Consumer Discretionary

Executive Summary Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts In the front section of the sector chart pack, we conduct cross-sectional comparisons. Profitability: Earnings expectations for the cyclical sectors are too high and will come down since analysts have little confidence in their forecasts. But despite their bullishness, analysts also expect margins of the most cyclical sectors to contract over the next 12 months. Balance sheet quality: Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors, which they used to repair their balance sheets. Tech, Materials, and Financials have improved the most. Valuations and technicals: Cyclical sectors appear inexpensive (both in absolute terms and relative to history) because multiples have contracted. Technicals signal that the market is oversold.  Much of the bad news is priced in, but “new” bad news is likely on the way: We are still in the early stages of the monetary tightening cycle, there is talk about earnings and economic recessions, rates have not stabilized yet, and inflation has not peaked. Bottom Line: We continue to recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.     This week we are sending you a Sector Chart Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will focus on cross-sectional comparisons.  As investors are starting to shift their attention away from worries about intransigent inflation toward concerns about slowing growth, they will seek out companies and sectors that offer the strongest and most resilient earnings growth, pristine balance sheets, and strong cash yield. In other words, companies that have the highest chance of surviving the downturn unscathed and of outperforming the market. Performance vs. Our Portfolio Positioning Chart 1Looking Under The Hood... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups The S&P 500 is down roughly 20% off its January 2022 peak. However, 11 industry groups have performed even worse, with Automobiles and Components down as much as 39% off peak. The rest of this inglorious list is dominated by Consumer Cyclicals, Technology, and Financials (Chart 1). We were foreseeing headwinds, and have preempted some of the damage by shifting our portfolio positioning away from the most cyclical areas of the market: We underweighted Semiconductors back in January, observing that Semis are both highly economically sensitive and “growthy” and will be hit by a double whammy of slowing growth and rising rates.  We have been underweight Hardware and Equipment since last summer, moving to this trade a bit too early.  We downgraded Consumer Durables And Retailing in February, observing that demand for goods, pulled forward by the pandemic, is waning and consumption is shifting away from goods to services. More recently, we downgraded Media and Entertainment. The sector has fallen significantly, but we reasoned that if an economic downturn is indeed on the way, advertisement expense is one of the first that companies curtail when they are tightening their belts. Last week, we downgraded Travel to underweight: Even well-heeled consumers are starting to feel the pinch of surging prices. And while most will take that long-awaited post-COVID vacation, the outlook beyond summer is bleak with surging costs of fuel and labor. As for Autos, we were complacent in our thinking that car shortages will eventually translate into strong earnings growth. Despite the disappointing performance, the EV Revolution remains a long-term investment theme for us. Also having opened the position in June 2021, we are still in the green at +7% in relative terms. We have also upgraded our position in Staples to overweight on a premise that many Americans are reeling from surging prices of food, fuel, and shelter. Consumer Staples is the only likely beneficiary, and its pricing power is on the rise. Bottom Line: We have been able to contain some of the damage incurred by market rotation away from cyclicals. Profitability Earnings Growth Expectations As we have written extensively in the past (e.g., “Is Earnings Recession In The Cards”,) the analysts' earnings growth forecast for the S&P 500 of 10% is too high, especially considering the number of adverse events that have taken place since the beginning of the year, and the overall trajectory of monetary policy and economic growth. The analysts are yet again missing the turning point, just as they did back in 2008, and even in 2020. Chart 2Earnings Forecasts For Cyclicals Are Still Way Too High Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups We have noticed that the cyclical industries with the highest EPS growth forecasts, such as Consumer Services, Transportation, and Auto, are most prone to earnings disappointment. To be fair, EPS growth expectations for Consumer Services and Transportation are down from December when they stood at 550% and 143% respectively (Chart 2).  Earnings Uncertainty So how certain are analysts about their projections? A short answer is – not particularly.  We gauge earnings uncertainty by looking at the dispersion of analyst EPS expectations scaled by the magnitude of EPS. In a way, this is a measure of analyst consensus, with estimates clustered around a certain number indicating extreme certainty of forecasts. We notice that the advent of COVID-19 rendered panic among analysts with the rate of uncertainty surging. More recently, uncertainty has decreased but remains elevated by historical standards (Chart 3). Looking at earnings projections by industry group (Chart 4), we notice that earnings uncertainty is the highest in the cyclical pockets of the market where the highest EPS growth is still expected: Consumer Services, Transportation, and Retailing. Chart 3Analysts Have Little Confidence In Their Forecasts... Analysts Have Little Confidence In Their Forecasts Analysts Have Little Confidence In Their Forecasts Chart 4... Especially For Cyclical Industry Groups Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups   Implications? Analysts as a group have little confidence in cyclical sector growth, and downward revisions are imminent. Margins In the “Marginally Worse” and subsequent “Sector Margin Scorecard” reports in October, we called for margins to roll over as early as 2022.  Curiously, despite their bullishness, analysts expect the margins of most cyclical sectors to contract over the next 12 months (Chart 5). Chart 5Despite Their Bullishness, Analysts Expect Margins To Contract Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Chart 6Pricing Power Is Declining But There Are Exceptions Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Pricing Power As we observed early on, one of the key reasons for margin contraction is a decline in companies’ pricing power, i.e., their ability to pass costs on to their customers (Chart 6).  The Materials sector experienced the most significant decline in pricing power, likely a positive as this may be an early sign that inflation is abating.  It is also important to note that three sectors – Consumer Staples, Utilities, and Tech–are still growing their pricing power. Consumer Staples and Utilities are necessities, demand for which is fairly inelastic, while Tech is offering services that are still in high demand, as they help improve productivity and substitute labor, which is in short supply, for capital, which is still abundant. Degree of Operating Leverage Chart 7Low Operating Leverage Helps In Case Of Downturn Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups If pricing power is waning, what else can come to the rescue? After all, with inflation in the high single digits, nominal sales growth is to remain robust. The crucial piece of the puzzle is the ability of companies to convert sales into profits, i.e., operating leverage (Chart 7). Companies with high fixed costs enjoy higher operating leverage, and a small increase in sales translates into significant earnings growth (and vice versa). However, in case of an outright sales contraction, we are better off holding industries and sectors with low operating leverage, such as Staples and Healthcare. Earnings Stability Chart 8Defensives Have The Most Resilient Earnings Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups What sectors have the most resilient earnings, that won’t let investors down in a downturn? To answer this question empirically, we looked at a historical variation in EPS-realized growth rates by sector1 (Chart 8).  We found that Staples, Healthcare, and Technology have had the most stable earnings growth rates. However, the last 12 years or so, characterized by low yields and nearly non-existent inflation, were a boon for long-duration technology stocks – so our experiment may not be pure. Bottom Line: Earnings expectations for the cyclical sectors are too high and will come down as analysts have little confidence in their forecasts.  Balance Sheet Quality Free Cash Flow Chart 9Post-pandemic Surge In Demand Resulted In Free Cash Flow Windfall... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors. Technology benefited from the transition to remote working. Energy and Materials have not been able to meet the “reopening” demand after years of underinvestment, which resulted in constrained supply, and soaring prices (Chart 9). Chart 10...Which Companies Used To Repair Their Balance Sheets Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Interest Coverage The companies used this profits windfall to repair their balance sheets and reduce their levels of debt. As a result, the interest coverage ratio has picked up across the board (Chart 10). Bottom Line: Corporate balance sheets across most sectors look strong. Tech, Materials, and Financials have improved the most. Cash Yield Companies that pay dividends and buy back their stocks not only enhance the returns of their shareholders but also signal their confidence in future earnings and the strength of their balance sheets (Chart 11). That is one of the reasons income funds were strong performers over the past few months as investors were seeking out quality investments (Chart 12). Chart 11Cash Yield Has Not Been This Attractive In Years... Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Chart 12High Dividend Yield Signals Corporate Confidence Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Valuations A corollary to our conclusion that earnings estimates are hardly trustworthy, is that forward multiples are not a great valuation metric on the verge of an earnings contraction. Trailing multiples are a better measure of value at this point in the cycle. We sorted PE multiples by their Z-score to 10 years of history (Chart 13) and notice the most cyclical sectors are rather inexpensive, both in absolute terms and relative to history as markets are forward looking.  Chart 13High Dividend Yield Signals Corporate Confidence Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Technicals Chart 14US Equities Appear Oversold Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups   And last, but not least: The US equity market is oversold, and most industry groups are several standard deviations below the neutral reading (Chart 14).  Bottom Line: Technicals signal that the market is oversold. Yet, a sustainable rebound may still be months away. Investment Conclusion Is it finally time for bottom fishing? We believe that oversold conditions and sectors trading at 30-40 percent of their peak are “necessary but insufficient conditions.” For the equity market to rebound, all the bad news needs to be fully priced in – however, we are still in the early stages of the monetary tightening cycle, and there is talk about earnings and economic recessions, the severity of which is impossible to gauge at this point. Rates have not stabilized yet, and inflation has not peaked. Much of the bad news is priced in, but “new” bad news is likely on the way.   Bottom Line We recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart II-1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash   Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash   Table II-1Performance Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Table II-2Valuations And Forward Earnings Growth Taking Stock Of Sectors And Industry Groups Taking Stock Of Sectors And Industry Groups Footnotes 1           Scaled and inverted Recommended Allocation

In this week’s report “Adaptive Expectations: Revisiting Our Views”, we concluded that the S&P 500 is unlikely to find a bottom until inflation turns and monetary conditions stabilize, and US equities will follow a “fat and down” trajectory. We recommended that investors should overweight defensives vs. cyclicals. Accordingly, today we downgrade our overweight in Travel complex (Hotels, Cruises, and Airlines) to underweight. As a reminder, we recently moved retailing and durables categories to below benchmark. The key reason for this call is the effect of persistently high inflation on discretionary spending. In the past, we have written about the bifurcation of the US consumer, and that, while lower-income Americans are struggling with soaring prices of food, gas, and shelter, wealthier Americans are more comfortable and just shift their spending away from goods to services, such as eating out and travel. We expect strong profits for the travel sector this summer on the back of strong consumer demand and return of the business and international travel. We have discussed the drivers of the industry in these reports (here and here). Yet, markets are forward-looking, and the outlook for the industry beyond the summer months is dimming. With inflation entrenched, now even middle- and upper-class Americans as well as retirees are also starting to feel the pain. The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion off their respective market value. This adds up to a combined $15.5 trillion or about 60% of US GDP (Chart 1). These are nest eggs and pensions shrinking by the day, diminishing future spending, and causing anxiety about the future. And while the S&P 500 is still at a level above the pandemic lows, adjusted for inflation, most of the gains are gone. On top of the reduced value of investments, negative real wage growth dampens consumer confidence (Chart 2). To make things worse, fears of recession and impending layoffs are pervasive in media stories, stoking fear of the future, and perhaps, making an economic downturn a self-fulfilling prophecy. Therefore, even wealthier Americans may have to tighten their belts and reduce their discretionary spending, with travel and leisure categories being on top of their list. Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Therefore, after the summer vacation surge is over, hotels and airlines are likely to experience slower demand which will weigh on their sales and pricing power. At the same time, these are industries most affected by the rising cost of fuel (airlines and cruise lines) and rising wages (hotels). As a result, we expect profitability to diminish and earnings growth recovery to stall. We have a negative outlook on the travel industry on a tactical time horizon. Bottom Line: Entrenched inflation is weighing on discretionary spending, and travel is likely to be the next victim of curtailed spending. We downgrade the S&P Hotels and the S&P Airlines indexes from overweight to underweight.  

Inflation continues to put pressure on the US consumers. Negative real wage growth (Chart 1) and soaring prices of food and energy are pushing many low and middle-class Americans to shift spending away from discretionary items toward necessities (Chart 2). We have written about this here.  Chart 1CHART 1 CHART 1 CHART 1 ​​​​​​ Chart 2 On The US Consumer, Powell, And Retailers Carnage On The US Consumer, Powell, And Retailers Carnage ​​​​​​ Table 1 On The US Consumer, Powell, And Retailers Carnage On The US Consumer, Powell, And Retailers Carnage The recent earnings commentary from Walmart and Target are attesting the trend. Both noted that consumers are switching from the high-margin items (non-necessities) to the lower-margin necessity items like food. Both companies have also commented on the ongoing supply chain challenges and rising costs of both goods (COGS) and wages. Target reported a 430bps contraction in gross margins. Peak margins for the sector are surely in the rear-view mirror. Both Walmart and Target provided negative guidance. As a result, a retail “carnage” has ensued, WMT is down 20%, COST 15%, and TGT 30% over the past three days.  The sell-off was exacerbated by the Powell’s comments that combating inflation is likely to incur economic pain, hinting at a possibility of a recession on the back of the Fed’s actions. These comments have reiterated the Fed’s hawkish stance, and have removed any hope of the Fed’s put, i.e., the Fed coming to the rescue of the spluttering equity market.  What’s next? We believe that the markets can continue to fall. A few conditions of our Equity Capitulation scorecard have not been yet met (Table 1).  Rate stabilization – The Fed’s hawkish stance and a plan to front-load a rate hiking cycle suggest that monetary conditions will continue to tighten (-1)  Economic growth expectations do not yet reflect the deteriorating economic backdrop. US GDP forecasts will be further downgraded (-1)  Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar (-1)  Oil prices have somewhat stabilized (+1)  Valuations have retraced, signaling that the market is reasonably priced. However, earnings downgrades will push forward multiples higher (0)  Technicals signal that the market is oversold (+2)  “Black swans” – headwinds from the war in Ukraine and lockdowns in China (-2)  Bottom Line: On balance, risks for US equities slightly outweigh the upside opportunity. A market bottom is still a few weeks, or even months, away.   

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators 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 Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-5Indicators 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 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 Cheap Or Expensive? Cheap Or Expensive? Cheap Or Expensive?  President Emmanuel Macron will be re-elected.French growth will slow in the coming quarters but will also remain solid beyond that horizon.France’s reform push will continue, particularly pension reforms and efforts to reduce inefficiencies. However, austerity is unlikely to materialize.French stocks will underperform once energy inflation peaks. Consumer discretionary and staples have run ahead of themselves relative to the broad market and to their European peers. French small-cap stocks and aerospace and defense equities are attractive.RecommendationsINCEPTIONDATERETURN (%)COMMENTBuy French Small-Caps Equities / Sell French Large-Caps Equities (*)04/04/2022 CyclicalSell French Consumer Equities Relative to French Benchmark (*)04/04/2022 CyclicalOverweight French Aerospace & Defense**04/04/2022 Structural  Bottom Line: A second Macron presidency will not boost the appeal of French large-cap equities, even if it helps French long-term growth. Investors should underweight the French market in Europe via a large underweight in French consumer discretionary and consumer staple stocks. However, investors should overweight French defense names as well as small-cap equities.FeatureThe French presidential election is upon us. President Emmanuel Macron ambitious pro-growth and pro-business reform agenda in 2017 tackled the roots of the French malaise of the past decades. Our conviction that Macron would win a second mandate has survived challenges such as the “Yellow Vest Movement” in 2019 and then COVID-19.  Now, with the shock of the Ukraine war, the evidence still suggests he will win the upcoming election.  Chart 1Five More Years Of Macron France: Macron And Macro France: Macron And Macro  Macron is the favorite with 53% of voting intentions against Marine Le Pen in the second round of the election (Chart 1). Even a potential Russian interference in the French election wouldn’t change the outcome of such a duel, which we discussed at length last summer.  Since then, Macron’s advantages over Le Pen have only strengthened, boosted by his handling of Omicron and the Ukraine/Russia crisis while the center-right and the far-right battle each other (Chart 1, bottom panel).Macron also took the unofficial leadership of Europe after Angela Merkel exited the stage. He managed to breathe new life into the European Union (EU), bringing forth greater unity. As a result, the current war in Ukraine and elevated energy prices have made this political rendez-vous more relevant. Chart 2Less Euroscepticism Helps Macron Less Euroscepticism Helps Macron Less Euroscepticism Helps Macron  The main axis of Macron’s next term is to make France a more independent nation within a stronger Europe. This is a paradox, but what it means is that he is capitalizing on the current geopolitical climate of great power struggle and hypo-globalization. France is breaking with its tradition of Euroscepticism to secure its national interests within a closer European bloc (Chart 2).True, the French economy will not be spared from the current stagflation episode and growth will slow in the near term. However, France is in a better position to withstand the energy shock than most of its European peers.After Macron is re-elected, his political capital will be replenished and his structural reform effort will continue, albeit with modifications to deal with the post-pandemic and post-Ukraine environment. Fiscal and monetary policies remain very accommodative. As a result, Macron has a favorable chance of reforming France further. Pension reform as well as the green and digital transitions will improve France’s economic competitiveness over the long run.2017 vs. 2022: One Pandemic, One Recession, And One War Later Chart 3The French Economy Will Surprise To The Upside France: Macron And Macro France: Macron And Macro  France was badly hit by COVID-19. However, appropriate fiscal policy and strong domestic demand are driving the recovery (Chart 3). While most sectors are expected to recover fully by 2023, a few sectors, such as automotive, aeronautics, and tourism, still lag behind pre-pandemic levels (Chart 3, panel 2). On the upside, France appears to be doing better than the other major European economies (Chart 3, bottom panel). Moreover, about 1.5% of GDP worth of leftover funds from emergency measures and the recovery plan are to be deployed in 2022.The Ukrainian conflict challenges this positive backdrop. Growth forecasts for 2022 were revised to 2.8% from 4%. The impact from elevated energy prices is projected to reduce annual GDP growth by 0.7% and to trim an additional 0.2% once international spillovers are factored in (Table 1). Nonetheless, France is not as vulnerable to Russian energy as Germany and Italy (Chart 4). For now, Russia-EU energy flow continues, although the threats are rising. Germany once again rejected an energy boycott when Biden visited Europe two weeks ago, but it is also preparing for the eventuality that gas flows may dry up, which highlights the fluidity of the situation. Table 1Impact Of High Energy Prices France: Macron And Macro France: Macron And Macro   Chart 4Low Vulnerability To Russian Energy… France: Macron And Macro France: Macron And Macro  The direct consequences of the conflict on French exports are limited. Russia, Ukraine, and Belarus represent 1.2% of French exports, or EUR12 billion, most of which comes from transport equipment and other manufactured goods (Table 2). Table 2… And Low Trade Exposure France: Macron And Macro France: Macron And Macro   The evolution of the Chinese economy is another major external influence on French growth. France is exposed to the deceleration of the Chinese manufacturing PMI induced by the slowdown in Chinese credit growth. The recent closing of cities like Shanghai or Shenzhen because of the spread of the Omicron variant will accentuate near-term risks. However, Chinese policymakers want to stabilize growth by the time the Communist Party reshuffles this fall and the credit impulse is trying to bottom, which will help French exports to China improve later this year or next (Chart 5).Higher inflation is another consequence of supply disruptions and elevated energy prices caused by the Ukrainian war. For now, this is not a pressing concern in France. Headline inflation came in at 5.1%, well below the European average (Table 3). The government intervened to shield consumers from rising energy prices by handing out energy vouchers, freezing gas prices until the end of the year, and cutting electricity taxes. Chart 5France Is Sensitive To The Chinese Economy France Is Sensitive To The Chinese Economy France Is Sensitive To The Chinese Economy   Table 3Lower Inflation In France France: Macron And Macro France: Macron And Macro   Chart 6French Households Accumulated Plenty Of Excess Savings France: Macron And Macro France: Macron And Macro  This is good news for French households, as it preserves some of their purchasing power, especially when compared to Spanish households that suffer an inflation rate of 9.8%. However, it is not enough to prevent consumer confidence from crumbling. From Table 1, consumer spending is projected to fall by 1%. Yet, French consumers benefit from their large savings, accumulated during the pandemic (Chart 6). Unlike the US, where the household savings rate has already gone back to pre-pandemic levels, the savings rate in France is still high. Households can use those excess savings to mitigate elevated energy prices.With respect to employment, the generous French furlough scheme contributed to this accumulation of savings by limiting the rise in unemployment (Chart 7). Therefore, the French labor market was resilient throughout the crisis and has recovered quickly. Labor force participation exceeds its pre-crisis level by about 0.5%. Youth unemployment reached its lowest level since the 1980s, at 14.8 %, in part because of the 2017 labor and vocational reforms. Moreover, labor market conditions are now tighter than they were pre-pandemic and firms are increasingly complaining about labor shortages (Chart 8). The business sector still expects employment growth to remain as robust as it was in 2018. As a result, French wage growth will firm up before the year-end. Chart 7The French Labor Market Has Recovered... The French Labor Market Has Recovered... The French Labor Market Has Recovered...   Chart 8...And Is Showing Signs Of Tightening ...And Is Showing Signs Of Tightening ...And Is Showing Signs Of Tightening    The corporate sector has several reasons to be optimistic (Chart 9). The emergency measures prevented widespread corporate defaults and bank lending remained supportive through the crisis. Profit margins are high. Additionally, conducting business in France is becoming easier. Business creation has continued to rise (Chart 9, bottom panel) and FDI projects were up 32% in 2021, making France the largest investment destination in Europe. Nonetheless, the rise in non-financial gross corporate debt is concerning, even though the increase in net debt was limited by the jump in bank deposits during the crisis (Chart 10). Chart 9France Is Becoming More Business Friendly France Is Becoming More Business Friendly France Is Becoming More Business Friendly   Chart 10Corporate Debt Is A Concern France: Macron And Macro France: Macron And Macro  Bottom Line: French growth will decelerate in the coming quarter in response to the Ukrainian crisis, but it will remain stronger than that of its European peers. In the second half of the year, stronger demand recovery in hard-hit sectors, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover markedly.Reforms: Take 2(022)The series of recent crises highlight several weaknesses in the French economy. The pandemic revealed how vulnerable and underfunded the French health sector is. It also underscored that digitalization is inadequate in French firms. The Ukraine/Russia conflict is mixed: it underscores the energy dependence of European countries and highlights the need for greater defense spending, even if France is already less dependent than others and manufactures state of the art military equipment.Related ReportEuropean Investment StrategyFrance: More Than Just A Déjà-VuIn both crises, the French social welfare state played a crucial role as an automatic stabilizer. The IMF estimates that stabilizers absorbed about 80% of the household income shock during the pandemic, while government spending to contain high energy prices amounted to €15.5 billion since last fall.The fiscal response to these crises caused a large addition to the public debt, which already stands at 115% of GDP. Furthermore, at 55% of GDP before COVID, France’s public expenditure ratio was already one of the highest in the Eurozone (Chart 11). For now, the debt burden is manageable because low interest rates make France’s debt arithmetic benign. However, such an elevated share of output controlled by the government increases resource misallocation and hurts productivity, meaning it weighs on potential GDP growth.Low interest rates are not guaranteed in the future. Putting France’s debt on a sustainable path requires structural reforms (Chart 12). Already, the OECD estimates that the 2017-2018 labor-market and tax reforms have generated positive economic spillovers across all income levels (Chart 12, bottom panel). Chart 11Public Debt Just Got Bigger France: Macron And Macro France: Macron And Macro   Chart 12Structural Reforms & Pubic Debt France: Macron And Macro France: Macron And Macro  Going forward, reducing debt and cutting spending will be hard considering France’s energy and defense structural goals. Macron’s political party, En Marche!, may perform well in this year’s legislative election, but it is unlikely to achieve the sweeping victory that it saw in 2017. Macron will therefore be forced to compromise to build a coalition in favor of structural reform. His strength in the Assembly will be the chief uncertainty and critical determinant of his ability to achieve his key reform goals in the coming five years. As a result, Macron will focus on lifting French trend growth further by encouraging digital and green transitions. Beyond pension reforms, fiscal austerity will be limited to ensure the social acceptability of structural reforms.In the rest of this section, we focus on the two most important reforms proposed by Macron for his second mandate: pensions and economic competitiveness plans. Reducing public spending is needed to alleviate the burden on resources created by the massive size of the French government, but France’s strategic needs outstrip Macron’s ability to slash spending.French Pension System: Too Generous Table 4Public Spending Comparison France: Macron And Macro France: Macron And Macro  Pension represents 14% of GDP compared with 10% in Germany (Table 4). Expenditures on pension explains 35% of the difference on total public spending between France and the Euro Area.Reforming the pension system is a sensitive topic in France. It arguably cost Nicolas Sarkozy his re-election bid in 2012. Yet, pension reforms are essential. The current system is complex and fragmented, with 42 different types of coexisting pensions, each with its own calculation rules. Chart 13Pension Reform Is Long Overdue France: Macron And Macro France: Macron And Macro  Additionally, it does not reflect the ageing of the population (Chart 13). Employment among the 55-64 age cohort is only 56% in France, compared to 62% in the OECD average. Also, the effective retirement age in France is 60.8, compared with an average of 65 in Europe. Furthermore, replacement rates (pension / last salaries) are high, which puts an unsustainable burden on the state’s finances.According to the French think tank Institut Montaigne, progressively pushing the retirement age to 65 would save €7.7 billion per year by 2027 and €18 billion per year by 2032. Overall, the government would save around €50 billion per year through such pension adjustments and simplification reforms as well as by operating cost reductions. This would largely finance Macron’s investment to improve competitiveness, digitalization, the green transition, and national defense.Transitioning To Reduce InefficienciesTo boost long-term growth, an important prong of Macron’s project is the €100 billion “France Relance” recovery plan. It is part of the NGEU pandemic relief funds and includes €30 billion for green transition (including measures to improve energy performance of buildings, to increase rail freight, and to support businesses to make the transition). It also includes €34 billion for competitiveness and innovation (tax cuts and support for digitalization). Chart 14French Handicap: Productivity France: Macron And Macro France: Macron And Macro  This plan is a band-aid if the many inefficiencies undermining France’s productivity are not tackled (Chart 14). The uptake of digital technologies is uneven and lags far behind other developed nations with respect to cloud computing and the internet of things. Small businesses perform particularly poorly (Chart 15). As a result, the French tech sector has become a priority of Macron’s government. The “France 2030” investment plan unveiled in October 2021, worth €30 billion over five years, aims to foster industrial and tech “champions of the future.” It intends to lift business creation in the tech sector. Nonetheless, this is easier said than done; picking low-hanging fruits will help productivity but matching the prowess of the US is highly unlikely.Another problem is the inefficiency of French R&D. Government support for business R&D is elevated but does not translate into high R&D intensity (Chart 16). This problem is not unique to France: R&D returns across the EU do not match those of the US. Addressing France’s bureaucratic and extremely centralized management structure could tackle some of this hindrance (Chart 16, bottom panel). Chart 15France Is Digitally Lagging … France: Macron And Macro France: Macron And Macro   Chart 16… And Full Of Inefficiencies France: Macron And Macro France: Macron And Macro  When it comes to the green transition, Macron focuses on three axes: renewable energies, energy efficiency, and electric vehicles.Macron wants a “massive deployment” of renewable energies. A new plan for the construction of additional nuclear reactors will be implemented, since it is the only solution that allows France to reduce its carbon emissions quickly. Alongside this plan for electricity generation, a strategy will be put in place to increase energy efficiency. This is where the support to electric vehicle production and adoption comes in (Chart 17).Reforming energy taxes is another avenue to generate greater revenues, such as from higher carbon pricing, and this would help finance more green investments. Eliminating fossil fuel subsidies, for which France spends significantly more than its peers, and streamlining tax collectioncould yield 1% in annual savings by 2027 (Chart 18). Moreover, increasing carbon prices to EUR65 per ton by 2030 would contribute to France’s environmental goals and provide additional revenue. Chart 17French EV-olution France: Macron And Macro France: Macron And Macro   Chart 18More Green Taxes France: Macron And Macro France: Macron And Macro  Bottom Line: The re-election of President Macron portends another reform push in France. The large public debt load threatens national long-term economic prospects. Hence, increasing potential GDP growth is paramount. True, Macron’s majority in the Assemblée Nationale will decrease, which will limit the scope of the next reform round. Nonetheless, France will implement pension reforms that can both increase the size of the labor force and finance further initiatives. Moreover, France will push forward with efforts to streamline tech investment, increase spending in the nuclear electricity production, and boost energy efficiency.Investment ImplicationsThe investment implications of a second Macron mandate are manifold. First, investors should remain overweight the French tech sector compared to that of the rest of the Eurozone because of the boost to earnings from greater public investment. Chart 19Small-Caps, Big Upside Small-Caps, Big Upside Small-Caps, Big Upside  French small-cap stocks will also benefit from reforms. French small-cap equities have become oversold relative to their large-cap counterparts, falling 30% in relative terms since their late 2017 peak (Chart 19). Part of that underperformance anticipated the drag on French households from spiking energy prices. However, French households are more insulated from the impact of high inflation than their US or European counterparts. Moreover, the previous set of reforms boosted lower- and middle-class income (Chart 12 on page 9). Consequently, French consumer confidence will grow compared to that in the US and China, which helps the relative performance of French small-cap shares (Chart 19, panel 2). Rising German yields and an eventual stabilization in the euro will also buoy these stocks (Chart 19, bottom two panels).French industrials equities will be another sector to enjoy a dividend from Macron’s policy initiatives. The “France 2030” plan involves an increase in capex. The build-up in nuclear power under the green transition plan is also positive for industrial earnings. These policies will favor domestic spending, which bolsters French industrial stocks.Last week, we described the tailwinds for European aerospace and defense equities.  The same logic holds true for French aerospace and defense names, which are our favorite plays within the French industrial complex. Chart 3 on page 3 highlighted that the aerospace sector is among the major areas of the economy for which gross value added has yet to recoup its pandemic losses. The gradual re-opening of the global economy will create an important tailwind for the sector. Moreover, France is the fourth-largest global defense exporter. Thus, the French defense industry will profit from the upside in global military spending.Related ReportGeopolitical StrategyFrance: Macron (And Structural Reforms) Still Favored In 2022In this context, French aerospace and defense stocks should outperform not only the overall French market, but also their industrial peers (Chart 20). Since we already favor aerospace and defense equities within the Euro Area, the overweight of French aerospace and defense shares does not translate into an overweight compared to their European competitors. The position of French large-cap stocks within a European portfolio is more complex. They are unlikely to exhibit any significant net impact from Macron’s reform push. French equities have outperformed the rest of Europe already. Most of this outperformance reflected sectoral biases; the French market overweights industrial and consumer stocks. However, the country effect explains the recent outperformance of French equities (Chart 21). The country effect can be approximated by comparing French stocks to the rest of the European market on a sector-neutral basis. Chart 20Favor French Aerospace & Defense Favor French Aerospace & Defense Favor French Aerospace & Defense   Chart 21Country Effect Explains The Recent Outperformance Of French Equities Country Effect Explains The Recent Outperformance Of French Equities Country Effect Explains The Recent Outperformance Of French Equities   The lower vulnerability of the French economy to higher energy prices compared to the rest of Europe explains this outcome (see Chart 4 on page 4). The outperformance of French consumer stocks (which account for nearly a third of the index) relative to their European competitors added to the country effect as well.An end to the energy spike is likely to arrest the outperformance of French equities. Over the past six years, Brent crude oil prices expressed in euros as well as oil and gas inflation have supported the performance of French equities relative to German ones much better than core inflation or bond yields (Chart 22). The forward earnings of French equities compared to those of the Eurozone market closely track energy markets (Chart 23). Essentially, the French market biases and the country’s low reliance on imported energy are valuable hedges when stagflation fears are rampant (Chart 24). Chart 22The End Of The French Reign Draws Near The End Of The French Reign Draws Near The End Of The French Reign Draws Near   Chart 23Supply Shock Lifted French Earnings Supply Shock Lifted French Earnings Supply Shock Lifted French Earnings   The best vehicle to underweight French large-cap stocks is to underweight French consumer stocks compared to the Euro Area MSCI benchmark. French equities outperformed the rest of Europe by a greater extent than relative earnings would have implied, which resulted in a small P/E expansion (Chart 25). However, when consumer stocks are excluded, French stocks have performed in line with the rest of the Euro Area and have underperformed relative earnings, which has caused a derating of the French market excluding consumer stocks (Chart 25, bottom two panels). Chart 24French Equities Thrive When Stagflation Fears Are High French Equities Thrive When Stagflation Fears Are High French Equities Thrive When Stagflation Fears Are High   Chart 25Cheap Or Expensive? Cheap Or Expensive? Cheap Or Expensive?   French consumer equities have become very expensive. Their relative performance has completely decoupled from earnings compared to their Eurozone competitors and their relative valuation has expanded to two sigma above its past 20 years average (Chart 26). Measured against the French broad equity market, the same dynamics can be observed (Chart 26, bottom two panels). These divergences are unsustainable and the most likely catalyst for their correction is the rapid decline in global consumer confidence (Chart 27). Chart 26French Consumer Equities Are Expensive Beware French Consumer Stocks Beware French Consumer Stocks   Chart 27Crumbling Consumer Confidence Does Not Bode Well For French Consumer Stocks French Consumer Equities Are Expensive French Consumer Equities Are Expensive    Bottom Line: The best direct bets on President Macron’s re-election are to overweight French small-cap stocks compared to large-cap ones and to favor aerospace and defense stocks within the French market. Investors should also underweight French stocks in Europe. However, to do so, investors should underweight French consumer stocks and maintain a benchmark weight for the other French sectors compared to their allocation in the Eurozone benchmark. Traders should buy Euro Area consumer staples and consumer discretionary stocks and sell French ones. Jeremie Peloso,Associate EditorJeremieP@bcaresearch.comMathieu Savary,Chief European StrategistMathieu@bcaresearch.comFootnotes

Today, we are downgrading the S&P restaurants index from overweight to neutral. Currently, the industry faces a trifecta of challenges: Rising input prices, a stronger dollar, and a shift in consumer spending away from discretionary goods and services towards necessities. Chart 1 Chart 1 Chart 1 Rising Input Costs: Soaring food prices and rising wages for the lowest-paid cohort of the US workers is pressuring US restaurants’ bottom line. Restaurants are trying to offset wage pressures by hiking prices with food away from home CPI climbing 2.2 standard deviations away from its five-year average (Chart 1). A mean reversion move is likely coming, meaning that going forward restaurants will have to absorb some of the cost increases, which will damage their bottom line.  Stronger USD: The index is dominated by two multinational players, Starbucks (SBUX) and MacDonald’s (MCD), that command a 40% and 30% weight of the industry, respectively.  When averaged together, those two companies derive over 45% of sales from abroad compared to 40% for the S&P 500.  Stronger dollar dents companies’ profits by making American goods and services more expensive, and because of the accounting translation effect (Chart 2).  Making things worse, US restaurants’ withdrawal from Russia to protest the invasion of Ukraine will have an adverse effect on their sales. McDonald’s announced that closing its extensive network of restaurants in Russia will cost it $50 million a day, or 9% of its revenue. Consumer spending is shifting towards necessities: High inflation in general, and rising prices of food and gasoline weigh on consumer spending, forcing many consumers to allocate a higher share of their spending towards necessities (Chart 3). As the US consumer tightens its belt, restaurants and other discretionary spending categories are likely to come under pressure. Chart 2 Chart 2 Chart 2 Chart 3 Chart 3 Chart 3 Bottom Line:  We are downgrading the S&P restaurants index from overweight to neutral, booking a loss of 13.5%.

Chart 1 Chart 1 Chart 1 Today, we are downgrading the overall Consumer Discretionary index to underweight by reducing our allocation in two key industry groups: Retailing and Consumer Durables & Apparel. We remain constructive on Consumer Services, i.e., the Travel Complex (Hotels & Cruises, Restaurants, and Airlines). Consumer spending is shifting from goods to services, for which there is still strong pent-up demand (Chart 1). While consumers still sit on $2.2 trillion in excess savings, their sentiment is in a downward trend. High inflation and negative real wage growth are cutting into middle-class Americans’ disposable income: For many high costs of food and gas crowd out discretionary spending.  Empirical analysis supports our reasoning. Performance of the S&P Retailing and the S&P Consumer Durables & Apparel industry groups has been strongly inversely correlated with consumer sentiment and inflation (Charts 2 and 3). With inflation high and intransigent, stimulus checks in a rear-view window, and consumers worried about their finances, these industries have been underperforming, and will continue doing so.  Chart 2 Chart 2 Chart 2 Chart 3 Chart 3 Chart 3 Even if inflation abates, thanks to unclogging of supply chain bottlenecks and tighter monetary policy, we will need to see an inflection in consumer sentiment and positive real wage growth to change our stance. Bottom Line: We downgrade the S&P Retailing and the S&P Consumer Durables & Apparel indexes to below benchmark. Those downgrades also push the overall S&P Consumer Discretionary into an underweight basket. Appendix Table 1 Inflation Bites Discretionary Spending Inflation Bites Discretionary Spending Table 2 Inflation Bites Discretionary Spending Inflation Bites Discretionary Spending

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

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast series ‘Where Is The Groupthink Wrong?' I do hope you can join. Executive Summary Spending on goods is in freefall while spending on services is struggling to regain its pre-pandemic trend.  If spending on goods crashes to below its previous trend, then there will be a substantial shortfall in demand. The good news is that the freefall in goods spending is leading inflation. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year. Underweight the goods-dominated consumer discretionary sector, and underweight semiconductors versus the broader technology sector. Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Overbought base metals are particularly vulnerable. Fractal trading watchlist: We focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Bottom Line: As spending on goods crashes back to earth, so will inflation, consumer discretionary stocks, semiconductors, and overbought commodities. Feature The pandemic has unleashed a great experiment in our spending behaviour. After a binge on consumer goods, will there be a massive hangover? We are about to find out. The pandemic binge on consumer goods, peaking in the US at a 26 percent overspend, is unprecedented in modern economic history. Hence, we cannot be certain what happens next, but there are three possibilities: We sustain the binge on goods, at least partly. Spending on goods falls back to its pre-pandemic trend. There is a hangover, in which spending on goods crashes to below its previous trend. The answer to this question will have a huge bearing on growth and inflation in 2022-23. After The Binge Comes The Hangover… The pandemic’s constraints on socialising, movement, and in-person contact caused a slump in spending on many services: recreation, hospitality, travel, in-person shopping, and in-person healthcare. Nevertheless, with incomes propped up by massive stimulus, we displaced our spending to items that could be enjoyed within the pandemic’s confines; namely, goods – on which, we binged (Chart I-1). Chart I-1Spending On Goods Is In Freefall Spending On Goods Is In Freefall Spending On Goods Is In Freefall Gradually, we learned to live with SARS-CoV-2, and spending on services bounced back. At the same time, we made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping. Additionally, a significant minority of people changed their behaviour, shunning activities that require close contact with strangers – going to the cinema or to amusement parks, using public transport, or going to the dentist or in-person doctors’ appointments. The result is that spending on services is levelling off well short of its pre-pandemic trend (Charts I-2-Chart I-5). Chart I-2Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Chart I-3Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Chart I-4Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Chart I-5Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Arithmetically therefore, to keep overall demand on trend, spending on goods must stay above its pre-pandemic trend. Yet spending on goods is crashing back to earth. The simple reason is that durables, by their very definition, are durable. Even nondurables such as clothes and shoes are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can binge on before reaching saturation. Indeed, to the extent that our bingeing has brought forward future purchases, the big risk is a period of underspending on goods. Countering The Counterarguments Let’s address some counterarguments to the hangover thesis. One counterargument is that some goods are a substitute for services: for example, eating-in (food at home) substitutes for eating-out; and recreational goods substitute for recreational services. So, if there is a shortfall in services spending, there will be an automatic substitution into goods spending. The problem is that the substitutes are not mirror-image substitutes. Spending on eating-in tends to be much less than on eating-out. And once you have bought your recreational goods, you don’t keep buying them! A second counterargument is that provided the savings rate does not rise, there will be no shortfall in spending. Yet this is a tautology. The savings rate is simply the residual of income less spending. So, to the extent that there is a structural shortfall in services spending combined with a hangover in goods spending, the savings rate must rise – as it has in the past two months. A third counterargument is that the war chest of savings accumulated during the pandemic will unleash a tsunami of spending. Well, it hasn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-6). Chart I-6Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending The explanation comes from a theory known as Mental Accounting Bias. This points out that we segment our money into different ‘mental accounts’. And that the main factor that establishes whether we spend our money is which mental account it resides in. The moment we move money from our ‘income’ account into our ‘wealth’ account, our propensity to spend it collapses. Specifically, we will spend most of the money in our ‘income’ mental account, but we will spend little of the money in our ‘wealth’ mental account. Hence, the moment we move money from our income account into our wealth account, our propensity to spend it collapses. Still, this brings us to a fourth counterargument, which claims that even though the ‘wealth effect’ is small, it isn’t zero. Therefore, the recent boom in household wealth will bolster growth. Yet as we explained in The Wealth Impulse Has Peaked, the impact of your wealth on your spending growth does not come from your wealth change. It comes from your wealth impulse, which is fading fast (Chart I-7). Chart I-7The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked Analogous to the more widely-used credit impulse, the wealth impulse compares your capital gain in any year with your capital gain in the preceding year. It is this change in your capital gain – and not the capital gain per se – that establishes the growth in your ‘wealth effect’ spending. Unfortunately, the wealth impulse has peaked, meaning its impact on spending growth will not be a tailwind. It will be a headwind. As Spending On Goods Crashes Back To Earth, So Will Inflation, Consumer Discretionary Stocks, And Overbought Commodities In the fourth quarter of 2021, US consumer spending dipped to below its pre-pandemic trend and the savings rate increased. Begging the question, how did the US economy manage to grow at a stellar 6.7 percent (annualised) rate? The simple answer is that inventory restocking contributed almost 5 percent to the 6.7 percent growth rate. In fact, removing inventory restocking, US final demand came to a virtual standstill in the second half of 2021, growing at just a 1 percent (annualised) rate. Growth that is dependent on inventory restocking is a concern because inventory restocking averages to zero in the long run, and after a massive positive contribution there tends to come a symmetrical negative contribution. If, as we expect, spending on services fails to catch up to its pre-pandemic trend while spending on goods falls back to its pre-pandemic trend, then there will be a demand shortfall. And if there is a hangover, in which spending on goods crashes to below its previous trend, then the demand shortfall could be substantial. As inflation crashes back to earth, so will overbought commodities. The good news is that the freefall in durable goods spending is leading inflation. In this regard, you might be surprised to learn that the US core (6-month) inflation rate has already been declining for five consecutive months. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year (Chart I-8). Chart I-8As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Given that the level (rather than the inflation) of commodity prices is irrationally tracking the inflation rate, the likely explanation is that investors have piled into commodities as a hedge against inflation. Hence, as inflation crashes back to earth, so will overbought commodities (Chart I-9). Overbought base metals are particularly vulnerable. Chart I-9Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Fractal Trading Watchlist This week we focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. To reiterate, overbought base metals are vulnerable, and the 70 percent outperformance of nickel versus silver through the past year has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2016, 2018, and 2020 (Chart I-10). Accordingly, this week’s recommended trade is to go short nickel versus silver, setting the profit target and symmetrical stop-loss at 20 percent.  Chart I-10Short Nickel Versus Silver Short Nickel Versus Silver Short Nickel Versus Silver A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell EUR/CZK At A Bottom EUR/CZK At A Bottom EUR/CZK At A Bottom Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... 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      

Highlights We reformatted and added three sections to our existing trade tables: strategic themes, cyclical asset allocations and tactical investment recommendations. An extensive audit of our current trade book shows that our country and sector allocation recommendations have been successful. Of the eight open trades in our book, six have so far generated positive returns. We now recommend closing three out of the eight positions, based on a review of the original basis and subsequent performance of our trades. We have also added one cyclical and two tactical trades. We will look for opportunities to propose new trades to our book in the coming months. Feature In this week's report, we introduce our newly formatted trade tables (on Page 15), which include the following: Strategic themes (structural views beyond 18 months) Cyclical asset allocations within Chinese financial markets (in the next 6 to 18 months) Tactical trades (investment recommendations for the next 0 to 6 months) We revisited the original basis and subsequent performance of our open trades as part of an audit of our trade book. We maintain five of the eight trades and will add one cyclical and two tactical trades. Our new features and the rationale for retaining or closing each trade are presented below. Strategic Themes The new Strategic Themes section now includes the following market relevant structural forces: President Xi Jinping’s “common prosperity” policy initiative, which is intended to narrow the nation’s wealth gap; a demographic shift of a shrinking population by 2025; and secular disputes between the US and China (Table 1). Table 1 Introducing New Trade Tables Introducing New Trade Tables These structural aspects will have a macro impact on China’s policy landscape, economy and financial markets. Investors should consider whether the themes point toward a reflationary policy bias; whether they will have a medium- to long-term effect on corporate earnings; and whether these themes will, on a structural basis, warrant higher/lower risk premiums for owning Chinese stocks. Cyclical Equity Index Allocation Recommendations (Relative To MSCI All Country World) Table 2 is a summary of our cyclical recommendations for Greater China equity indexes. We recommend the following equity index allocations within a global equity portfolio, for the next 6 to 18 months: Table 2 Introducing New Trade Tables Introducing New Trade Tables Underweight MSCI China (Chinese investable stocks). Underweight MSCI China A Onshore (Chinese onshore or A-share stocks). Neutral stance on MSCI Hong Kong Index. Overweight MSCI Taiwan Index. Chart 1Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Our recommendation to underweight MSCI China Index and MSCI China A Onshore Index were extremely successful in 2021 (Chart 1). We will continue to maintain an underweight stance for the time being, based on our concern that the current policy easing measures will be insufficient to revive China’s slowing economy. We expect policy stimulus to step up in the coming months and economic growth to start improving by mid-2022. However, corporate profits are set to disappoint in the first half of the year. This implies that Chinese share prices will remain volatile with substantial downside risks. Chinese investable stocks are in oversold territory and will likely rebound in the near term in both absolute and relative terms (discussed in the Tactical Recommendations section on Page 14) (Chart 2). Nonetheless, on a cyclical basis, they face challenges both from the impact of a slowing economy on earnings growth and ongoing regulatory and geopolitical risks. Our model suggests high odds (70%) of a considerable earnings contraction in Chinese investable stocks in the next 6 to 12 months. We recommend investors upgrade their allocation to the MSCI Hong Kong Index from underweight to neutral within a global equity portfolio. The MSCI Hong Kong equity index appears to be very cheap compared with global equities (Chart 3). Chart 2Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chart 3MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap The MSCI Hong Kong equity index includes Hong Kong-domiciled companies and not mainland issuers listed in Hong Kong. Rising US Treasury yields will be a headwind to Hong Kong-domiciled company stock performance because the HKD is pegged to the USD and therefore Hong Kong bond yields tend to follow the direction of bond yields in the US. Chart 4MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature However, an offsetting factor is that due to composition changes over time, the MSCI Hong Kong equity index has become much more defensive and tends to perform better than the emerging Asian and EM equity benchmarks during turbulent times (Chart 4). The weight of insurance companies and diversified financials account for over 40% of the MSCI Hong Kong Index, compared with property stocks, which take up 20% of the equity market cap. The insurance and diversified financials subsectors are less vulnerable to escalating short-term interest rates compared with property stocks. During risk-off phases, the defensive nature in the MSCI Hong Kong Index will support its performance relative to the some of the more industrial- and tech-heavy EM and global equity indexes. We maintain an overweight stance on the MSCI Taiwan Index relative to global equities. The trade (see discussion in the Cyclical Equity And Sector Trades section) has brought an impressive 40% rate of return since its inception in 2019. Cyclical Recommended Asset Allocation (Within Chinese Onshore Assets) Image We recommend an underweight position in equities in China’s onshore multi-asset portfolios (Table 3). Chinese onshore stocks are not cheap and will likely underperform onshore government bonds as the economy struggles to regain its footing. Chart 5Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Chart 5 shows that in the past decade total returns in Chinese onshore stocks have barely kept up with that in onshore long-duration government bonds. During policy easing cycles Chinese onshore stocks generated positive excess returns over government bonds, however, the outperformance has been extremely volatile and very brief. Given that we do not expect Beijing to allow a significant overshoot in stimulus this year, there is a good chance that the returns in Chinese onshore stocks will underperform onshore government bonds. Cyclical Equity And Sector Trades Our rationale for retaining or closing each trade is described below. Chart 6Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Long China A-Shares/Short Chinese Investable Stocks (Maintain) We initiated this trade in March 2021. The recommendation has been our most successful trade, generating a 40+% return since then (Chart 6). China’s internet platform giants have a large weight in the MSCI Investable index and they remain vulnerable (Chart 7). Although China’s antitrust regulations may have passed the peak of intensity, they will not be rolled back and multiple compression in these stocks will likely continue in 2022. In contrast, the A-share index is heavily weighted in value stocks. The trade is in line with our view that the global investment backdrop has shifted in favor of global value versus growth stocks due to an above-trend US expansion and climbing US bond yields in the next 6 to 12 months. The relative ratio between China A-shares and investable stocks is overbought and will likely pull back in the near term (Chart 8). However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Chart 7Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Chart 8A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely Long CSI500/Short Broad A-Share Market (Maintain) The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the broad A-share market by 32% since mid-February (Chart 9). We think the outperformance in SMID stocks has not fully run its course. Historically, SMID-caps tend to outperform large caps in the late phase of an economic recovery and the valuation premia in small cap stocks remains near decade lows (Chart 10). In addition, the government’s increasing efforts to support small- and medium-sized corporates will help to shore up confidence in those companies. Therefore, SMID will probably continue to outperform large cap stocks this year. Chart 9A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps Chart 10SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Long MSCI Taiwan Index/Short MSCI All Country World (Maintain) The MSCI Taiwan equity index has consistently outperformed global equities since mid-2019, mostly driven by the rally in Taiwanese semiconductor stocks. Global chip supply shortages since the COVID pandemic have further boosted the sector’s outperformance (Chart 11). Furthermore, Chart 12 highlights improvements in the cyclical case for Taiwanese stocks as an aggregate. Panels 1 & 2 show an uptick in the new export orders component of Taiwanese manufacturing PMI. The new export orders component has historically coincided with both Taiwanese exports to China and the relative Taiwanese manufacturing PMI on a cyclical basis. As such, the economic fundamentals also support a continued outperformance in Taiwanese stocks. Chart 11A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis Chart 12Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Long Chinese Onshore Industrial Stocks/Short MSCI China A Index (Maintain) This trade, initiated in September last year, has brought a slightly positive return as of today. Our view was based on improving manufacturing investment and policy support for the sector, even though China’s business cycle had already peaked. Chart 13China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals While we maintain the trade for now, we will monitor credit growth in Q1 to assess whether to close the trade. The sector’s performance is highly correlated with our BCA China Activity Index and the Li Keqiang Leading Indicator (Chart 13). A bottoming in both indicators in mid-2022 would suggest that investors should maintain the trade. The caveat, however, is that the sector’s valuations have already become extreme, indicating that the bar may be higher for the sector to outperform even when economic fundamentals improve in 2H22. We will watch for signs of an overshoot in stimulus in the coming three to six months. Conversely, credit growth in Q1 that is at or below expectations will warrant closing this trade. Long Domestic Semiconductor Sector/Short Global Semiconductor Benchmark (Close) Replace with: Long Domestic Semiconductor Sector/Short MSCI China A Onshore The trade has been our biggest loser since its inception in August 2020. Although Chinese onshore semiconductor stocks outperformed the broad A-share market by a large margin, they have underperformed their global peers (Chart 14). Thus, we are closing the trade and replacing it with long Chinese onshore semis relative to the broad A-share market. We remain bullish on Chinese semi stocks, on both a structural and cyclical basis. Secular pressures from the US and the West to curb the advancement of Chinese technology will encourage China’s authorities to double down on supporting state-led technology programs. Moreover, prices of Chinese onshore semis have plummeted since November last year, bringing their lofty valuations closer to long-term trend and providing a better cyclical risk-reward profiles for these stocks (Chart 15). Chart 14Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chart 15...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market Long Domestic Consumer Discretionary/Short Broad A-Share Market (Close) Chart 16A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance We placed the trade in May 2020 when China’s economy and household discretionary consumption showed a strong rebound from the deep slump in Q1 2020. As strength waned in the country’s domestic demand for housing, housing-related durable goods and automobiles, the sector’s relative performance also started to dwindle from its peak in the fall of last year (Chart 16). Going forward, even though China’s economy will start to improve on a cyclical basis, domestic consumer discretionary sector will face non-trivial headwinds. The performance of its subsectors, such as hotels, restaurants, and services, will remain subdued due to China’s zero tolerance COVID policy that leads to frequent lockdowns and travel restrictions (Chart 17). Moreover, the internet and direct-marketing retail subsectors are facing tighter regulations, which lowers the sector’s profitability and valuations (Chart 18). Chart 17Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Chart 18Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Short Hong Kong 10-Year Government Bond/Long US 10-Year Treasury (Maintain) In the past decade, Hong Kong's 10-year government bond yield has been consistently below that of the US, even though Hong Kong has an exchange rate pegged to the US dollar and its monetary policy is directly tied to that of the US. Chart 19The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-Hong Kong 10-year yield spread has substantially narrowed since early 2020 when the US Fed aggressively cut its policy rate. In the coming 6-12 months, however, the spread will likely widen given that the Fed will start to normalize rates (Chart 19, top panel). Chart 19 (bottom panel) highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Although cyclically the relative total return will likely reverse to its trend line and argues for a short stance on US Treasury, we think it is too early to close the trade. The USD will likely remain strong in the near term, and we have yet to turn positive on Chinese and Hong Kong assets over a 6 to 18-mont time horizon. Therefore, we maintain this trade until the USD starts to weaken, and foreign investment flows into China and Hong Kong shows sustainable momentum. Long USD-CNH (Close) We are closing this trade, which we initiated in May 2020 when tensions between the US and China were rising. The trade has lost more than 10% since its inception because the RMB exchange rate was boosted in 2021 by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China would abate. Chart 20A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation We expect all three favorable conditions supporting the RMB to start reversing in 1H22, suggesting downward pressure on the RMB. However, over a longer period of 6 to 18 months the US dollar also has the potential to trend lower, preventing the RMB from any sizable depreciation (Chart 20). The dollar strength in the past year has been the result of both speculative flows into the US dollar based on rising interest rate expectations and portfolio inflows into the US equity markets.  In the next 6 to 18 months, however, our Foreign Exchange Strategist Chester Ntonifor predicts that the dollar could begin a paradigm shift, whereby any actions by the Fed could eventually lead to a weakening of the US dollar. Higher rates than the market expects will initially boost the US dollar, but will also undermine the US equity market leadership, reversing the substantial portfolio inflows from recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US relative to other developed markets. Chester further predicts that the DXY could touch 98 in the near term but will break below 90 in the next 12-18 months. Tactical Recommendations (0-6 months) We are initiating two tactical trades to go long on the MSCI China Index and MSCI Hong Kong Index relative to global equities. Relative to global stocks, Chinese investable equities are very oversold and offer value. In addition, while US tech stocks are entering a rollercoaster phase due to higher bond yields in the US, Chinese tech stocks will also fall but by a lesser degree because China’s monetary policy cycle is less affected by the Fed’s policy decisions. In other words, Chinese investable stocks may passively outperform global equities. Nonetheless, as noted in our previous reports, Chinese investable stocks face both cyclical and structural challenges. Hence the overweight stance on these stocks is strictly a tactical play rather than a cyclical one. We favor the MSCI Hong Kong Index versus global equities for similar reasons as Chinese investable stocks. The Hong Kong equity index is also technically oversold. Since the composition of the index has become more defensive, it will likely outperform in risk-off phases. In addition, if the US dollar rallies in the near term, share prices of Hong Kong-domiciled companies will materially outperform.   Jing Sima China Strategist jings@bcaresearch.com Strategic View Cyclical Recommendations Tactical Recommendations