Employment: It May Be Faster Than You Think”, dated August 26, 2021, available at bca.bcaresearch.com 4  Please see US Bond Strategy “The Fed In 2022”, dated December 21, 2021, available at bca.bcaresearch.com 5   Opinion | Schumer and Sanders: Limit Corporate Stock Buybacks - The New York Times (nytimes.com) Accessed December 17, 2021. 6   https://www.bcg.com/about/overview/our-history/growth-share-matrix Accessed December 19, 2021. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: