Corporate Profits

Today we are publishing a charts-only report focused on the key macroeconomic data as well as each GICS1 S&P 500 sector. 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 in these sectors.

Long-term deflationary forces in Japan are weakening, setting the stage for inflation to make a comeback over the remainder of the decade. Investors should prepare to structurally reduce exposure to Japanese bonds starting early next year. Higher Japanese bond yields will lift an extremely undervalued yen. To the extent that global growth should surprise on the upside over the next 12 months, Japanese equities could see some modest outperformance.

Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.

Executive Summary Assessing the future scenarios discounted in asset prices is always a challenge, but investors need a consensus baseline so they can formulate their own investment strategy decisions. The conversations we had at BCA’s annual investment conference last week reinforced our view that investors are overly pessimistic about corporate earnings prospects. Fears about runaway compensation growth are unfounded. The money markets, on the other hand, appear to be overly blasé about the fed funds rate. We think terminal rate expectations will have to be revised higher and that investors will have to wait longer for rate cuts than the OIS curve currently projects. Margins Have Peaked, But They're Still High Margins Have Peaked, But They're Still High Margins Have Peaked, But They're Still High Bottom Line: We remain more optimistic than the consensus over the immediate term and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are more cautious about the twelve-month outlook and recommend neutral positioning over that timeframe. Feature BCA held its first in-person conference in three years last week at The Plaza Hotel in New York. The agenda offered attendees a smorgasbord of thought-provoking discussions with recognized experts inside and outside of BCA. We enjoyed the programmed content as well as the impromptu interactions with speakers, attendees, our colleagues and the financial media. Again and again, our unplanned conversations homed in on questions about the expectations embedded in stock prices and bond yields. The future scenarios that securities prices are discounting cannot be directly observed and therefore can never be known definitively in real time. If investors do not continuously approximate them, however, they will be unable to evaluate the likelihood that actual outcomes will be better or worse than expected. Our view that markets and the economy can surprise on the upside has been built on the idea that expectations are overly gloomy. That is still our view on balance, as we think the S&P 500 is pricing in a worse near-term earnings outlook than is likely to occur, though we expect the Fed to surprise markets hawkishly before this rate hiking cycle ends. The combination of positive earnings surprises over the next few quarters and a negative monetary policy surprise coming sometime by the second half of next year leaves us optimistic about risk assets over the next six months but wary of them over the next twelve months and beyond. Earnings The analyst consensus currently estimates that S&P 500 earnings per share over the next four quarters will exceed the second quarter’s annualized run rate by just 0.3% and the trailing four quarters by 5.5% (Table 1). Modest as those expectations may be, we do not sense that investors are counting on them. Financial media reports and our discussions with clients and colleagues suggest that investors are braced for peak-to-trough earnings declines in the double digits, consistent with past recessions (Chart 1). Those bandying about estimates of a 10-20% decline are not necessarily calling for them to occur in the next four quarters, but we think it is clear that the forward S&P 500 whisper number is below the official I/B/E/S consensus. Table 1The Official Bar Is Low, The Whisper Bar Is Lower What Are Markets Discounting? What Are Markets Discounting? Chart 1Recessions Are Hard On Earnings Recessions Are Hard On Earnings Recessions Are Hard On Earnings For nominal earnings growth to miss such meager expectations while inflation is high, profit margins will have to contract sharply, but we would also expect declining revenues to play a major role, as in the 2001 and 2007-2009 recessions (Chart 2). That expectation follows from our view that nominal GDP growth is a solid proxy for S&P 500 sales growth (Chart 3), with nominal GDP explaining 41% of the variation in S&P 500 sales since 1997 (64% correlation). Nominal GDP grew at close to a 10% clip in the first half, and if inflation is around 6% in the second half, we would expect 8% growth over the next two quarters and about 6% growth in the first half of next year.1 Chart 2Sales Fall In Downturns, Too Sales Fall In Downturns, Too Sales Fall In Downturns, Too Chart 3As Goes GDP, So Go Corporate Revenues As Goes GDP, So Go Corporate Revenues As Goes GDP, So Go Corporate Revenues Despite the revenue buffer provided by 7% nominal GDP growth, we expect S&P 500 profit margins will extend their decline from the 2Q21 peak (Chart 4). Investors nearly unanimously expect that margins are imperiled, but we are more sanguine about the pace of the decline than the consensus and suspect the difference comes down to the pace of wage growth. Compensation is the largest expense category by a wide margin and has the capacity to move the aggregate margin needle on its own. Just as the US growth outlook may rest on consumption, compensation may be the key to margins’ future path. Chart 4A Slower-Than-Expected Decline A Slower-Than-Expected Decline A Slower-Than-Expected Decline Much has been made of the shortage of available workers and its impact on wages, which are rising at the fastest pace in decades (Chart 5). In real terms, however, wage growth has been deeply negative ever since frontline workers stopped receiving hazard pay early in the pandemic (Chart 6). Real wages should find a footing as inflation cools and may eventually break into positive territory, but rampant talk of a wage-price spiral suggests that the consensus is factoring in much more. We think the prospects of a wage-price spiral like the one in the late seventies are being dramatically overestimated. Chart 5The Nominal Gains Have Been Great ... The Nominal Gains Have Been Great ... The Nominal Gains Have Been Great ... ​​​​​ Chart 6... But They're Way Behind Consumer Prices ... But They're Way Behind Consumer Prices ... But They're Way Behind Consumer Prices ​​​​​ We will not revisit the rationale for our wage-price spiral view in detail, but it is founded on the notion that workers’ current advantage, even if it were to persist for the rest of the Biden administration’s term, will not be sufficient to offset four decades of employers’ structural gains. Labor surely has the upper hand from a cyclical perspective – demand for workers exceeds supply – but we do not think it can convert its near-term advantage into durable gains. Private sector union membership has dwindled from over 30% at its mid-sixties peak to less than 7% today, leaving workers badly outgunned when trying to assemble a sellers’ cartel to counter the formidable buyers’ cartel enabled by 40 years of lax anti-trust enforcement. Even the “most pro-labor president leading the most pro-labor administration you’ve ever seen” isn’t likely to be able to counter several decades of weakened state-level labor protections.2 History says that employers will take as hard a line with their employees as is socially acceptable and what is deemed kosher has moved so far in their favor since President Reagan crushed the air traffic controllers’ union early in his first term that the seventies template does not apply. Monetary Policy If the earnings mood is unduly glum, however, it would seem to be offset by what strikes us as unfounded expectations that the Fed will stand down from its inflation fight before too long. Perhaps BCA strategists are a bit too credulous, but we are inclined to take the Fed at its word that, as former Vice Chair Richard Clarida put it at the conference, “failure [to subdue inflation] is not an option.” While we side with the consensus in our expectation that inflation will soon recede to 4% of its own accord as COVID bottlenecks are cleared, we judge that monetary and fiscal policymakers overstimulated aggregate demand in their efforts to shelter the economy from the pandemic. As a result, we expect that the Fed will have to administer much harsher monetary medicine to achieve its inflation mandate than markets are currently discounting. We have two objections to the money market’s fed funds rate expectations as derived from the overnight index swap curve (Chart 7). We think the fed funds rate will peak well north of 4% in this hiking cycle and there is almost no chance that the Fed will cut rates at any point in 2023. While markets have gotten more realistic about the monetary policy path than they were after the FOMC’s July meeting, we think they are still clinging to a vain hope. All financial assets will have to be repriced once it is snuffed out, and that repricing represents a significant risk to our constructive six-month view if it occurs before underweight asset managers are forced back into risk assets to protect their funds’ relative performance. Chart 7Magical Thinking Magical Thinking Magical Thinking The wide range of views about the neutral, or equilibrium, rate that demarcates the line where the fed funds rate flips from accommodative to restrictive explains the terminal rate uncertainty. The neutral rate cannot be directly observed and everyone from investors to central bankers is left to infer its location from the variables that they can see. We think the neutral rate is north of 4%, possibly as high as 4.5-5%, especially given our view that inflation will likely linger at 4%. New York Fed president John Williams suggested in a Wall Street Journal interview two weeks ago that it may be in the mid-3s. “We need to get the interest rate, relative to where inflation is expected to be over the next year, into a positive space and probably even higher.” The article said Williams expects inflation to range between 2.5 and 3% next year, suggesting that the real funds rate is on course to turn positive this fall. Melting one-year inflation expectations as implied by TIPS break-evens suggest that it’s been rising in sizable chunks week after week since the FOMC’s July meeting (Chart 8). We would take the over on Thursday’s 1.71% close if only it were available on New York’s newly legalized online sports books but someone who does expect sub-2% inflation next year might logically conclude that the Fed will be cutting rates soon. Chart 8Garbage In, Garbage Out Garbage In, Garbage Out Garbage In, Garbage Out Investment Implications Our conversations at the conference and its margins left us essentially where we began. We think investors are underestimating the economy’s ability to grow at a rate that will support continued corporate earnings growth over the next four quarters, albeit at a decelerating rate. On the other hand, we think markets face a reckoning when they are forced to price in a longer and more extensive rate hiking campaign than they currently expect. We square the circle from an investment strategy perspective by conditioning our views on investor timeframes. Because we think the earnings whisper numbers will be meaningfully revised higher before monetary policy expectations are reset more hawkishly, we remain tactically bullish. If rate expectations were to reset sooner than we currently expect (sometime early next year), our tactical call would be at significant risk and we would likely become as cautious over the six-month timeframe as we are over the twelve-month timeframe. As it stands now, we continue to recommend overweighting equities in balanced portfolios over the next six months while pursuing neutral risk asset positioning over timeframes of twelve months or more.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Our nominal growth expectations assume the US economy maintains real growth at close to its 2% trend level, as consumption is supported by households’ considerable excess savings, but we do not repeat our case here. 2     The weather is fine, and the Saturday football unmatched, but it is flimsy labor protections that drew Boeing’s Dreamliner assembly work and a slew of foreign automakers to the Southeastern Conference’s legacy Deep South footprint and the other states competing for good factory jobs have taken notice.

Executive Summary Non-Commodity Enterprises: No Profit Expansion For 12 Years Flat Profits For Non-Commodity Enterprises Flat Profits For Non-Commodity Enterprises The past decade has seen a deterioration in the financial performance metrics of industrial Chinese companies. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long-term profitability of China’s industrial sector. Potential deleveraging by local governments, companies and households will cap revenue growth for enterprises and, hence, weigh on their profitability. High commodity prices in the past 18 months have improved profitability and financial metrics for commodity producers. These strengths will reverse as commodity prices sink in the coming months. Corporate earnings are set to disappoint in 2H. Bottom Line: We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. In absolute terms, risks to Chinese shares prices are to the downside. ​​​​Among Chinese industrial companies, underweight commodity producers and overweight food & beverage, autos and utilities.   The data for this report for industrial enterprises, which are sourced from China’s National Bureau of Statistics (NBS), encompass state-owned and holding enterprises (SOEs) and other forms of ownership, including private ones. It covers both listed and non-listed companies. The sectors included are construction materials, steel, non-ferrous metals, energy, coal, machinery, auto, tech hardware, food & beverage and utilities. An analysis based on this dataset shows that China’s corporate profitability and efficiency ratios have experienced a prolonged structural downturn since the early 2010s (Chart 1 and 2). Chart 1Chinese Industrial Companies: Structural Deterioration in Productivity... Chinese Industrial Companies: Structural Deterioration in Productivity... Chinese Industrial Companies: Structural Deterioration in Productivity... Chart 2… And Operational Efficiency ...And Operational Efficiency ...And Operational Efficiency Chart 3Cyclical Improvements Within Structural Downtrend Cyclical Improvements Within Structural Downtrend Cyclical Improvements Within Structural Downtrend In the past 10 years, these measures improved only modestly during recovery periods and stumbled during downturns (Chart 3). The structural deterioration in corporate profitability from 2011 onward has followed structural improvements from the late 1990s to 2010. Beyond cyclical upswings, China's corporate profitability will likely continue to face structural headwinds. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long run profitability of China’s industrial sector. Furthermore, potential deleveraging by local governments, companies and households will curtail revenue growth for enterprises and, hence, weigh on profitability. Investigating The Financial Performance Of Industrial Enterprises Our analysis of corporates’ financial ratios shows the following: Corporate leverage: The total liabilities (debt)-to-sales ratio rose sharply from 2011 until 2021. However, the leverage ratio has declined in the past 18 months. A close examination suggests that the descent in the debt-to-sales ratio has been due to surging revenues of resource producing companies propelled by rising commodity prices. Chart 4 illustrates that the debt-to-sales ratio has dropped substantially for commodity producers, but much less so for other industrial companies. In the case of non-commodity industrial enterprises, the leverage ratio has not declined much because nominal sales have been lackluster. As resource prices continue to drop, revenues of commodity companies will be devastated, and their debt-to-sales ratios will spike. The thesis that corporate leverage has not yet dropped in China is corroborated by data on all companies. The country’s corporate leverage remains the highest worldwide (Chart 5). Chart 4The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices Chart 5China's Corporate Leverage Remains The Highest In the World China's Corporate Leverage Remains The Highest In the World China's Corporate Leverage Remains The Highest In the World Chart 6Corporates' Debt servicing Ability Has Been propelled by falling interest rates Corporates' Debt Servicing Ability Has Improved Due To Lower Interest Rates Corporates' Debt Servicing Ability Has Improved Due To Lower Interest Rates Debt servicing: Even though debt levels of industrial companies remain elevated, their interest coverage ratios – operating profits-to-interest expense – have improved since late 2020. For all industries, interest expenses have dropped substantially because of falling interest rates (Chart 6). On the margin, this has also helped industrials’ profit margins.   Efficiency: Asset turnover (sales/assets), inventory turnover (sales/inventory) and receivables turnover (sales/receivables), have all have sunk in the past 10 years, as shown in Chart 2. Lower turnover indicates falling efficiency. Coal, steel and non-ferrous metals have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign. Meanwhile, there has been no improvement in inventory turnover for non-commodity enterprises.   Profit margins: Net profit margins for industrial corporates have recently risen slightly. However, the entire improvement in industrial profit margins is attributable to commodity producers. With the exception of commodity producing sectors, there has not been any upturn in operating profit margins and/or net profit margins (Chart 7). Rising corporate income taxes from 2011 to 2020 were one of the reasons worsening profitability (Chart 8). Chart 7Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Chart 8Rising Corporate Income Taxes Have Contributed The Divergency Between GPM And Net Profit Margin Corporate Tax Burden Rose From 2010 To 2020 Corporate Tax Burden Rose From 2010 To 2020 Profitability: The return on assets (RoA) and the return on equity (RoE) for industrial corporates have dwindled during the past decade (Chart 1 above). The spike in commodity prices in the past two years has helped profitability of commodity producers, but this is about to reverse. A DuPont analysis1 illustrates that the downturn in corporate profitability was driven by poor operating efficiency and a lack of improvement in net profit margins. Chart 9 shows that the profitability of non-commodity producers has worsened dramatically during the past 10 years. After more than a decade-long structural downturn, the RoA and RoE for commodity producers have recently strengthened along with asset turnovers and net profit margins (Chart 10). However, the commodity bonanza is over for now and profitability measures of resource companies are set to worsen significantly.2 Chart 9A DuPont Analysis: Non-Commodity Enterprises A DuPont Analysis: Non-Commodity Enterprises A DuPont Analysis: Non-Commodity Enterprises Chart 10A DuPont Analysis: Commodity Enterprises A DuPont Analysis: Commodity Enterprises A DuPont Analysis: Commodity Enterprises Bottom Line: The past decade has seen a deterioration in the financial performance metrics of industrial companies. The profitability of corporates has undergone a structural decline along with a prolonged slump in operating efficiency.  High commodity prices in the past 18 months have ameliorated profitability and efficiency parameters for commodity producers. Nevertheless, these improvements will vanish as commodity prices fall materially in the coming months. Structural Headwinds To Corporate Profitability The following factors will weigh on China’s corporate profitability in the long term: 1. Demographics and rising labor costs: A shrinking workforce since mid-2010s has led to higher wages that have weighed on the corporate sector’s profitability (Chart 11). This dynamic is also confirmed by rising labor compensation as a share of non-financial corporates’ value added, as illustrated in Chart 12. Chart 11China: Shrinking Labor Force China: Shrinking Labor Force China: Shrinking Labor Force Chart 12Labor Compensation As A Share Of Corporate Revenues Labor Compensation As A Share Of Corporate Revenues Labor Compensation As A Share Of Corporate Revenues In China, blue-collar labor shortages and upward pressures on wages will likely intensify in the coming decade. A rapid decline in the population’s natural growth rate with the third lowest fertility rate in the world (below Japan) foreshadows a decline in China’s working age population which started in 2015.  2. Common prosperity policies: The share of labor compensation in GDP has risen since 2011 at the expense of the share of corporate profits (Chart 13). China’s common prosperity policies will only reinforce this trend. These policies will encourage enterprises to assume more social duties, distributing a larger share of profits to society at the expense of shareholders. Chart 13Labor's Share Will Continue Rising In China's National Income Labor's Share Will Continue Rising In China's National Income Labor's Share Will Continue Rising In China's National Income Chart 14Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling 3. Declining efficiency of investments: A deteriorating output-to-capital ratio  indicates capital misallocation or falling efficiency (Chart 14). When a nation attempts to invest substantially for a long time, capital will likely be misallocated and the return on new investment will be low. This will drag down the overall return on capital. Falling efficiency ultimately entails lower productivity. 4. Slowing productivity growth: China’s productivity growth has downshifted, and total factor productivity growth slipped again recently. Notably, total factor productivity – a measure of productivity calculated by dividing economy-wide total production by the weighted average of inputs – has contributed less and less to China’s real GDP growth in the past decade. It is unrealistic to expect that China will reverse the downward trend in productivity growth in the next few years. 5. Deleveraging by companies and households: China’s corporate sector continues to face deleveraging pressures. Although some industrial enterprises underwent deleveraging in recent years, the country’s overall corporate debt is still very elevated. Remarkably, Chinese corporate debt as a share of nominal GDP is the highest in the world, as shown in Chart 5. China’s households are reducing debt. Depressed household income growth and deflating home prices have curbed borrowing. Deleveraging by households heralds weaker consumption, which is negative for corporates revenues. Bottom Line: Rising labor compensation and declining efficiency of investments constitute formidable headwinds to the profitability of China’s industrial sector. Moreover, the secular outlook of corporates’ profitability is also vulnerable to lower productivity growth and weaker top-line growth due deleveraging among companies and households. The Cyclical Outlook In our report two weeks ago, we discussed how China’s business cycle recovery in the second half of this year will be more U rather than V shaped. Both sluggish domestic demand and contracting external demand for Chinese exports will curb the rebound of the industrial sector in 2H. Industrial earnings are set to disappoint.  Chart 15Non-Commodity Enterprises: No Profit Expansion For 12 Years Flat Profits For Non-Commodity Enterprises Flat Profits For Non-Commodity Enterprises Manufacturing producers have not been able to fully pass on higher input prices to consumers given weak demand. This weakness together with elevated commodity prices has led to a substantial profit divergence between upstream and mid- and downstream industries since late 2020 (Chart 15).  However, upstream commodity producers face the headwind of commodity price deflation. At the margin, weakening resource prices will benefit mid- and downstream industries that use commodities. However, their revenue growth will remain fragile due to subdued domestic and external demand and a lack of pricing power. The tight correlation between industrial profits and raw material prices reinforces the importance of commodity prices as a driver of China’s industrial profit cycles Therefore, if commodity prices drop meaningfully in the second half of this year, then overall industrial profits in China will suffer markedly. Chart 16The share of loss-making industrial enterprise ventures has Rocketed The Share of Loss-Making Industrial Enterprises Has Been Surging The Share of Loss-Making Industrial Enterprises Has Been Surging Furthermore, overcapacity and operational inefficiencies persist despite supply-side reforms and a capacity reduction campaign implemented by China’s authorities. Chart 16 demonstrates that the share of loss-making industrial enterprise ventures has soared to 24%, implying capital misallocation.  With a further rising share of enterprises making losses as commodity prices plunge, the ability of companies to service debt will deteriorate and hence banks will experience climbing non-performing loans. Bottom Line: China’s recovery in the second half of this year will be more U than V shaped. Corporate earnings are set to disappoint in 2H. Investment Strategy The gloomy outlook for corporate profitability does not bode well for the performance of Chinese stocks. Chinese A-shares are struggling to bottom on the back of shaky economic fundamentals, while investable stocks are cheap for a reason. We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. Lower profitability and return on equity have ramifications for the valuations of China’s industrial companies. Remarkably, China’s industrial profits have been flat in the past 12 years (Chart 15 above). That is a reason why many Chinese stocks have been de-rated. Among A-share industrial companies, sectors with higher profitability are coal, non-ferrous metals, auto, construction materials and food & beverage. However, coal, non-ferrous metals and construction materials are pro-cyclical sectors, and their profit growth is positively correlated with economic growth, which is facing downward pressure at least through the end of this year. In addition, resources and commodity plays are vulnerable in the next 6 to 12 months. We recommend to underweight these sectors.  Within the Chinese equity universe, we recommend overweighting autos, food & beverage, and utilities sectors. Food & beverage and utilities are interest rate-sensitive sectors, which will continue to benefit from lower onshore bond yields. In addition, utilities sector’s profit margin and earnings will improve as coal prices decline. The auto sector will gain an advantage from China’s stimulus for auto purchases, especially for new energy vehicles.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The DuPont analysis breaks down return on equity in three distinct elements: net profit margin, operational efficiency, and leverage. This analysis enables to identify how various drivers impact return on equity. 2Please see China Investment Strategy Special Report "Global Copper Market: No Bottom Yet," dated July 27, 2022, and Emerging Markets Strategy Report "A Cocktail Of Falling Oil Prices And Surging US Wages," dated July 21, 2022, available at bcaresearch.com Strategic Themes Cyclical Recommendations

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary An Optimal Control Policy An Optimal Control Policy An Optimal Control Policy We could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, but we caution against turning overly bullish on bonds even if you anticipate a recession. An optimal control approach to monetary policy tells us that the Fed should be willing to accept a significant increase in the unemployment rate to tame inflation. The implication is that the next recession may not be met with the dramatic easing of monetary policy we have become accustomed to. Short-maturity real yields remain deeply negative, but they will move into positive territory before the end of the economic cycle. Indicators of corporate balance sheet health are not flashing red, but they are moving in the wrong direction.   Bottom Line: Investors should keep portfolio duration close to benchmark, maintain a defensive posture on corporate bonds and short 2-year TIPS.   The Return Of Optimal Control Bonds rallied into the close last week and, as of Monday morning, their gains have only been partially unwound. The 2-year Treasury yield is down to 3.07% from its recent high of 3.45% and the 10-year yield is down to 3.16% from its recent high of 3.49% (Chart 1). The 2-year/10-year Treasury slope remains close to inversion at 9 bps (Chart 1, bottom panel). Increasingly, the message from the Treasury market is that the Fed is no longer playing catch-up to runaway inflation. Rather, the dominant market narrative is that the Fed may have to moderate its hiking pace to avoid an economic recession. With the unemployment rate at 3.6% and nonfarm payroll growth averaging +408k during the past three months, the US economy is clearly not in a recession today. That said, leading indicators are pointing to increased risk of a downturn within the next 12 months. For example, the S&P Global Manufacturing PMI fell sharply last week from 57.0 to 52.4 (Chart 2). The more widely tracked ISM Manufacturing PMI remains elevated at 56.1, but regional Fed surveys and trends in financial conditions suggest that the ISM could dip into contractionary territory during the next few months (Chart 2, bottom 2 panels). Chart 1Treasury Yields Treasury Yields Treasury Yields Chart 2Recession Risk Is Rising Recession Risk Is Rising Recession Risk Is Rising This is obviously a tricky situation for the Fed as there is a risk that its two mandates of price stability and maximum employment could come into conflict. Not surprisingly, the Fed has a playbook for these sorts of situations, one that was described by Janet Yellen as “optimal control” in a 2012 speech.1 Under an optimal control approach to policymaking the Fed specifies a loss function that is based on deviations of inflation from its 2% target and of the unemployment rate from its estimated full employment level. Understanding that it will be impossible to perfectly achieve both of its objectives, the Fed attempts to set policy so that the output of the loss function is minimized. One example of a simple loss function was given by St. Louis Fed President James Bullard in a speech from 2014.2 That function is as follows: Distance From Goals = (π – π*)2 + (μ - μ*)2 Where: π = inflation π* = The Fed’s target inflation rate μ = the unemployment rate μ* = The Fed’s estimate of the unemployment rate consistent with full employment Chart 3An Optimal Control Policy An Optimal Control Policy An Optimal Control Policy Let’s apply Bullard’s loss function to the present-day economic situation. The top panel of Chart 3 shows the square root of the function’s output. The Fed’s goal, of course, is to get that line as close to zero as possible. First, let’s see what happens if we input the median FOMC member’s forecast for core PCE inflation and the unemployment rate. That forecast has core PCE inflation falling to 4.3% by the end of this year and it has the unemployment rate edging up to 3.7%. Not surprisingly, this scenario leads to a modest improvement in Bullard’s loss function. Now let’s examine an alternative scenario where core PCE inflation falls to 4% by the end of the year but we set the loss function to remain at its current level. That outcome can be achieved even with the unemployment rate rising to 6.68%. This scenario is instructive. It tells us that, from an optimal control perspective, the Fed would be willing to tolerate an increase in the unemployment rate all the way up to 6.68% if it meant that inflation would fall back down to 4%. Why is this example important? It’s important because it gives us some perspective on what sort of labor market pain the Fed may be willing to tolerate to tame inflation. More specifically, there is a growing sense among some market participants that the US economy will soon fall into recession and that recessions are usually accompanied by Fed rate cuts. However, the magnitude of the increase in the unemployment rate that is shown in our alternative scenario would almost certainly be classified as a recession, but an optimal control perspective tells us that the Fed shouldn’t back away from tightening if that were to occur. The bottom line is that while we could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, we caution against turning overly bullish on bonds even if you anticipate a recession within the next 6-12 months. Given where inflation is today, there are strong odds that the Fed would respond to a rising unemployment rate by simply tempering its pace of rate hikes or perhaps temporarily pausing. Optimal control tells us that we would need to see an extremely large employment shock for the Fed to consider reversing course and cutting rates. Investors should stick with ‘at benchmark’ portfolio duration for the time being. A Quick Note On Real Yields   Chart 4Short 2-Year TIPS Short 2-Year TIPS Short 2-Year TIPS The 2-year real yield has risen to -0.70% from a 2021 low of -3.05%, but we have high conviction that it has further to run (Chart 4). At the press conference following the June FOMC meeting, Fed Chair Powell hinted that he viewed positive real yields across the entire Treasury curve as a reasonable intermediate-term goal. He then made similar claims when testifying before the Senate last week: It’s really only the very short end of the curve where our rates are still in negative territory from a real perspective. If you look further out, real rates are positive right across the curve and that’s really what you’re trying to achieve in a situation like this where we have 40 year highs in inflation.3 One way or another, we think it is highly likely that the Fed will achieve its goal of positive real yields across the entire curve. This could happen in a benign scenario where falling inflation expectations push short-maturity real yields higher. Or, it could happen in a more dramatic fashion where inflation expectations remain elevated but that only quickens the pace of Fed tightening. In that scenario, rising short-maturity nominal yields would drag real yields with them. Either way, investors should continue to hold outright short positions in 2-year TIPS. Corporate Health Check-Up In prior reports we noted the extremely good condition of corporate balance sheets, while also suggesting that balance sheet health would deteriorate going forward.4  An updated read on the status of corporate balance sheets suggests that conditions are still favorable, but much less so than even a few months ago. We begin with our Corporate Health Monitor (CHM), a composite indicator of six financial ratios calculated from the US National Accounts data for the nonfinancial corporate sector. This indicator was deep in “improving health” territory at the end of 2021, but it moved close to neutral in 2022 Q1 (Chart 5). Ratings trends, meanwhile, send a similar message. Through the end of May, upgrades continued to dramatically outpace downgrades in the investment grade space (Chart 5, panel 2), but the rate of net upgrades slowed somewhat in high-yield (Chart 5, bottom panel). Digging deeper, we find that the main culprit behind the CHM’s recent jump is a large drop in the ratio of Free Cash Flow to Total Debt (Chart 6). This drop occurred because after-tax cash flows held roughly flat in Q1 but capital expenditures surged, causing free cash flow to dip (Chart 6, panel 2). Chart 5Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor Chart 6Capex Surged In Q1 Capex Surged In Q1 Capex Surged In Q1 This trend is confirmed by another important indicator of corporate balance sheet health, the financing gap. The financing gap is the difference between capital expenditures and retained earnings. A positive financing gap means that retained earnings are insufficient to cover capital expenditures and firms therefore have an incentive to tap debt markets. We see that the financing gap jumped sharply in Q1, from deeply negative into positive territory (Chart 7). Chart 7The Financing Gap Is Positive The Financing Gap Is Positive The Financing Gap Is Positive A positive financing gap on its own does not send a negative signal for corporate defaults. However, when a positive financing gap coincides with tightening lending standards, then an increase in the default rate becomes likely. For now, lending standards are close to unchanged (Chart 7, bottom panel), but there is a strong chance that continued Fed hiking will push them into ‘net tightening’ territory in the months ahead. Investment Implications Chart 8Attractive Value In HY Attractive Value In HY Attractive Value In HY Corporate balance sheet health isn’t quite flashing red, but it is certainly trending in the wrong direction. With continued Fed tightening likely to weigh on lending standards and interest coverage going forward, a defensive posture toward corporate bonds is warranted. We continue to recommend an underweight allocation (2 out of 5) to investment grade corporate bonds in US fixed income portfolios. We maintain a somewhat higher neutral (3 out of 5) allocation to high-yield bonds for the time being. This is because high-yield valuation is quite attractive, and we see potential for some near-term spread tightening as inflation rolls over (Chart 8). That said, the sector’s long-term return prospects are not good, and we will consider turning more defensive should the average high-yield spread narrow to its 2017-19 average or should core inflation move closer to our 4% target.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 2 https://www.stlouisfed.org/from-the-president/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/bullardowensborokychamberofcommerce17july2014final.pdf   3 https://www.c-span.org/video/?521106-1/federal-reserve-chair-jerome-powell-testifies-inflation-economy 4 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The recent pullback was all about a multiples contraction while strong earnings growth helped absorb the blow. With the multiple contraction phase complete, the S&P 500 performance is now all about earnings. Consensus still expects earnings to grow at 10% over the next 12 months, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability. We need to see downgrades or earnings will disappoint. Our brand-new model predicts that earnings growth will trend towards zero over the next three months. Earnings growth is a tug of war between rising input costs and corporate pricing power. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months. Because growth is slowing not only in the US but also abroad. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power Is Earnings Recession In The Cards? Is Earnings Recession In The Cards? Bottom Line: We forecast that earnings growth will undershoot consensus expectations and an earnings recession is likely.  Since the multiples contraction phase of the bear market is likely over, equities performance will be dictated by earnings growth.  In the short run, we expect equities to be range-bound, with rallies and pullbacks alternating.  In case of an earnings recession, equities may fall another 5-8%. Feature Related Report  US Equity StrategyMarginally Worse Ever since the Fed started hiking interest rates back in March, investors started worrying about the recession. The BCA house view is that a recession is unlikely over the next 12 months.  However, to us, of even greater concern is the likelihood of an earnings disappointment or even an outright earnings recession. We believe that earnings growth will slow dramatically. We wrote back in October 2021 report, “Marginally Worse”, that margins will contract at the beginning of the year – indeed, this prediction materialized during the Q1-2022 earnings season (Chart 1). Shrinking profit margins are likely to translate into flat to negative real earnings growth over the next 12 months. However, economic and earnings growth expectations remain elevated. As our readers may recall from the “Have We Hit Rock Bottom?” and “Fat and Flat” reports, we believe that for the markets to begin to heal, growth expectations need to come down and a negative outlook needs to get priced in. Chart 1Margins Are Contracting Margins Are Contracting Margins Are Contracting In this week’s report, we take a close look at the S&P 500 earnings growth expectations and provide our own estimate based on a simple regression model. We will also discuss implications for the US equity market. Sneak Preview: We estimate that earnings growth will trend towards zero over the next three to six months, consistent with current trends in US economic growth, inflation, corporate pricing power, monetary conditions, and the strength of the USD. Sell-off Driven By Multiples Contraction, Not Earnings Growth This year’s sell-off has been triggered by fears of an aggressive Fed, tighter monetary policy, and rising rates. However, decomposition of the total return demonstrates that the pullback was all about multiples contraction, while strong earnings growth helped absorb the blow (Chart 2). A pertinent question is what happens to the market when earnings growth softens? One may wonder whether the bad news has already been priced in, as multiples tend to front-run growth. A case in point is strong market performance in 2020 on the back of multiples expansion in anticipation of a post-pandemic rebound in earnings growth (Chart 3).  Chart 2Sell-off Was Driven By A Multiples Contraction Is Earnings Recession In The Cards? Is Earnings Recession In The Cards? Chart 3Multiples Lead Earnings Multiples Lead Earnings Multiples Lead Earnings With multiples down from 23x to 17x over the past two years, and the S&P 500 down by 19% from its January 2022 peak, arguably much of the upcoming earnings growth slowdown/contraction is priced in. Much but not all. The next chapter of the bear market will be driven by earnings growth. Earnings Growth Headwinds As we have pointed out on multiple occasions, it is confounding that, despite negative corporate guidance and a whole constellation of factors that present challenges to corporate profitability, earnings estimates for 2022 have been revised up (Chart 4) and stand at about 10% (Chart 5). However, at long last, upgrades are starting to moderate (Chart 6). We need to see downgrades. Chart 42022 Earnings Estimates Are Still Trending Up 2022 Earnings Estimates Are Still Trending Up 2022 Earnings Estimates Are Still Trending Up Chart 5Earnings Are Expected To Grow At 10% Earnings Are Expected To Grow At 10% Earnings Are Expected To Grow At 10% Chart 6Analysts Are No Longer Upgrading Analysts Are No Longer Upgrading Analysts Are No Longer Upgrading Chart 7Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Slowing Global Growth Has An Adverse Effect On The US Earnings Growth Since the beginning of 2022, there have been quite a few developments that will weigh on earnings growth: Slowing growth in the US and globally means sales growth is decelerating. This week, the World Bank downgraded global GDP growth from 4.1% to 2.9%. Global manufacturing PMI is also trending towards 50 (Chart 7). Consumer demand is weakening: Negative real wage growth saps consumers’ confidence and cuts into their purchasing power. Moreover, demand for goods is returning to the pre-pandemic trend, and retail sales, especially in real terms, are flagging (Chart 8). Demand for services remains strong, but the S&P 500 index is dominated by goods producers. Corporate pricing power is still strong but is showing signs of waning as many US consumers, distraught by the negative wage growth, are strapped for cash (Chart 9). Chart 8Retail Sales Are Contracting In Real Terms Retail Sales Are Contracting In Real Terms Retail Sales Are Contracting In Real Terms Chart 9Corporate Pricing Power Is Waning Corporate Pricing Power Is Waning Corporate Pricing Power Is Waning Prices of raw materials have soared and supply disruptions are exacerbated by lockdowns in China and the war in Ukraine. Companies’ COGS (Cost of Goods Sold) bills are skyrocketing. Nominal wage growth is 6% and is on the rise, affecting companies’ bottom lines. The dollar is strong: it has gained 15% since January 2021. This makes US goods more expensive and reduces companies’ earnings via the currency translation effect. These are the reasons why it is increasingly hard for companies to preserve margins and grow earnings – a commentary that we have heard repeatedly during earnings calls. According to Refinitiv, for Q2-2022, there have been 73 negative EPS preannouncements issued by S&P 500 corporations, compared to 42 positive EPS preannouncements (N/P=73/42=1.7). A year ago, in Q2-2021, the N/P ratio was 0.8, with more companies offering positive guidance. All of this points to weakening profitability. Refinitiv also estimates the earnings growth rate for the S&P 500 for Q2-2022 at 5.3%. If the energy sector is excluded, the growth rate declines to -1.9%. We believe growth will come to a halt or contract into the end of the year. We expect slower top-line growth and shrinking profit margins to translate into flat to negative real earnings growth over the next 12 months. Earnings Recessions Often Happen When The Economy Is Still Growing One may wonder if an earnings recession is even possible without an economic recession. In fact, that happened quite a lot in the past. Out of 27 earnings recessions since 1927, 11 did not coincide with economic recessions (Chart 10). Chart 10Earnings Recessions And Economic Recession Often Don't Coincide Earnings Recessions And Economic Recession Often Don't Coincide Earnings Recessions And Economic Recession Often Don't Coincide The S&P 500 does not mirror the US economy, with the former dominated by larger companies, many of which are multinationals and more exposed to global demand and the USD than the broad economy. Also, services and consumer spending constitute roughly 70% of the US economy, while the index overrepresents manufacturing, technology, and goods-producing companies. With the S&P 500 being global in nature, quite a few earnings recessions were triggered by events abroad: The 2016 earnings recession was caused by the devaluation of the Chinese yuan; in 2012, one was triggered by a post-GFC double-dip recession in Europe; and the 1998 one was triggered by an Asian financial crisis. It is also often the case that a profit recession is a harbinger of economic recession. Both the 2000 dot-com crash and GFC economic recessions were preceded by earnings recessions, one starting in December 2000, and the other in August 2007. The 2019 earnings recession was brief and came hand in hand with widespread fears of the end of the business cycle. Hence, we believe that a confluence of factors both at home and abroad, as discussed above, makes an earning recession a high probability event. There is a high likelihood of an earnings recession, even if an economic recession is unlikely over the next 12 months, because of slowing growth not only in the US but also abroad. Modeling Earnings Growth Since we are distrustful of the consensus of 10% expected eps growth, we have built our own simple earnings growth forecast model to gauge what earnings growth rate we may expect over the next quarter. The model has five factors, each of which has fundamental relevance to earnings growth (Table 1): Table 1EPS Growth Forecast Model Is Earnings Recession In The Cards? Is Earnings Recession In The Cards? ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in input costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. Roughly 35% of S&P 500 sales are outside the US. Each factor is calculated on a year-on-year percentage change basis, with a three-month lag to allow the effects of macroeconomic developments to get priced in. Adjusted R2 is 65%, which is a strong fit. All factors are statistically significant at the 1% level. The model forecasts that earnings growth will come down from 6% MoM as of April 2021 to 1.3% as of August 2022 (Chart 11). While this does not map directly to the “next 12 months” of eps growth, it does indicate that earnings growth is trending towards zero in nominal terms and will be outright negative in real terms. Further, while we are unable to predict earnings growth more than three months ahead, we do expect that it will reach zero and then shift into contraction territory into the balance of the year. Chart 11Model Predicts That Earnings Growth Will Be Flat Is Earnings Recession In The Cards? Is Earnings Recession In The Cards?   Looking closer at the key drivers of growth (Chart 12), we observe that there is a tug of war between pricing power and rising costs (PPI), with earnings growth falling as pricing power starts to give away ground. The other factors that have an adverse effect on earnings growth are slowing growth (ISM PMI), an appreciating dollar, and rising borrowing costs (HY spreads). Chart 12Earnings Growth Is A Tug Of War Between Rising Costs And Pricing Power Is Earnings Recession In The Cards? Is Earnings Recession In The Cards? The model indicates that earnings growth is trending towards zero over the next three months. Price Target What does all of this mean for US equities?  If the multiple contraction phase is complete, the S&P 500 performance is now all about earnings.  If we expect earnings to grow only 0-3% in nominal terms, with the forward earnings multiple unchanged at roughly 18x, then the S&P 500 is likely to come down another couple of percentage points. If earnings contract 5%, the index may be down as much as 8%. If multiples contract another point to 17x and earnings contract by 5%, the market may be down as much as 15% (Table 2). Table 2The S&P 500 Target Scenario Analysis Is Earnings Recession In The Cards? Is Earnings Recession In The Cards? For now, we are sticking with our “fat and flat” thesis expecting the S&P 500 performance to continue to trend down as rallies and pullbacks alternate. Earnings growth slowdown/shallow contraction is likely to result in another leg down of roughly 5-8%. Investment Implications Street forward earnings growth expectations are too high at 10% and need to be downgraded. There are multiple reasons why earnings growth will be underwhelming, ranging from slowing growth abroad to weaker demand for goods and rising wages at home. We anticipate that earnings growth will be flat to negative into the balance of the year. The multiple contraction phase of the bear market is over, and now equities performance will be dictated by earnings growth. If an earnings recession does materialize, equities may have another leg down, perhaps another 5-8%. Bottom Line We forecast that earnings growth will undershoot consensus expectations and that an earnings recession is likely. Since the multiple contraction phase of the bear market is likely over, equity performance will be dictated by earnings growth. In the short run, we expect equities to trend down, with rallies and pullbacks alternating. In the case of an earnings recession, equities may fall another 5-8%.     Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum Is Earnings Recession In The Cards? Is Earnings Recession In The Cards?

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed A Setback For The Fed A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations 2022 Rate Expectations 2022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Short-term Inflation Expectations Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Long-term Inflation Expectations Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record The Fed’s Inflation Problem The Fed’s Inflation Problem Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Goods Inflation Goods Inflation Chart 8Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Peak Shipping Costs Peak Shipping Costs Chart 10The Upside In Real Yields The Upside In Real Yields The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Gross Leverage Is Falling Gross Leverage Is Falling Chart 12Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Leverage Ratios Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns