Consumer Staples

Executive Summary Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally China’s food price inflation accelerated in April. The rising cost of global agricultural goods and domestic COVID-related disruptions in the supply-chain contributed to a sharp bump in food prices last month. China is not overly reliant on food imports. The country is also well stocked with grain reserves and should weather ongoing global food supply shortages, particularly wheat, better than most emerging economies.  However, China will still be impacted by escalating prices of global agricultural products and energy. Some imported goods (e.g. soybeans and related products) that China relies on, coupled with higher energy costs and a bottoming in China’s pork prices, will continue to push up food prices and headline inflation. Higher reading in headline inflation will not change the direction of the PBoC’s monetary policy. However, more expensive food will dampen Chinese households’ spending power on non-food consumer goods, especially as income growth slows. The food and beverage sector in China’s onshore stocks will benefit from higher food costs. We are initiating a new trade: long domestic consumer staples/broad A-share market. CYCLICAL RECOMMENDATIONS (6 - 18 MONTHS) INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG DOMESTIC CONSUMER STAPLES/BROAD A-SHARE MARKET 05/18/2022     Bottom Line: Despite China’s solid self-sufficiency in food supplies, its food price inflation is not immune from the mounting prices of global agricultural products.   Is China’s Food Price Inflation Transitory? The food component of China’s consumer price index (CPI) increased by 0.9% in April compared with the previous month, a sharp reversal from a 1.2% month-over-month decline in March. Higher food and energy prices pushed headline CPI to 2.1% in April, the fastest year-on-year growth since August 2020. China is not overly reliant on food imports and has abundant grain reserves.  The country is in a better position to weather ongoing global supply shortages in grain compared with other emerging economies, such as the Middle East and North Africa. Moreover, agricultural product prices in China have been structurally higher than those traded in the global commodity market. Large margins in China’s bulk agricultural pricing provide a cushion from escalating global food prices. Nonetheless, China remains at risk for higher food prices this year. Elevated oil prices and the war in Ukraine will further lift the price of fertilizers, adding to input costs for agricultural products. A strong USD will add to the price of USD-denominated commodity imports, particularly soybeans. In addition, China’s domestic pork price may have reached its hog cycle bottom and will pick up in the second half of this year. Food Prices Are Driving Up Inflation China’s headline CPI accelerated to 2.1% in April, on a year-on-year basis, from 1.5% in the previous month. Even though pork prices plunged by 33% in April from a year ago, food prices grew by 1.9% and have been boosted by a jump in the cost of fresh food, such as vegetables (+24% year-on-year), fruit (+14%) and eggs (+12%). Prices in other food categories, such as grains and edible oil, also rose, albeit more modestly (Chart 1A and 1B). Chart 1ALarge Jump In Fresh Food Prices In April Large Jump In Fresh Food Prices In April Large Jump In Fresh Food Prices In April Chart 1BOther Food Prices Also Picked Up, But More Modestly Other Food Prices Also Picked Up, But More Modestly Other Food Prices Also Picked Up, But More Modestly China’s strict COVID-19 containment measures have had a broad-based impact on food supplies. Mobility restrictions, roadblocks and risk-averse truck drivers introduced significant challenges in food supplies and transportation. Lockdowns in some large urban areas also led to panic buying and stockpiling among consumers, pushing up demand. Chart 2Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Meanwhile, higher global food and energy prices have likely both directly and indirectly contributed to food price inflation in China. The UN Food and Agriculture Organization (FAO) Food Price Index in April this year leapt to its highest level since its inception in 1990; it is 30% higher than last year and nearly double from its trough in mid-2020. Although price increases in China’s domestic agricultural products have been more moderate, the country’s agricultural wholesale prices have jumped by 10% from a year ago (Chart 2). Bottom Line: Food accounts for about 20% of China’s CPI basket (Chart 3).  Climbing food, along with energy, prices are driving up China’s headline inflation. Chart 3Food Accounts For 20% Of Chinese Household Budgets Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? China Is In A Good Position To Weather Global Food Supply Shocks … Chart 4Ex-China Food Inventories Haven’t Been Built Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? China is well stocked with food reserves and does not rely on imports for most of its agricultural supplies. Thus, the country should weather ongoing global shortages in the food supply better than most emerging economies (Chart 4).  China’s food inventories are significantly higher than levels in the 2006-2008 and 2010-2012 global food price hikes (Chart 5). The nation’s inventories have been steadily building up in the past decade to avert potential food supply shortages. Corn and rice stocks are sufficient to cover consumption for nearly three quarters of a year and wheat stocks are at nearly a year’s worth of consumption. Chart 5China Has Been Building Up Inventories To Buffer Against Supply Shortfalls Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Chart 6China Is Not Overly Dependent On Ag Imports Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Furthermore, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 6). The country is self-sufficient in supplying rice, wheat, and corn, three major staples in China’s grain consumption basket. Less than 5% of China’s total consumption of the three staple grains comes from imports. Bottom Line:  China is well stocked with agriculture products and is not overly dependent on imports for its food supplies. … But Not Immune To Food Price Hikes Worldwide Chart 7Ag Products Are Traded At Higher Prices In China Than In The Global Market Ag Products Are Traded At Higher Prices In China Than In The Global Market Ag Products Are Traded At Higher Prices In China Than In The Global Market Rising global agricultural and energy prices could still push up the country’s food price inflation. In USD terms, prices of China’s domestic agricultural products have been structurally higher than those traded on global commodity markets (Chart 7). The government heavily regulates and subsidizes its agricultural procurement prices as an encouragement to domestic farmers.  When global food supply shocks sharply pushed up agricultural prices worldwide, China’s domestic agricultural prices, with their large buffer versus global food prices, rose more moderately.  Nonetheless, China’s domestic food prices are not insulated from worldwide price hikes. China is facing higher inflation in food prices this year for the following reasons: Pork prices, which account for 13% of China’s CPI food basket, have likely bottomed. Although pork prices remain in a deep contraction year-over-year, they rebounded sharply in April on a month-on-month basis (Chart 8). The number of sows peaked in mid-2021 and has been declining for the past 10 consecutive months. Falling sow numbers have historically led to rising pork prices (Chart 9).   Chart 8Pork Prices May Have Bottomed Pork Prices May Have Bottomed Pork Prices May Have Bottomed Chart 9Pork Prices Will Likely Increase In 2H22 Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Nearly 90% of China’s soybean consumption relies on imports, making the country vulnerable to external price fluctuations. Soybean prices have jumped sharply this year. A stronger USD will also add to the price of USD-denominated commodity imports. About 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry, which means higher soybean prices will indirectly lead to rising pork prices by boosting input costs. Given that pig output is approaching its cyclical bottom, an increase in pig livestock would mean more demand for soybeans.  Chart 10Edible Oil Prices Reached Their Highest In Decades Edible Oil Prices Reached Their Highest In Decades Edible Oil Prices Reached Their Highest In Decades Growing prices in soybeans and corn will lift the cost of cooking oil, which represents about 8% of China’s food CPI basket (Chart 10). Ukraine supplies 30% of China’s corn imports, and Russia and Ukraine together account for nearly 20% of China’s soybean oil imports. China ramped up corn imports from Ukraine through March despite the war and snapped up large volumes of US corn in April after supplies from Ukraine were cut off. Nonetheless, prices of soybeans and corn will likely remain elevated with no end in sight to the Russia-Ukraine war and supply shortages globally. In addition, as global travel becomes more popular and oil prices remain elevated, the demand for corn-based ethanol, which is blended with gasoline, will also expand. Wheat prices will continue to experience upward pressure in the global market, mainly due to reduced production and exports from Ukraine and Russia (these countries account for 30% of world’s wheat exports). The World Bank forecasts that wheat will be 40% more expensive this year, reaching an all-time high in nominal terms.1 Although China is about 96% self-sufficient in wheat, the upsurge in global prices has boosted China’s domestic cost for wheat; it climbed by 15% in May from a year ago (Chart 11). Higher shipping and input costs, especially for fertilizers, will exacerbate the upside price pressures on agricultural goods. China is the world’s largest exporter of phosphate fertilizer, but its domestic fertilizer prices are heavily subsidized and much cheaper than exported ones (Chart 12). However, the domestic cost of fertilizer will likely follow the lead of rising global prices for fertilizers and agricultural products. Chart 11Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chart 12China's Domestic Fertilizer Prices Will Likely Trend Up China's Domestic Fertilizer Prices Will Likely Trend Up China's Domestic Fertilizer Prices Will Likely Trend Up The relationship between agricultural prices and the dollar broke down early last year (Chart 13). Historically, a strong USD would weigh down agricultural prices by encouraging ex-US producers to raise exports and boost global supplies. However, the COVID pandemic and war in Ukraine have triggered a global surge in government controls on food exports. Such broad enforcement of protectionist measures will continue to exacerbate worldwide inflationary pressures on food. Chart 13The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down Bottom Line: China’s food prices face upward pressure. Strengthening global prices in a wide range of agricultural products, coupled with higher energy costs and a bottoming in China’s pork prices, will all contribute to higher food price inflation in the country. Investment Conclusions Chart 14Core CPI Remains Subdued Core CPI Remains Subdued Core CPI Remains Subdued Food price inflation should not constrain the PBoC from further easing monetary policy. As mentioned in previous reports, China’s monetary policy framework has shifted away from headline CPI and has been anchored in core CPI, which has remained subdued  (Chart 14). However, China’s accelerating food and energy prices, as household income growth is slowing, will lower households’ purchasing power and curb their demand for non-food consumer goods and services.  While China’s overall consumption and economy will suffer from higher food price inflation, soaring food prices will help to widen the profit margins among food processing firms (Chart 15).  Furthermore, food and beverage companies in China’s onshore equity market have one of the highest ROAs and the lowest financial leverages (Chart 16). We are initiating a new trade: long Chinese onshore consumer staples/short broad A-share market. Chart 15Long Chinese Onshore Consumer Staples... Long Chinese Onshore Consumer Staples... Long Chinese Onshore Consumer Staples... Chart 16...As The Sector Will Benefit From Rising Food Prices ...As The Sector Will Benefit From Rising Food Prices ...As The Sector Will Benefit From Rising Food Prices   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1     The World Bank’s Commodity Markets Outlook Report, April 2022.     Strategic Themes Cyclical Recommendations

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

Feature Upgrading Consumer Staples Upgrading Consumer Staples In our latest Sector Chart Pack, we initiated a new overweight position in the S&P Consumer Staples index.  Staples outperformed the S&P 500 by 4% YTD.  Staples stocks are a “deep” defensive industry that offers downside protection in an environment of heightened volatility, slowing economic growth (top panel), and the hawkish Fed.  Consumer confidence has also been deteriorating for a while (bottom panel) 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, slightly trailing the 8% growth number for the S&P 500.  Bottom Line: Overweight the S&P Consumer Staples index to reduce portfolio volatility. 

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

Highlights Demand in the major economies remains well below its pre-pandemic trend. Meaning that relative to potential output, demand is lukewarm, at best. Inflation is hot, not because of strong overall demand, but because of the surging demand for goods. If the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Underweight personal goods versus consumer services. Bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market and the $100 trillion global equity market. Long-term investors should continue to own US T-bonds and focus their equity investments in long-duration (growth) stocks, sectors, and stock markets… …because the ultimate low in bond yields is yet to come. Feature Chart of the WeekWill Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? 2022 begins with an investment conundrum. Why have long bond yields been so chilled when inflation is running so hot? (Chart I-1) While US and UK inflation have ripped to 6.9 percent and 5.1 percent respectively, the 30-year T-bond yield and 30-year gilt yield remain a relative oasis of calm – standing at 2.1 percent and 1.2 percent respectively. 10-year yields have also stayed relatively calm. Moreover, as long-duration bonds set the valuations of long-duration stocks, a calm bond market has meant a calm stock market. What can explain this apparent conundrum of chilled yields in the face of the hottest inflation in a generation? Long Bond Yields Are Tracking Demand, Not Inflation Chart I-2 answers the conundrum. The long bond yield is taking its cue not from hot inflation, but from economic demand, which is far from overheating. Quite the contrary, US real GDP and consumption are struggling to reach their pre-pandemic trends. Meanwhile, UK real GDP languishes 5 percent below its pre-pandemic trend (Chart I-3), and other major economies tell similar stories. Chart I-2Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Chart I-3Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Some people mistake the strong economic growth in recent quarters for overheating demand. In fact, this robust growth is just the natural snap-back after the pandemic induced collapse in early-2020. Meaning that the strong growth is unsustainable, just as the bounce that a ball experiences after a big drop is unsustainable. Demand in the major economies remains well below its pre-pandemic trend. To repeat, demand in the major economies remains well below its pre-pandemic trend. As this pre-pandemic trend is a good gauge of potential output, economic demand is lukewarm, at best. And this explains why long bond yields have remained chilled. Inflation Is Tracking The Displacement Of Demand Yet solving the first conundrum simply raises a second conundrum. If overall demand is lukewarm, then why is inflation so hot? (Chart I-4). The answer is that inflation is being fuelled by the displacement of demand into goods from services (Chart I-5). Chart I-4Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Chart I-5Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods If a dollar spent on goods is displaced from a dollar spent on services, then overall demand will be unchanged. However, what happens to the overall price level depends on the relative price elasticities of demand for goods and services. If the price elasticities are the same, then overall prices will also be unchanged, because a higher price for goods will be exactly countered by a lower price for services. But if the price elasticities are very different, then overall prices can rise sharply because the higher price for goods will dominate overall inflation. All of which solves our second conundrum. Spending on services that require close contact with strangers – using public transport, going to the dentist, cinema, or recreational activities that involve crowds – are suffering severe shortfalls compared to pre-pandemic times. Some people say that this is due to supply shortages, yet the trains and buses are running empty and there is no shortage of dentists, cinema seats, or even (English) Premier League tickets. Indeed, the Premier League team that I support (which I will not name) has been sending me begging emails to attend matches! Surging inflation is no longer a reliable reflection of overall demand. If somebody doesn’t use public transport, or go to the cinema or crowded events because he is worried about the health risk, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In other words, the price elasticity of demand for certain services has flipped from its usual negative to zero, or even positive.   This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging inflation is no longer a reliable reflection of overall demand, which remains below its potential. Instead, surging inflation is largely reflecting the surging demand for goods. Two Ways That Inflation Can Resolve: One Good, One Bad It follows that if the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. We recommend that equity investors play this inevitable normalisation by underweighting personal goods versus consumer services. Still, the resolution of inflation could also take a ‘bad’ form. If inflation persisted, then bond yields could lose their chill as they flipped their focus from lukewarm demand to hot inflation. Given that long-duration bonds set the valuations of long-duration stocks, and given that stock valuations are already stretched versus bonds, this would quickly inflict pain on stock investors (Chart I-6). Chart I-6The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits More significantly, it would also quickly inflict pain on the all-important real estate market. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent1 (Chart I-7). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields (Chart I-8). Chart I-7The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion… The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... Chart I-8…And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields This means that bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, the massive deflationary backlash would annihilate any lingering inflation. Some people counter that in an inflationary shock, stocks and property – as the ultimate real assets – ought to perform well even as bond yields rise. However, when valuations start off stretched as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. The scope for higher bond yields is limited by the fragility of stock market and real estate valuations. With the scope for higher yields limited by the fragility of stock market and real estate valuations, and with the ultimate low in yields yet to come, long-term investors should continue to own US T-bonds. And they should focus their equity investments in long-duration (growth) stocks, sectors, and stock markets. Fractal Trading Update Owing to the holidays, we are waiting until next week to initiate new trades. We will also add a new feature – a ‘watch list’ of investments that are approaching potential turning points, but are not yet at peak fragility. We believe that this enhancement will help to prepare future trades. Stay tuned.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades Image 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 - 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 - 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 ​​​​

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

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

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

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

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