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Executive Summary Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Markets now expect five-to-six rate hikes in 2022  The rate of change in rates as opposed to their level has triggered the fast and furious repricing of long-duration assets.  However, rising rates are a temporary headwind to equities The repricing of the equity market came through the P/E as opposed to the “E” Demand is clearly shifting from goods to services. Supply disruptions are clearing Earnings were strong, but investors expected more We are upgrading Consumer Staples, which is a “deep” defensive sector that offers downside protection in an environment of heightened volatility and slowing economic growth   Bottom Line: While it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Feature Performance Hit Undo 2021 January had a nasty shock in store for equity investors: At the lowest point, the S&P 500 was down 12% from its peak, and NASDAQ was down 20%, officially entering correction territory. January market moves were a partial reversal of the 2021 gains (Chart 1A), with some of the hottest investment themes, such as clean energy, fintech, and Cathie Wood's innovation ETFs hit the hardest (Chart 1B). Investors were rushing to monetize their super-charged gains before the Fed starts draining liquidity off the market. Chart 1APerformance: Sectors And Styles Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 1BPerformance: Investment Themes Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Post-Mortem A post-mortem of the sell-off shows that the stocks that have pulled back most, were trading at extended valuations and had long duration, i.e., companies that are not very profitable now but expect to grow earnings at a robust pace far into the future. These companies are akin to lottery tickets – a small payment now may result in a low-probability event of a high gain in the future. Small-cap growth stocks are down 30% from their peak. Over time, the sell-off of small-cap growth has spread to other areas of the market and has hit all sectors but Energy, almost indiscriminately. Overall, the S&P 500's multiple has contracted by over 10% (Chart 1C). Chart 1CJanuary Correction Was Down To Multiple Contraction Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Valuations And Technicals Pullbacks are responsible for equity market hygiene, cleansing the market of overextended valuations, taking the froth off the names that got ahead of themselves, and offering a reset for a new leg of upward moves, fueled by inflows into oversold names and cash deployed by new market entrants. Forward multiples of the S&P 500 have come down from 21.7x to a more reasonable 19.5x (Chart 2A). Now, 8 out of the 11 sectors have a forward PE below 20x (Chart 2B). Chart 2AMultiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Chart 2BValuations Moderated Across All Sectors But Energy Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack By many technical metrics, such as the bull/bear ratio (Chart 2C), market breadth, and RSI, the market appears oversold. Many investors may consider this a good entry point. Chart 2CRetail Investors Have Capitulated Retail Investors Have Capitulated Retail Investors Have Capitulated Macroeconomic Backdrop Six Is The New Four This correction was triggered by a market surprised by the grave tone of Fed officials, acknowledging their concern about the intransigent, as opposed to transient, inflation. While monetary tightening has been on the cards for a while now, what a difference a month makes! In December, the market was pricing in three rate hikes in 2022, while currently, the probability of five rate hikes stands at over 90%, and of six rate hikes at over 80% (Chart 3A). The 10-year Treasury yield moved from 1.5% at the end of December to 1.87% at its January peak. It is important to note that monetary policy is still easy and it was the rate of change in rates as opposed to their level that triggered the fast and furious repricing of long-duration assets. Chart 3AInvestors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Is Monetary Tightening A Death Knell For US Equities? Historically, equities wobbled two-to-three months prior to the first rate hike, and then took a breather for another couple of months for the dust to settle (Chart 3B). January and now February volatility and pullbacks are textbook behavior of equities at the cusp of a new monetary regime. However, in three of the four tightening cycles since 1990, the stock market was higher a year later. The same is true for long-term rates: In all but one of the episodes of a sharp rise in the 10-year Treasury yield since 1990, the stock market rose (Table 1). Chart 3BEquities Wobble Around The First Rate Hike Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Table 1Equity Performance Around Periods Of Rising Treasury Yields Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Economic Growth: Supply (Finally) Meets Demand Of course, the best antidote to higher rates is strong economic growth. So far, everything is in order on that front, with economists projecting solid 2022 nominal GDP growth of around 7.6%. Economic growth is slowing but off high levels. At last, global supply chains are gradually unclogging, and shipping bottlenecks are starting to clear. Even automakers are now saying that auto chips are becoming more readily available. However, part of the reason that supply and demand are getting closer to each other is that demand for goods is waning, dampened by both saturation and higher costs. The latest ISM PMI reading shows that both new orders and the backlog of orders are falling (Chart 4, top panel). Prices paid have also turned, heralding that the worst of price increases may be behind us (Chart 4, bottom panel). Will this contain inflation enough to appease the Fed? Possible, but not highly likely. Chart 4Demand Is Weakening Demand Is Weakening Demand Is Weakening Earnings: Good But Not Good Enough With economic growth slowing, earnings and sales growth are also rolling over (Chart 5A). As investors are trying to decipher the state of the American economy, they are increasingly focused on corporate guidance. So far 12 companies offered positive guidance vs 28 with negative guidance. The Negative/Positive ratio for Q4-2021 currently stands at 2.3, compared to 0.8 in the prior four quarters. Price action in response to projected lower growth has been brutal. And while 78% of companies have beaten earnings expectations, this is a smaller share than during the other pandemic recovery quarters. The magnitude of the earnings surprise has also fallen (Chart 5B). Chart 5AEarnings And Sales Growth Are Slowing Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 5BThe Magnitude Of Earnings Surprises Has Fallen Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack This earnings season has also seen some of the largest moves on the back of companies’ reports. Positive surprises by Google, Microsoft, and Amazon have soothed investors' fears and led to broad-based next-day rallies, while skimpy results from PayPal and Meta, not only have sent these companies down more than 20%, erasing billions in market capitalization, but also have dragged down their nearest competitors (Square, Snap, etc.). Also, many companies are complaining about rising input and labor costs cutting into their profitability. This is hardly a surprise. According to our analysis of the NIPA accounts, in the US labor costs constitute 55% of sales. With wages rising at the fastest pace in years, their effect on corporate profitability can be meaningful (Chart 6A). To make things worse, input costs are also soaring – the latest PPI reading is 9.7%. Chart 6AMargins Are Contracting As... Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack However, companies are more and more constrained in their ability to pass on their cost increases to customers, although the elasticity of demand varies across industries. Many companies can no longer afford to raise prices without suppressing demand for their products. Corporate pricing power has turned decisively lower (Chart 6B). As a result, profit margins have contracted across all sectors, except Energy. Bottom-line – earnings are good so far, but they have failed to allay investor fears of waning profitability. Chart 6B...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining Sector Positioning Revenge Of The Nerds – Be Granular While we believe that equities are poised for another leg up, as economic growth remains strong and corporate earnings are decent, we recommend that investors be granular in their sector selection: Avoid areas most adversely affected by a tighter monetary regime and slowing growth. Per our previous analysis, we recommend underweighting the Technology sector on a tactical basis, but within Tech, stay overweight more defensive Software and IT Services. We also like Banks and Insurers that benefit from rising rates and prefer Value and Small over Growth. We are also constructive on Industrials, which are the primary beneficiaries of the new Capex cycle and the US industrial renaissance. Consumer Services Are Finally Rebounding In the meantime, with Omicron finally receding, consumer spending is shifting from consumer goods to services (Chart 7A). Consumers are flush with cash, and still have $2.2 trillion in their coffers. We have been overweight the Travel complex (Hotels, Restaurants, Cruises) since October. However, performance was derailed in the late fall as many consumers chose to stay at home and wait for the variant to pass. Also, many of the industries in the Travel complex have been challenged by the sheer number of staff quarantining or on sick leave. We upgraded Airlines at the beginning of January and remain optimistic about the outperformance of the Consumer Services sector. Upgrading Consumer Staples We are also upgrading Consumer Staples, which is a “deep” defensive that offers downside protection in an environment of heightened volatility and slowing economic growth (Chart 7B). Moreover, consumer confidence is down as Americans are disheartened by prices in the supermarket and at the gas station. However, demand for consumer staples is inelastic and should be inflation-proof. The sector is trading at 21x forward multiples and is expected to grow earnings at 6% over the next 12 months, bettering the S&P 500. Chart 7AWaning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Chart 7BMacroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Investment Implications The market correction is still running its course, and while it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. Rising rates are a temporary headwind. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500  Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Footnotes

  Nearly two-thirds of the S&P 500 companies reported their Q3 earnings, and the earnings season is drawing to a close. 83% of companies have beaten the street expectations with an average earnings surprise standing at 11% (40% earnings growth vs. 29% expected on October 1, 2021). Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25% exceeding expected 6% contraction. Compared to Q3-2019, eps CAGR is 12%. Chart 1 Approaching The Finish Line Approaching The Finish Line Financials, Energy, and Health Care have delivered the largest earnings surprises. Financials have done well on the back of the robust M&A activity, while the unfolding energy crisis has lifted the overall S&P 500 Energy complex. Pent-up demand for the elective medical procedures has translated into strong Health Care earnings.   Industrials and Materials were amongst the worst: China-related headwinds continue to weigh on both of these sectors. However, some analysts expect China to ease in Q1-2022, providing a tailwind for these sectors.  Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. However, as we see, most have navigated a challenging economic environment swimmingly. Strong pricing power and operating leverage have preserved margins and earnings so far. Looking ahead, companies’ ability to raise prices further is waning (Chart 1), while costs continue marching up. These factors are the ubiquitous reasons for a negative guidance – 52.6% of companies are guiding lower for Q4-2021 (compare that to 32.7% previous quarter). Bottom Line: Companies are exceeding analysts’ expectations both in terms of sales and earnings growth.     Chart

With 119 S&P 500 companies having reported Q3-2021 earnings, it’s time to take a pulse of the interim results. So far, the blended earnings growth rate is 34.8% while actual reported growth rate is 49.9%. The blended sales growth rate is 14.4%, while the actual reported rate is 16.6%. Analysts expected Q3-2021 earnings to be 6% below the Q2-2021 level. As of now, this quarter’s earnings are only 3% lower. Most of the companies that have reported are beating analysts’ forecasts are surprising to the upside. Currently, 83% of companies reported EPS above expectations, with five out of eleven sectors delivering an impressive 100% beat score. In terms of the magnitude of the beats, the overall number currently stands at 14% with Financials and Technology leading the pack. However, these results are bound to change as more companies report: less than 5% of the market cap has reported within the Energy, Materials, Real Estate, and Utilities sectors. The big theme for the current earnings season is input cost inflation. Many industrial giants, including Honeywell (HON), are complaining about supply-chain cost increases, and their potential adverse effect on margins. As a result, many companies are reducing guidance for the fourth quarter. So far, there are 59 positive pre-announcements, and 45 negative. On the bright side, the majority of companies are reporting that demand for their products remains strong, potentially offsetting some of the cost increases. This is especially the case with consumer demand: a few consumer staples companies, such as P&G, commented that their recent price hikes have not dampened demand for their products and have fortified their bottom line against rising costs. Bottom Line: The earnings season is gaining speed, and so far, it appears that Q3-2021 growth expectations are set at a low bar, that is easy to clear for most companies. Chart

Who Likes A Flattening Yield Curve? Who Likes A Flattening Yield Curve? In a recent daily report, we analyzed relative performance of the S&P 500 sectors and styles under different US 10-year Treasury yield (UST10Y) regimes. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the distinct US Treasury yield curve regimes, defined as a three-months change between 10-year and 2-year yields. To analyze sector and style performance by regime, we calculate contemporaneous three-months relative returns of sectors and styles. To summarize the results, we calculate median relative return of each sector/style in each regime. We subtract total period median to remove the sector and style biases in the long-term performance. In a flattening yield curve environment, Defensives, Quality, and Growth tend to outperform, as it indicates scarcity of growth. Accordingly, Real Estate, Technology, Utilities, and Communications Services also outperform. Yield curve steepening is usually associated with growth acceleration. This regime gives boost to more economically sensitive and capex intensive sectors and styles: Value, Small caps, and Cyclicals. Bottom Line: The shape of the US Treasury yield curve will be an important variable to monitor going forward, as it has a substantial effect on relative sector and style performance. ​​​​​​​

Foreword Today we are publishing a charts-only report focused on the S&P 500, and GICS 1 sectors.  Many of the charts are self-explanatory; to some, we have added a short commentary. The charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to make investment decisions along these sector dimensions. We also include performance, valuations and earnings growth expectation tables for all styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We alternate between Styles and Sector chart pack updates on a bi-monthly basis. Changes In Positioning Downgrade Growth to an equal weight and upgrade Value to an equal weight.  Upgrade Small to an overweight and downgrade Large to an underweight. Downgrade Technology to equal weight by reducing overweight in Software and Services.  We remain overweight Semiconductors and Equipment. We are on board with the ongoing market rotation: We were waiting for a decisive shift in rates and a dissipation of the Covid-19 scare as a signal to initiate this repositioning (Chart 1). Chart 1Performance Of S&P 500 Sectors And Styles US Equity Chart Pack US Equity Chart Pack Overarching Investment Themes: Rotation Has Begun! Taper Tantrum 2.0: With tapering imminent and monetary tightening around the corner, both real yields and nominal yields are up sharply over the past couple of weeks (Chart 2A).  Chart 2ARates Are Up Sharply Rates Are Up Sharply Rates Are Up Sharply Chart 2BProbability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Market expects two rate hikes by the end of 2022: Although Chairman Powell has explicitly separated the decision to taper from the timing of the first rate hike, which he conditioned on full employment and which is “a long way off,” the market is still spooked by the timing and the speed of rate hikes. Currently, the probability of two rate hikes in 2022 stands at around 40%, rising sharply over the past two weeks (Chart 2B). The BCA house view is that the Fed will start hiking in December of 2022. Market rotation is on: Rising yields and a recent decline in Delta variant infections have triggered a fast and furious style and sector rotation. Higher rates put pressure on rate-sensitive sectors and styles, such as Growth, Technology, Communication Services, and Real Estate. While the “taper tantrum” pullback affects the entire US equity market, areas most geared to rising rates, such as Cyclicals, Financials, and Small Caps fare the best (Chart 3). An easing of the Delta scare has led to the “reopening” trade outperforming the ”work-from-home” trade.   Chart 3Rotation Away From Rate-sensitive Sectors And Styles US Equity Chart Pack US Equity Chart Pack Macro Economic slowdown is finally priced in: At long last, deteriorating economic data is fully digested by investors. The Citigroup Economic Surprise index is still in negative territory (Chart 4A) but has turned decisively. The markets move on the second derivative and a “less bad” economic surprise is a major positive for the markets. Chart 4ADeterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Chart 4BSupply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply-chain disruptions are not abating: Shipping costs continue their ascent. The average delay of cargo ships traveling between the Far East and North America is 12 days – compare that to 1 day in January 2020.1 The ISM PMI Supplier Performance index increased from 69.5 in August to 73.4 indicating that supply bottlenecks are not easing (Chart 4B). There are also significant backlogs of goods (Chart 5A), and plenty of new orders. It will take time for supply chains to normalize, with most industry participants expecting the situation to improve only in 2022. Chart 5AManufacturers Are Overwhelmed Manufacturers Are Overwhelmed Manufacturers Are Overwhelmed Chart 5BA Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Labor shortages: Companies are still struggling to fill job openings. According to the US Census Survey, “pandemic layoff” or “caring for children” were the top reasons for not working. The number of people not working because of Covid-19 infections or fear of Covid spiked at the end of August.2  This explains the August jobs report. The ugly “S” word: With the ubiquitous shortage of input materials and labor, along with transportation delays, suppliers are simply unable to meet demand for goods, pushing prices higher.  Stagflation may be rearing its ugly head: The Dallas Fed manufacturing index is showing a divergence, with prices moving higher while business activity is shifting lower. This is not the case with the ISM PMI index components, but investors need to be vigilant (Chart 5B). Americans are in a worse mood: Consumer confidence survey readings continue on a downward path. The combination of higher prices for everyday goods, the loss of purchasing power, the discontinuation of supplementary unemployment benefits, and paychecks not adjusted for inflation weigh on consumer sentiment. On the positive side, jobs are still plentiful.  Valuation And Profitability Despite recent turbulence and rotations across sectors and styles, consensus is still expecting 15% YoY earnings growth over the next 12 months. However, QoQ growth rates look very different as we remove the base effect: Growth is expected to dip this coming quarter (Q3, 2021), and stay modest for most of 2022. This is a low bar that should be easy for companies to clear, although supply disruptions may dent corporate earnings. In the meantime, valuations remain elevated at 20.7 forward earnings (Chart 6). Chart 6Earnings Growth Expectations Are Modest US Equity Chart Pack US Equity Chart Pack Sentiment There are still inflows into US equities, but they are easing. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines that many retail investors aim to park in US equities.  (Chart 7A). However, this is changing as rising rates render the TINA (“there is no alternative”) trade much less attractive. Chart 7AInflows Into US Equities Are Easing Inflows Into US Equities Are Easing Inflows Into US Equities Are Easing Chart 7BCapex Is On The Rise Capex Is On The Rise Capex Is On The Rise Uses Of Cash Capex: Capital goods orders are soaring, pointing to robust capex.  The latest S&P estimates suggest that capex will rise 13% this year.3 This points to economic normalization, and attests to corporate confidence in economic growth. It is also a likely byproduct of shortages that plague the US supply chain – companies are expanding their capacity. (Chart 7B). Investment Implications Low for longer is over: The Fed has committed to tapering within the next 2-3 months.  Unless this intention is derailed by another Covid scare or a significant deterioration in economic growth, we are now convinced that rates will move up to hit the BCA house view of 1.7%-1.9% by year-end. S&P 500:  There is plenty of rotation under the hood; yet we expect US equities to hold their own into the balance of the year as, for now, monetary and fiscal policy remain easy, and earnings growth is likely to surprise on the upside. Severe and prolonged supply disruptions are a key risk to this view, as they chip away from economic growth, and cut into companies sales growth and profitability. Growth vs. Value: With rates rising into year-end, interest-rate sensitive stocks, such as Growth and the Technology sector, are under pressure.  Since we opened overweight Growth and underweight Value position on June 14, Growth has outperformed S&P 500 by 4.1%, and Value underperformed by 4.5%.  We do not want to overstay our welcome, and are neutralizing both sides of the trade, bringing positioning to an equal weight.  Technology has beaten the S&P 500 by 2.2%, and we are shifting to an equal weight positioning by reducing overweight of the Software Industry Group. We remain overweight Semiconductors and Equipment. We are closing our overweight to Growth and underweight to Value allocation. We reduce overweight to Technology. Chart 7C US Equity Chart Pack US Equity Chart Pack Cyclicals vs. Defensives:  The onset of the Delta variant is dissipating, and we expect consumer cyclicals to rebound as more people are willing to travel and eat out. We also believe that the parts of the Industrials sector most exposed to restocking of inventories, infrastructure, and construction will perform strongly. Small vs. Large: We are upgrading Small from neutral to an overweight, and downgrade Large to an underweight. Small is highly geared to rising rates. It is also cheaper than Large, and most of the earnings downgrades are already in the price. We are now constructive on this asset class.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash       Footnotes 1     Source: eeSea 2     US Census Household Pulse Survey, Employment Table 3. 3    S&P Global Market Intelligence, S&P Global Ratings; Universe is Global Capex 2000   Recommended Allocation

Chart 1Cyclicals Styels and Sectors Outperform In The Rising Rates Environment Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance In a recent daily report, we analyzed performance of the S&P 500 sectors before and after the 2013 tapering announcement. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the different US 10-year Treasury yields (UST10Y) regimes, i.e., rates rising vs rates falling.1  As expected, deep cyclicals, such as Energy, Financials, and Industrials fare best in a rising rates environment, while Communication Services and Health Care outperform when rates head south (Chart 1, top panel). Styles’ performance across regimes is broadly consistent with the sector performance. Specifically, Small Caps, thanks to their high exposure to deep cyclicals, post the best performance when UST10Y is rising. Meanwhile, defensives are a mirror image of Small Caps and outperform once global growth starts softening (Chart 1, bottom panel). Finally, we bring one more dimension to our analysis and calculate the performance of the long-duration Technology and Health Care sectors, under different rates and yield curve regimes (Chart 2).  To do so, we overlap rates and yield curve regimes and calculate median performance of each cell. Both Technology and Health Care underperform when rates are rising, and the yield curve is steepening: Long end of the curve is most important for discounting cash flows. Chart 2Performance of Technology and Health Care Sectors Is Also A Function Of Changes Of The Yield Curve Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance The current environment of rising rates and flattening yield curve is empirically a goldilocks scenario for these sectors as a flattening yield curve signifies that the long-term rate, which is more important for discounting future cash flows, is falling and the P/E contraction phase will be limited.  It will also be offset by the growth in earnings as rising long rates indicate higher growth. Falling rates are also good for Tech stocks regardless of the direction of change in the yield curve.  The Health Care sector behaves somewhat differently: It tends to underperform when rates are falling but the yield curve is steepening as such scenario is not dire enough for Defensives to outperform. Bottom Line: Cyclical sectors and high beta styles tend to outperform in a rising rates environment. At the same time, the performance of Technology and Health Care stocks is more nuanced: rising Treasury rates are not necessarily bad for these sectors if the yield curve is flattening.   Footnotes 1 Methodology: We calculate three months change in UST10Y and calculate median of three months contemporaneous relative returns for each sector at each regime.  To remove historical performance biases, we subtract sector median relative return for the whole period.  

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" "Buying Conditions Are Poor" "Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Demand Is On Trend... Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend ...But Employment Is Well Below Trend ...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Tin Is Fragile Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic 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  

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 1 CHART 1 CHART 2 CHART 2 CHART 2 Appendix CHART 3 CHART 3 CHART 4 CHART 4  

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Chart 3 CHART 3 CHART 3 Chart 4 CHART 4 CHART 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.    

Highlights Earnings season was impressive, with 87% of companies beating analyst earnings expectations. Analysts’ targets were too low because a whopping 38% of companies provided negative forward guidance for the Q2-2021 results. The markets expect 12-17% earnings growth over the next 12 months. Growth is past its peak and is returning to trend. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet, returns will be lower than in the past due to high valuation “speed limit.” US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent up demand for elective procedures will propel earnings growth higher. Overweight Industrials to benefit from the US manufacturing Renaissance long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Feature The Q2-2021 earnings season is coming to an end, and it is time to take stock of the companies’ results and validate our equity views on styles, sectors, and investment themes into the balance of the year. Review Of The Q2-2021 Earnings Season The S&P 500 Key Earnings Results Stats S&P 500 quarterly earnings grew 93% YoY, and sales increased by 23.5% YoY compared to the same quarter a year ago (Table 1). Q2-2021 earnings stand 29% above the Q2-2019 level, which translates into 14% annualized growth. CAGR for sales for the same period is 4.6%. 87% of the companies have beaten both sales and earnings expectations. Earnings surprise is 16%, while sales surprise is 4.6%. As our colleagues from US Investment Strategy (USIS) have observed, beats are unprecedented: Their magnitude is more than two standard deviations above the historical average (Chart 1). Table 1S&P 500 Q2-2021 Earnings And Sales Results Decoding Earnings Decoding Earnings Chart 1Earnings Surprises Are Unprecedented Decoding Earnings Decoding Earnings Decoding The S&P 500 Earnings Season Results While we are impressed with the earnings results delivered by the US companies, our reaction to these superb growth numbers and beats is tepid, like the market’s reaction. The average reaction to an EPS beat this earnings season was about 0.9%. Misses were penalized harshly with stocks falling 1.1%. S&P 500 is up only 2% since the beginning of the reporting season. There are a few reasons for this lukewarm reception: Analyst targets were too low: Ubiquitous beats of earnings and sales expectations indicate that the analyst targets were too low despite upgrades throughout the earnings season (downgrades are more typical). The bar was set too low because a whopping 38% of the companies provided negative forward guidance for the Q2-2021 results. Growth was lumpy: Much of the robust growth can be explained by what we can call two sides of the same coin, one being a low base for the comparisons – after all, in the summer of 2020, the economy was close to a standstill – and the other is a pent-up demand for goods and services. In other words, all the growth postponed in 2020 was delivered at once over this past couple of quarters. With that, a 14% annualized growth rate for the S&P 500 earnings since 2019, which smooths results over time, is strong but not exceptional. Corporate guidance was cautious: Many companies have warned investors that their high growth rates are unsustainable (31% of companies guided lower for Q3-2021). Since the markets are forward-looking, reported earnings growth is seen in the rearview mirror and is priced in, and it is future growth that matters. Earnings growth has returned to trend: Earnings have fully recovered from the pandemic dip. The street bottom-up EPS growth projections (according to Refinitiv) for the rest of 2021, 2022, and 2023 are based on that assumption (Chart 2). The corollary to the point above is that earnings growth has peaked (Chart 3, RHS): Earnings will grow forward along the trend line at about 6-8% annually, which is the historical average. Chart 2Earnings Growth Is Returning To Trend Decoding Earnings Decoding Earnings What To Expect Over The Next Four Quarters? According to the data compiled by Refinitiv, analysts expect Q3-2021 earnings to be 5% (QoQ) below their Q2-2021 level, staying flat for the next couple of quarters and exceeding the current level only in Q2-2022 (Chart 3, LHS). Aggregating quarterly growth rates into next 12 months growth rate, analysts expect 12.6% YoY growth over the next 12 months. Chart 3Growth Has Peaked And Quarterly Earnings Are Expected To Be Almost Flat Decoding Earnings Decoding Earnings We believe that these growth expectations are too low, as they are based on the expectation that over the next four quarters EPS will stay practically flat. Therefore, most of the 12.6% YoY growth can be attributed to a base effect. It is likely that YoY growth will be higher: Some sector earnings are still at a pre-pandemic level, while others should grow simply because the economy is expanding. IBES expects EPS NTM to grow at 17% over the next 12 months, which is slightly more realistic in our opinion (Chart 4). The difference with Refinitiv is in the calculation methodology. Our working assumption is that next year’s growth will be within the 12-17% YoY range. From Multiple Expansion To Earnings Growth! Return decomposition demonstrates that in 2020, the S&P 500 return was 26%, with 43% contributed by the multiple expansion, and 19% detracted by the earnings contraction: Over the past year, returns have been borrowed from the future, but this year is payback time. The source of the equity returns is shifting from multiple expansion to earnings growth. This means that 12%-17% expected EPS growth (and possibly more if we get a positive earnings surprise) in the upcoming four quarters will propel the markets higher (Chart 5). Chart 4IBES Expect Next 12 Months Growth To Be 17% IBES Expect Next 12 Months Growth To Be 17% IBES Expect Next 12 Months Growth To Be 17% Chart 5Earnings Growth Replaces Multiple Expansion As A Driver Of Returns Decoding Earnings Decoding Earnings Will the S&P 500 Grow Into Its Big Valuations Shoes? Not So Fast At present, the S&P 500 is trading at 21.3x forward earnings (PE NTM), which is steep compared to a historical average of 18x. PE NTM multiples will compress if earnings growth exceeds index price appreciation. While we do expect multiple expansion to pass the baton to earnings growth over the next 12 months, we are curious to know by how much earnings would have to grow for PE to come down to 18x. To get an answer, we created a scenario analysis matrix, varying price and earnings growth simultaneously. The most likely scenario is for the earnings to grow at 3-5% each quarter over the next 12 months (13-16% annualized) and, assuming that the S&P 500 price does not move, it will trade at 20.5-21x forward earnings multiples. For PE to come down to 18x, earnings would have to grow by more than 10% every quarter, or 30% over the next 12 months, which is way above the growth rates expected by the market. Therefore, we are unlikely to see significant multiple compression without a market correction (Table 2). US equities are expensive, no excuses. Table 2Earnings Have To Grow in Double-Digits For PE NTM To Come Down To 18x Decoding Earnings Decoding Earnings Zooming In On The US Equity Market Segments Table 3Style Indices Q2-21 Sales And Earnings Growth Decoding Earnings Decoding Earnings Value Outgrew Growth: Earnings of Value grew 31% faster than earnings of Growth (Table 3). However, looking under the hood, annualized EPS growth of Growth was 16% p.a. since 2019, while EPS of Value contracted by 2% p.a. This means that for many Value companies, the earnings surge is a function of the base effect; earnings have not yet reached their pre-pandemic levels (Chart 6) and have room to run further. Chart 6Small Delivered Spectacular 2019-2021 Growth Decoding Earnings Decoding Earnings Small Crushes Earnings: Small Caps' quarterly results have been nothing short of astonishing: EPS in Q2-21 is 10 times higher than during the same quarter a year ago. This growth surge can’t be attributed just to the base effect, as earnings are double what they were two years ago. The S&P 600 has an annualized earnings growth rate over the past two years of 42%, and sales growth of 6.2%. Sectors Sector results are characterized by a powerful rebound of the cyclical sectors: Industrials, Consumer Discretionary, Energy, Materials, and Financials have delivered triple-digit earnings growth, and double-digit sales growth (Table 4). Table 4S&P 500 Sectors' Q2-21 Sales And Earnings Growth Decoding Earnings Decoding Earnings However, looking at 2019-2021 CAGR, we observe that the Industrials sector earnings are still 10% below the 2019 level, and the Consumer Discretionary sector has only grown 2% annualized, much slower than the market. The case is the same for Energy. Financials and Materials growth was very strong: The former benefited from the M&A and IPO boom, while the latter has grown thanks to stimulative Chinese policy, which has been tightened lately (Chart 7). Chart 7Cyclical Sectors Did Not Grow Much Since 2019 Despite Recent Profit Rebound Decoding Earnings Decoding Earnings Profitability Is Unlikely to Return To A Previous Peak Many companies have tightened their belts during the pandemic to preserve capital in the face of uncertainty. Margins have compressed, but less than expected in such a dire situation. Currently, the majority of sectors has margins close to their historical averages (Chart 8). While most sectors, with exception of Financials and Technology, are below peak margins, it is unlikely that they will be able to return to their former highs. Sales will soar thanks to stimulative fiscal and monetary policies, strong demand by consumers, and inflation. Yet the bottom line may be impeded by the increases in labor and input costs and tighter fiscal policy, which have not yet been priced in by the market. Market Expectations For The Next 12 Months According to IBES, earnings growth will be propelled by the cyclicals, such as Industrials, Consumer Discretionary and Energy (though less so as it is a small sector). These expectations are well aligned with our investment thesis (Chart 9). Chart 8Most Sectors' Margins Are Back To Normal, But Peak Margins Are Elusive Decoding Earnings Decoding Earnings Chart 9Cyclical Sectors Are Expected To Grow The Most Over The Next 12 Months Decoding Earnings Decoding Earnings Investment Themes Consumers Are Flush With Cash One of our key investment themes is that the US consumer still has plenty of money to spend: Excess savings in the US currently stand at $2.5 trillion, and disposable incomes have been padded by the pandemic helicopter cash drops. While spending on goods had exceeded its historical trend and has recently turned, spending on services is still below pre-pandemic levels (Chart 10). During Q2-2021, Consumer Services earnings grew by 154%, exceeding analyst targets by 27%, though the level of earnings is only 5% above the Q2-2019 level (Chart 11). This suggests that the theme has worked, but also that it has the potential to run further only if not derailed by the fear of COVID-19 variants. However, the approach to investing in this sector needs to be granular, with overweights allocated to service industries such as hotels, restaurants, and leisure (S&P leisure products, S&P hotels, S&P restaurants). Chart 10Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Chart 11The Consumer Discretionary Sector Growth Will Stay Robust The Consumer Discretionary Sector Growth Will Stay Robust The Consumer Discretionary Sector Growth Will Stay Robust We recommend staying away from Internet Retail (downgrade is pending) and the other sectors that have outsized exposure to consumer goods. Amazon earnings were a case in point: The company disappointed analysts with weaker revenue growth as well as provided a more cautious outlook as it finds it difficult to surpass its stellar pandemic numbers. Brick and mortar retail is likely to fare better, as going out to shop now falls into the “experiences” basket. China Slowdown: Underweight The Materials Sector Chinese growth is slowing, which has an adverse effect on demand for industrial metals (Chart 12). As a result, we have underweighted the Materials sector, along with the Metals and Mining industry. This call was on the money: While Materials more than doubled earnings over the past year, its earnings surprise at 6.40% is the smallest of all the sectors. The Materials sector has underperformed S&P 500 by 8% since the beginning of June. Chart 12Materials Sector Earnings Growth Is Slowing Materials Sector Earnings Growth Is Slowing Materials Sector Earnings Growth Is Slowing Post-COVID-19 Normalization: Overweight The Health Care Sector We upgraded this sector to an overweight three weeks ago. We intended to add a defensive sector in our portfolio to make it more robust in the face of an imminent market pullback, likely volatility on the back of elevated valuations and the upcoming debt ceiling kerfuffle. This quarter, Health Care posted mixed results despite being among the key beneficiaries of the pandemic. There are several factors at play. One is that some US vaccine manufacturers pledged to produce vaccines at no profit (J&J). Another reason is that the pandemic forced hospitals to halt their non-emergency operations that serve as an important end-demand market for the S&P Health Care sector. Weak Q2-2021 earnings suggest untapped demand for medical services and elective procedures. Just now, hospitals started reopening, and we expect a spike in the number of hospital visits, with positive spillover effects for medical equipment manufacturers and pharmaceutical companies. We are sticking to our overweight unless Delta and Lambda take over the hospital beds. US Manufacturing Renaissance The Industrials delivered triple-digit growth, but the sector’s earnings are still below pre-pandemic levels. There was an earnings growth dichotomy at play. Manufacturing companies that derive a high percentage of earnings from abroad have been affected by a slowdown of Chinese demand and by inflationary pressures. CAT’s recent 20% drawdown in relative terms encapsulates these headwinds. Domestic and services-oriented stocks like railroads reported exceptionally strong demand. Looking ahead, we are constructive on the sector. There is still significant pent-up demand for industrial goods and services, inventories are historically low (Chart 13) and need to be replenished, Federal infrastructure spending is a near certainty, and onshoring of US manufacturing is a new structural theme. Analysts concur: Expected EPS growth for the sector over the next 12 months is 46%. Chart 13Inventories Are At All Time Low Inventories Are At All Time Low Inventories Are At All Time Low Chart 14Value-Growth Earnings Growth Differential Is Closing Value-Growth Earnings Growth Differential Is Closing Value-Growth Earnings Growth Differential Is Closing Rate Stabilization: Overweight Technology and Growth vs Value Technology is one of our core overweights in the portfolio and the sector fared well last quarter. One of the drivers behind the strong quarter is an accelerating shift to remote work as companies re-evaluate the need for offices, especially given the possibility of new virus variants. A similar upbeat message came from the semiconductor industry: A shortage of chips that touches all corners of manufacturing from cars to computers, translates into strong earnings growth, which is likely to continue far into the future. As our BCA colleague, Arthur Budaghyan observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. We have been overweight Growth vs Value in our portfolios since the beginning of June. Since then, Growth has outperformed Value by about 6%. While Value was growing faster than Growth in Q2-21, the earnings growth expectation between Growth and Value is closing. After a strong run, Growth is expensive again, trading at 28x forward earnings compared to 16x for Value. We expect the yield curve to steepen and yields to rise this fall once workers return to work and the unemployment rate falls further. In other words, we are edging closer to downgrading Growth to neutral; we are just waiting to get more visibility on the Delta variant scare. Upgrade Small vs Large When Rates Rise Again Back in June, we wrote a deep-dive report on Small / Large cap allocation and concluded that an equal-weighted allocation was warranted. This call has not worked so far as Small has underperformed Large by about 5%. Our reasons for not overweighting Small vs Large were manifold: Slowing growth, flattening yield curve, mean reversion of high-yield spreads and, most importantly, a significant downgrade of earnings expectations (Chart 15). Chart 15Small Cap Downgrades Likely Ran Their Course Small Cap Downgrades Likely Ran Their Course Small Cap Downgrades Likely Ran Their Course However, we are warming up to Small: Reported earnings and sales growth was impressive. Furthermore, we expect the yield curve to steepen (helping banks in the S&P 600) as people go back to work in September, and rates to go up to as high as 1.8% by the end of the year. When the timing is right, we will swap overweight in the Growth stocks to an overweight in Small. Investment Implications The earnings season was impressive, but growth is returning to trend and is past its peak. The markets expect 12-17% earnings growth over the next 12 months. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet returns will be lower than in the past due to a high valuation “speed limit.” The US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent-up demand for elective procedures will propel earnings growth higher. Overweight Industrials which will benefit from the US manufacturing Renaissance over the long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending over the short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Bottom Line The earnings season produced peak growth, and the next phase of the cycle is earnings growth returning to trend. This normalization will be a tailwind for the equity markets and will replace multiple expansion as a driver of equity returns. We are sticking to our overweights in Industrials, Health Care and Consumer Discretionary, and our underweight in Materials. We are reconsidering our overweight in Growth and neutral positioning in Small Caps. Once rates turn up decisively, a rotation into Small and Value is warranted.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation