Cyclicals vs Defensives

Executive Summary What To Do With The Euro? What To Do With The Euro? What To Do With The Euro? The outlook for European assets is uniquely muddled. European energy prices will remain elevated, but the worst of the adjustment is already behind us. The global economy is teetering on the edge of a recession and weak global growth is historically very negative for European assets. However, European valuations and earnings forecasts already discount an extremely severe outcome for global growth. A hawkish Fed should support the dollar, but investors increasingly realize foreign central banks are fighting inflation equally aggressively. The dollar already anticipates a global recession. Meantime, European credit offers a large spread pickup over sovereigns and even appears as a decent alternative to equities. Within a credit portfolio, we adopt a more cautious approach towards European investment grade bonds (IG) relative to their US counterpart. Instead, we recommend favoring UK IG over Euro Area IG as well as Swedish IG relative to US IG.    Recommendations INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Set a stop buy at EUR/USD 0.9650 with a stop-loss at 0.9400 9/26/2022     Bottom Line: Investors should maintain a modest long position in equities in European portfolios, with a preference for defensive stocks over cyclicals. The conditions are falling in place to buy the euro tentatively.   Following the hawkishness that transpired from the Fed press conference and revised forecasts last week, EUR/USD plunged below 0.99 and hit a 20-year low. Moreover, President Vladimir Putin’s announcement of a broader mobilization of the Russian army is stoking fears that the Ukrainian conflict will only be prolonged. The prospects of a lengthier war and greater energy market shock are raising further worries for Europe’s growth outlook, which weighs on European asset prices, notably the euro and the pound. The odds of a global financial accident are on the rise. Global central banks have joined the Fed and are relentlessly tightening global monetary and financial conditions. Moreover, the surging dollar is adding to global risks by raising the cost of capital around the world. This is a very fragile situation and the odds of a global recession have jumped significantly. Against this backdrop, investors should continue to overweight defensive equities at the expense of cyclical stocks. The euro also has more downside, but we are issuing a tentative stop-buy at EUR/USD 0.9650 with a stop at 0.9400. Credit remains a safer alternative to European stocks. The Evolving European Energy Backdrop Chart 1All About The Gas All About The Gas All About The Gas The surge of natural gas and electricity prices since the fall of 2021 has been one of the main drivers of the underperformance of European assets and the fall in the euro (Chart 1). While the medium-term outlook for European energy prices remains fraught with risk, the near-term prospects have improved. Following a surge from €77.4/MWh in June to €340/MWh on August 26, one-month forward natural gas prices at the Dutch Title Transfer Facility (TTF) have declined 45% to €187/MWh. These wild gyrations reflect the evolution of both the natural gas flows from Russia, which have fallen from 3,060Mcm to 599 Mcm today, and the rapid buildup of natural gas inventories across the European Union. The good news is that the costly efforts to rebuild European gas inventories have been successful. EU-wide inventories are at 85.6% capacity, achieving its 80% storage objective well before November. Germany has gone even further, with storage use now standing at 90% of capacity. This large stockpile, along with the re-opening of coal power plants and consumption curtailment efforts, should allow Europe to survive the winter without Russian energy imports, as long as the temperatures are not abnormally cold. The absence of a summer dip in Norwegian gas exports and the surge in LNG flows to Europe have partially replaced the missing Russian inflows, thus helping Europe rapidly rebuild its natural gas inventories (Chart 2). This success was a consequence of elevated European natural gas prices, which have allowed Europe to absorb LNG flows from the rest of the world (Chart 3). Chart 2No Restocking Without LNG No Restocking Without LNG No Restocking Without LNG Chart 3LNG Flowed Toward High Prices LNG Flowed Toward High Prices LNG Flowed Toward High Prices So far, the European industrial sector has managed to adjust better than expected to the jump in the price of natural gas, a crucial energy input. Take Germany as an example. For the month of August, Germany’s consumption of natural gas by the industrial sector fell 22% below the 2018-2021 average (Chart 4, top panel), while PPI moved up vertically. Yet, industrial output is only down 5% year-on-year and industrial capacity utilization stands at 85%, which is still a level that beats two thirds of the readings recorded between 1990 and this the most recent quarter (Chart 4, bottom panel). The adjustment will be uneven across various industries, with those most voracious of natural gas likely to experience a declining share of Europe’s gross value added. Using the German example once again, we can see that the chemicals, basic metal manufacturing, and paper products sectors are the most at risk from higher natural gas prices and most likely therefore to suffer the most from gas rationing this winter (Chart 5). Chart 4A Surprisingly Successful Transition A Surprisingly Successful Transition A Surprisingly Successful Transition Chart 5The Three Sectors Most At Risk Is Europe About To Be Crushed? Is Europe About To Be Crushed? Going forward, important changes are likely to take place that will allow the European economy to continue to survive on diminished Russian gas flows: European natural gas prices will remain elevated compared to the rest of the world to attract LNG flows to the region. Importantly, Europe’s capacity to absorb these flows keeps increasing, as more re-gasification ships are docked around the continent. Moreover, North America is building more facilities to export LNG to Europe. Chart 6Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear electricity production will rebound. Currently, the EU’s nuclear production is around 43.2TWh, well below the normal 60TWh to 70TWh winter levels, driven mostly by the collapse in French production from 35TWh to 18TWh (Chart 6). This decline in nuclear electricity generation has accentuated the upward pressure on European natural gas and electricity prices. One of the key objectives of the nationalization of EDF by the French government is to accelerate the maintenance of France’s ageing nuclear power plants and allow a return to more normal production levels by the winter. The role of natural gas in European household’s energy mix will decline. Currently, EU households are the largest natural gas consumers and account for 41% of the bloc’s gas consumption (Chart 7). It will be easier to replace their natural gas consumption over time with other sources of energy than it will be to cut the industrial sector’s consumption extensively. As a result, even if European natural gas imports are permanently below 2021 levels, the industrial sector will not bear the brunt of the adjustment. Chart 7Households To Be Displaced Is Europe About To Be Crushed? Is Europe About To Be Crushed? These developments imply that natural gas prices have limited downside. However, we believe that the worst of the spike in prices is behind us, at least over the near term. The reason is that the inelastic buying created by the inventory re-stocking exercise since May 2022 is ending. In fact, the German Federal Minister for Economic Affairs and Climate Action, Robert Habeck, declared last week that his country would no longer purchase gas at any price. Chart 8The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over If prices stabilize around €200/MWh, European industrial activity will continue to face a headwind, but the worst of the adjustment process will be in the rearview mirror as natural gas inflation recedes (Chart 8). Ultimately, capitalist systems are dynamic, and it is this rapid change in price that causes the most pain. In other words, the impoverishment of the European private sector has already happened. Steady states are easier to manage. Moreover, if natural gas prices eventually follow the future’s curve (this is a big “if”), the picture for Europe will improve considerably. One additional mitigating factor should ease the pain being experienced by the European private sector. Fiscal policy is responding very aggressively to the current energy crisis. So far, EU countries and the UK have allocated more than €500 billion to protect their private sectors against higher energy costs (Chart 9) and the UK just announced tax cuts of £45 billion. This is in addition to the disbursement of €150 billion from the NGEU funds in 2023. Moreover, the European commission is planning to modify the EU fiscal rules to abandon annual structural deficit targets and for debt sustainability to be evaluated over a ten-year period. Chart 9Massive Fiscal Support Is Europe About To Be Crushed? Is Europe About To Be Crushed? Bottom Line: The worst of Europe’s adjustment to higher energy prices is now behind us. However, European energy prices will remain elevated, which will continue to put Europe at a handicap compared to the rest of the world. Bad News From The Rest Of The World The worst of Europe’s energy crisis is behind us, but the world is teetering toward a recession, which will hurt the trade- and manufacturing-sensitive European economy. Chart 10A Global Recession This Way Comes A Global Recession This Way Comes A Global Recession This Way Comes The tightening in global financial conditions created by the surge in the dollar and by the jump in global yields is pushing the US Manufacturing ISM and the Euro Area PMIs toward the low-40s, which is consistent with a recession (Chart 10). The problem does not stop there. Global central banks have become solely focused on fighting inflation. For 2023, the FOMC’s dot plot forecasts both an interest rate rise to 4.6% and a 0.7% increase in the unemployment rate. This is tantamount to the Fed telling the market that it will increase interest rates as a recession emerges to repress inflation. Not to be undone, European central banks are also rapidly increasing their policy rates, even as they also forecast an imminent deterioration in domestic growth conditions. Quickly tightening policy in a slowing growth environment, especially as the dollar hits a 20-year high, is a recipe for a financial accident and a global recession. Chart 11No Help From China No Help From China No Help From China Moreover, China’s economy is still unable to create a positive offset to the deterioration in global monetary and financial conditions. The marginal propensity of China’s private sector to consume remains in a downtrend, hampered by the country’s zero-COVID policy and the continuing meltdown in real estate activity (Chart 11). Furthermore, the most rapid decline in the yuan exchange rate in 5 years is imparting an additional downside risk to the global economy. European stocks are uniquely exposed to these threats. Europe overweights deep cyclicals, which are currently squeezed by the deteriorating global growth outlook. The message from the collapse in FedEx’s stocks on very poor guidance is particularly ominous: this company has a much closer correlation with the Dow Jones Euro STOXX 50 than with the S&P 500 (Chart 12). European share prices are already factoring in much of the bad news. Valuations are significantly less expensive than they once were. The Shiller P/E ratio of European equities and their equity risk premium stand at the same levels as those in the 1980s. This is in sharp contrast to the US (Chart 13). Chart 12FedEx's Gloomy Delivery FedEx's Gloomy Delivery FedEx's Gloomy Delivery Chart 13Low CAPE In Europe Low CAPE In Europe Low CAPE In Europe Table 1A Deep Downgrade To European Earnings Is Europe About To Be Crushed? Is Europe About To Be Crushed? European forward earnings have also already done considerable work adjusting downward. Excluding energy, 2022 and 2023 forward EPS are down 10.3% and 11.9% since their peak, respectively (Table 1). But inflation flatters earnings growth and European large-cap indices are dominated by multinational firms, which implies that looking at earnings in USD terms makes more sense. In both real and USD terms, 2022 and 2023 forward EPS, excluding energy, are already down 25% and 26.4%, respectively. These adjustments are in line with previous recessions. The counterargument is that analysts still expect positive earnings growth in 2023 relative to 2022. However, at 4%, this increase in expected earnings is still well below inflation and 6% below the average expected growth in forward earnings recorded over the past 35 years (Chart 14). Additionally, a global recession could put further downward pressure on energy prices in Europe, which would create an additional cushion under European earnings in 2023 The implication here is that it still makes sense to be modestly long European equities in absolute terms, especially for investors with an investment horizon of twelve months or more. However, we cannot be complacent, as the risk of an additional selloff is still too large for comfort. As a result, for now investors should only garner a small exposure to European equities and do so while favoring defensive names over cyclical ones (Chart 15). Chart 14Weak Forward Earnings Growth Weak Forward Earnings Growth Weak Forward Earnings Growth Chart 15Continue To Favor Defensive Names Continue To Favor Defensive Names Continue To Favor Defensive Names Bottom Line: European stocks must still contend with the growing threat of a global recession catalyzed by tighter financial conditions and aggressive global central banks. The good news is that they already discount considerable pessimism, as illustrated by their low valuations and downgraded forward earnings. Consequently, investors can continue to nibble at European equities, but do so to a limited degree and by favoring defensive stocks over cyclical ones, at least for now. The Euro Dilemma On the back of the very hawkish Fed meeting and the announcement of Russia’s broadened military mobilization, the EUR/USD broke below the 0.99 support level and fell under 0.98, a level we judged in the past as very attractive on a six-to-nine months basis. Obviously, Fed Chair Jerome Powell’s reaffirmation of the FOMC’s war on inflation is a major boost to the dollar. The momentum property of the greenback implies that it has room to rally further in the near term. This narrative, however, overlooks the fact that the Fed is not the only central bank intent on fighting inflation, no matter the cost. The Norges Bank, the Riksbank, the ECB, and even the SNB have all showed their willingness to move aggressively against inflation. While the BoE only increased rates by 50bps last week, its communication suggested that an at least 75bps increase would be due at the November meeting, when the MPC publishes its Monetary Policy report that will incorporate the impact of the budget measures announced by new British Prime Minister, Liz Truss. Chart 16The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed As a result, market interest rate expectations are climbing in the US, but they are rising even faster in Europe, albeit from a lower base. However, the decline in the expected rate of interest in the US relative to Europe and in the number of expected hikes in the US relative to Europe are consistent with a sharp decline in the DXY in the coming months (Chart 16). Due to its 80% weight in European currencies, a weaker DXY implies a rebound in the EUR, GBP, CHF, NOK, and SEK against the USD. Chart 17Surprising European Resilience Surprising European Resilience Surprising European Resilience Moreover, there could be room for expected interest rate differentials to narrow further against the dollar. The analysis we published two weeks ago shows that, even when the different nonfinancial private debt loads are accounted for, the gap in the US and Eurozone r-star stands at 1%. However, the spread between the Fed funds rate’s upper bound and the ECB Deposit Rate is 2%. The gap between the July 2023 US and Eurozone OIS is 1.7%. Since European inflation may prove more stubborn than that of the US in the near term, there is scope for the expected interest rate gap to narrow further, especially as the Euro Area final domestic demand is surprisingly more robust than that of the US (Chart 17). What about global growth? The view that the global economy is about to experience a recession is consistent with a stronger dollar, since the greenback is an extremely countercyclical currency. However, the DXY’s 25% rally since January 2021 already prices in such an outcome (Chart 18). Similarly, the euro is trading again at 2002 levels, which is also in line with a global recession with deep negative repercussions for the Eurozone. Additionally, the Euro has fallen 21% since May 2021, which compares to the 21.4% fall in 2008, the 20% decline in 2010, the 18% plunge in 2011/12 and the 24% collapse in 2014/15; yet EUR/USD is much cheaper now than in any of those instances. Moreover, the wide difference between the competitiveness of Germany and that of the rest of the Euro Area has now faded, which means that a major handicap against the euro has disappeared (Chart 19). Chart 18The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession Chart 19Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness This does not mean that the euro is not without risk. First, since the major euro collapse began in June 2021, EUR/USD breakdowns have been followed by average declines of 3.6%, ranging from 2.7% to 4.2%. Since the dollar is a momentum currency, it is unlikely that this time will be different. Second, if the tightening in global policy does cause a financial accident, the dollar will catch one last major bid that could push EUR/USD toward 0.9. As a result, to mitigate the danger, we recommend setting a stop-buy in the euro at EUR/USD 0.965 or 2.6% below the breakdown level of 0.9904. This position comes with a stop-loss at 0.94. For now, we would view this bet as a tactical position if it were triggered. Bottom Line: While a hawkish FOMC is very positive for the dollar, markets now expect foreign central banks to catch up to some extent with the Fed. This process is dollar bearish. Additionally, while a global recession would be supportive of the greenback, the USD already discounts this scenario. Instead, Europe is proving surprisingly resilient, which could soon create a tailwind for EUR/USD. Set a stop-buy at EUR/USD 0.965, with a stop-loss at 0.94. Market Update: European Credit After Central Bank Week For investors concerned with the left-tail risk in European equities, European credit offers a credible alternative in the near term. This asset class is also attractive relative to European government bonds. Taken together, the Fed, the ECB, the BoE, the Riksbank, the Norges Bank, the SNB, and the BoC have tightened policy by 475bps over the past month (Chart 20). Moreover, the SNB’s hike closed the chapter of negative rates in Europe. But make no mistake – there will be a second chapter. Until then, European corporate bond yields have risen enough to offer attractive spreads over duration-matched government bonds and to challenge the earnings yield provided by equities (Chart 21). Besides, the volatility observed in equity markets over the past few months makes the European corporate bond more appealing. Chart 20Central Bank Week Is Europe About To Be Crushed? Is Europe About To Be Crushed? Chart 21Push Back Against TINA Argument Push Back Against TINA Argument Push Back Against TINA Argument In the Euro Area, BB-rated bonds, which are the highest credit quality and largest tranche within the high-yield space, are particularly attractive. They sport a 6.6% YTM, at a spread of 480bps over 3-year German government bond yields. This compares to an equity earnings yield of 7.4% (Chart 21, top panel). In other European corporate bond markets, there is no need to go down in credit quality. Yields-to-maturity for investment grade corporate bonds in the UK, Sweden, and Switzerland provide appealing alternatives to equities, with shorter duration still. This is especially true in Sweden, where the equity earnings yield has collapsed and is now only 60bps above Swedish IG yield, with substantially greater risk. Meanwhile, the spread pickup offered by Swiss IG over Swiss government bonds of similar duration is at its widest in more than ten years (Chart 21, bottom panel). Chart 22Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials This week, we turn neutral on European credit versus US credit. Back in March, we made the case that European credit would outperform its US counterpart in response to a more hawkish Fed than the ECB. Since then, European IG outperformed US IG by 1% on a total return basis. However, with the Fed funds rate at 3.25%, traders now expect more monetary policy tightening from the ECB, which often corresponds to an underperformance of Euro Area credit relative to that of the US (Chart 22, top panel). On the other hand, Swedish IG is expected to outperform US IG over the next six months (Chart 22, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Definitions Matter Definitions Matter Definitions Matter Year-to-date, cyclical stocks have underperformed their defensive counterparts. It is difficult to quantify this underperformance precisely considering the divergence in definitions of what makes a sector cyclical or defensive. We offer a novel way to classify sectors based on a combination of equity beta coefficients and correlations with global macro and financial variables. Importantly, we acknowledge the importance of granularity by looking at the GICS2 sectors. This new approach leads to a cyclicals/defensives equity performance that is superior and more in line with the global economic cycle. Bottom Line: A proper definition of what constitutes a cyclical and a defensive equity sector is essential – whether a recession is around the corner and investors adopt a more defensive portfolio tilt or markets are just responding to what might simply be a mid-cycle slowdown.   Investors around the globe are holding their breath over two questions: Has inflation peaked? And will the US and Europe enter a recession? A peak in inflation may be enough to avoid a hard landing, as it would allow the Federal Reserve and the ECB to moderate their policy tightening. However, if inflation is not peaking, central banks will be forced to engineer recessions. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks In turn, the answers to these questions will determine how cyclical equities perform relative to defensives. So far, the underperformance of cyclical sectors relative to defensives has mostly reflected a valuation squeeze. But if a recession takes place, relative profits will drive the next phase of this market cycle. For now, European defensive sectors are likely to retain the upper hand until EM/China economic activity recovers enough to provide a lift to cyclical sectors, and/or the US dollar rally reverses course on a sustained basis. Chart 1Definitions Matter Definitions Matter Definitions Matter Despite their recent rebound, Euro Area cyclical stocks have underperformed relative to their defensive counterparts over the past nine months. However, quantifying this underperformance depends on how one defines cyclicals and defensives (Chart 1). The aim of this Special Report is to address this issue. There is no perfect way to define a sector as a cyclical or a defensive. In this piece, we review the generally accepted definitions. We draw two conclusions from our assessment; (i) the GICS1 sectors are too broad to get an accurate representation of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD Composite Leading Indicator (LEI), is lacking. We propose a different approach, which looks at the GICS2 sectors and applies an average of the market beta and the correlations to a set of global macro as well as financial variables sensitive to the global economy. This novel approach leads to a cyclicals/defensives equity performance that is more properly aligned with the global economic cycle. Challenging the Accepted Approach Each of the definitions of the cyclicals/defensives split has its own merit. For example, our own preferred definition of cyclical equities excludes the tech sector, because it sports a negative correlation with interest rates.     Finance theory posits that companies (or sectors) may be categorized based on how they perform in different phases of the business cycle. Consequently, cyclical companies should perform better in the first stages of a new business cycle (especially coming out of a recession) and defensive companies should shine during downturns. Table 1Definitions Matter Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives MSCI defines cyclical and defensive sectors by measuring the correlation between sectors’ relative annual performance to the annual change in the OECD Composite Leading Indicator (LEI) of the corresponding region.1 Table 1 presents the current MSCI classification. There are two issues with this approach. First, results differ substantially depending on the sample period (Table 2). GICS1 sectors match their definitions when using the full history available (from 1995 to present). However, on shorter samples, starting for example from 2005 or 2015, the correlations do not necessarily support the current MSCI classification; the communication services sector correlates negatively with the Euro Area OECD LEI from 2005 to present,2 while the energy sector displays a positive correlation since 2015. Table 2Cyclicality Changes Over Time Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Looking at the five-year moving correlation of the relative performance of European sectors to the annual change in OECD LEI, four things stand out (Chart 2). First, the energy sector displays a positive correlation, meaning that it behaves as a cyclical. Second, it is not clear that communication services should be labeled a cyclical sector. Third, although tech has on average displayed a five-year moving correlation with activity of around 0.5, it is increasingly behaving like a defensive sector. And fourth, over the past 20 years, all sectors have at one point or another moved from a positive (negative) correlation to a negative (positive) one. Chart 2Cyclicality Is Not Static Cyclicality Is Not Static Cyclicality Is Not Static The second issue with the MSCI approach is the use of the OECD LEIs. While the OECD LEIs are satisfactory at capturing the peaks and troughs in economic activity, we have some concerns over relying on this measure alone to label a sector as cyclical or defensive. Many of the country’s LEIs already include stock prices. Moreover, academic studies have found that the LEIs performed worse than some of their single component indicators, but displayed more accuracy – that is, fewer false signals. In particular, financial components used in some of the country’s LEIs, such as interest rates, spreads, and credit indicators, proved to be better classifiers of both growth and business cycles than the overall LEIs. Chart 3Global Growth Sensitivity Global Growth Sensitivity Global Growth Sensitivity Finally, many (if not most) of the components of the LEIs are domestic variables. As a result, they may not properly reflect how the global economic and trade cycles affect an economy such as that of the Euro Area. In fact, the correlation between the relative performance of Euro Area cyclicals versus defensives and the annual change in the US and Global LEIs is similar to the correlation between the cyclical/defensive split and the Euro Area LEI (Chart 3).3  Reclassifying Cyclicals And Defensives We may draw two conclusions from our earlier assessment; (i) the GICS1 sectors are too broad to secure an accurate definition of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD LEI, is insufficient. Granularity Holds The Key Many industries or sectors have experienced profound changes over the past decades. Industries evolve and new ones emerge that may disrupt the status quo. For instance, today’s tech sector shares few similarities with its past-self twenty years ago. Chart 4AMore Granularity Needed (I) More Granularity Needed (I) More Granularity Needed (I) Without getting to the company level, many GICS2 sectors already exhibit characteristics deviating substantially from those of the GICS1 sectors of which they are a part (Chart 4A & 4B). Most noticeably: Within industrials: commercial and professional services (9% weight) have a negative correlation with the LEI of -0.23 (Chart 4A, top panel). Within consumer discretionary: the correlation of the retailing sector with the LEI (15% weight) went from 0.75 in the early 2010s to -0.5 in 2018 and has since been trending toward 0 (Chart 4A, third panel). Within tech: software and services (46% weight) sport a negative moving correlation of -0.25, and highlight that this sector has effectively become akin to “digital utilities.” Meanwhile, technology hardware and equipment display a correlation close to 0 (Chart 4A, fourth panel). Chart 4BMore Granularity Needed (II) More Granularity Needed (II) More Granularity Needed (II) Within communication services: telecommunication services (78% weight) still behave like a defensive sector, and it appears that the cyclicality of the GICS1 sector is driven by media and entertainment stocks (Chart 4B, top panel). Within consumer staples: food beverage and tobacco (53% weight) now display a positive correlation of 0.1 with the LEI, whereas it used to have a -0.8 correlation until 2018 (Chart 4B, second panel). Within energy: GICS2 sectors have displayed positive correlations since 2015 (Chart 4B, third panel). For the remaining GICS1 sectors, namely materials, financials, utilities, and healthcare, except for large swings observed in the past, their respective GICS2 sub-sectors currently display correlation coefficients sharing the same sign as their broader aggregates. Thus, adding granularity by looking at the GICS2 sector level instead of the GICS1 classification when creating cyclical and defensive baskets offers a more accurate picture. Good Old Beta Is the market itself the best indicator of a stock’s cyclicality? The returns on the stocks of cyclical (defensive) sectors should reflect high (low) correlation with the market index’s returns. Table 3A presents the beta coefficients obtained from linearly regressing the monthly equity returns of European GICS1 sectors on the monthly equity returns of the All-Country World benchmark. We run into the same issue of getting different results based on the sample period. Historically, the energy sector has had a beta coefficient below 1, but, from 2005, its beta has risen to 1.12. Meanwhile, communication services has a beta coefficient below 1 across all three sample periods selected. Table 3AGICS1 Beta Coefficients Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives We perform the same exercise at the European GICS2 sector level (Table 3B). The results reify the benefit of additional granularity when defining cyclicals and defensives. Table 3BGICS2 Beta Coefficients Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Combining Correlations With Macro And Financial Variables While stock prices are certainly anticipatory, at times they can also decouple from the business cycle. Equity markets and stock indices are becoming more concentrated, which means that measuring cyclicality through beta alone is no longer sufficient. We complement the use of the beta coefficients with a composite measure of cyclicality based on correlations with global macro and financial variables. We select the following global macro variables (Chart 5A):​​​​​​​ Global Manufacturing PMI Global Industrial Production G3 Capital New Orders Global Exports Chart 5AGlobal Macro Variables Selected Global Macro Variables Selected Global Macro Variables Selected Chart 5BFinancial Variables Selected Financial Variables Selected Financial Variables Selected And we opt for the following high-frequency financial variables (Chart 5B): Trade-weighted USD: The cyclicals-to-defensives ratio and the trade-weighted US dollar display a robust negative correlation. A strong dollar both tightens global financial conditions and indicates weaker economic growth. GS Commodity Price Index: Commodity prices reflect both global supply and demand dynamics. Strong economic activity usually lifts commodity prices, while a slowdown hurts commodity demand. US 10-year Treasury Yield: The relationship with the US 10-year Treasury yield is somewhat more complex. At the beginning of a new business cycle, higher yields reflect reflation and usually correlate with an outperformance of cyclical equities. However, if yields rise too much, they start hurting growth prospects and end up damaging cyclicals. If they fall, it usually reflects increasing growth fears, which is negative for cyclical shares. Junk Spreads: US high-yield corporate bond spreads and the cyclicals/defensives ratio have a strong negative correlation. Widening junk spreads coincide with the end of the business cycle when fears of rising default risk precede a recession. Although these financial variables are highly anticipatory, they are also prone to whipsaws. Consequently, they must be viewed in conjunction with macro variables. We also compute the five-year moving correlations between monthly equity returns of European sectors relative to the ACW benchmark and the two sets of macro and financial variables (Table 4A & 4B). The results are broadly consistent between the long-term correlations with macro and financial variables, as well as with the beta coefficients,4 which comforts us into using a simple average of the three. Table 4ACombining Coefficients For GICS1 Sectors Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives Table 4BCombining Coefficients For GICS2 Sectors Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives At the GICS1 sector level, our new approach indicates that the energy sector should be treated as a cyclical, not a defensive. In fact, it displays more cyclicality than the tech sector. Communication services should also be defined as cyclicals, although it is less of a clear cut than for the other sectors since the adjusted beta coefficient is the culprit behind the negative sign. Taking a closer look at the GICS2 sector level once again provides valuable insight. The computed mean correlation for cyclical GICS2 sectors is 0.34, with a variance of 0.04 and standard deviation of 0.2. For defensive GICS2 sectors, the computed mean correlation is -0.23, with a variance of 0.02 and a standard deviation of 0.13. Assessing This New Approach Having reclassified the GICS2 sectors as cyclicals or defensives, the next step is to assess how this approach performs compared to the MSCI definition of cyclicals/defensives. To do so, we use the average coefficients displayed on Table 4B to create a dynamic basket of cyclicals and defensives GICS2 sectors. These baskets are weighted by market capitalization and are updated monthly. Chart 6New Baskets Of Cyclicals/Defensives New Baskets Of Cyclicals/Defensives New Baskets Of Cyclicals/Defensives Chart 6 shows how the novel cyclical vs. defensives performs over time in the Euro Area relative to the other definitions. Next, we perform a simple back-testing exercise to assess the performance over time of the new cyclicals-to-defensives ratio, with the Global Manufacturing PMI as a control variable. A superior definition of cyclicals vs. defensives should lead to a better performance of cyclicals when the PMI is above its 50 boom/bust line and improving, and to a better performance of defensives when the PMI is below 50 and deteriorating. We look at coincident equity returns (Table 5A). Overall, the results indicate that our new approach is superior and more accurate, both on a 3- and 12-month time horizon. This is especially true when the global economy is deteriorating. When the PMI is below 50 and falling, our basket of defensives outperforms our basket of cyclicals on average by 20% on a 12-month horizon, compared to 14% using the MSCI definition. Table 5AAssessing The Performance (I) Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives The subsequent performance of cyclicals relative to defensives following certain thresholds for the PMI also reinforces our new approach (Table 5B). Interestingly, our new basket of defensives is the only one to outperform cyclicals twelve months after the Global Manufacturing PMI deteriorated over several months and is below 50. Table 5BAssessing The Performance (II) Revisiting Cyclicals Versus Defensives Revisiting Cyclicals Versus Defensives ​​​​​​​ Bottom Line: We are introducing a new approach to defining cyclical versus defensive equities. GICS1 sectors are too broad to achieve an accurate definition of cyclicality. However, the GICS2 classification offers the necessary level of granularity to do so. Moreover, we broaden the set of variables used to determine whether a GICS2 sector is cyclical or defensive. This new approach offers tighter links with the state of the global economy when selecting cyclical or defensive portfolio biases. For now, since EM economies and China remain under duress and the USD has yet to roll over clearly, we maintain our preference for defensive stocks over their cyclical counterparts within equity portfolios.   Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Amr Hanafy Associate Editor AmrH@bcaresearch.com Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     Applied Research MSCI, “Index Performance in Changing Economic Environments,” 2014, p. 4. 2     Admittedly, communications services – formerly known as telecommunication services – was removed from the list of defensive sectors and classified as a cyclical one following the 2018 GICS structure adjustment. 3    In the remainder of the report, the relative equity performance of European sectors is measured against the ACW index. 4    We normalized the beta coefficients to have a mean of zero, to be comparable with correlation coefficients.

Executive Summary Then And Now Then And Now Then And Now Investors are fixated on inflation; for now, the peak in US CPI is a positive for global stocks. However, this tailwind could easily transform into fear if inflation becomes deflation. The risk of deflation is greater than investors currently appreciate. In the early 1920s, the policy-driven inflation of World War One quickly morphed into a violent deflationary shock, which prompted a severe bear market. Even in the absence of the gold standard, many contemporary factors parallel those that were apparent before 1921. As a result, if commodity prices do not stabilize by year-end, investors will start to worry about deflation. This fear could prompt another sell-off in stocks, which would be particularly painful in Europe. Buy protection against deflation while it is cheap by selling EUR/JPY. Continue to favor defensive over cyclical equities. Bottom Line: The deflation risk for 2023 is greater than the investment community currently appreciates. While it remains a tail risk, it is an underpriced one. As a result, investors should use the current rebound in stocks to buy protection against deflation.     Last week, the NASDAQ entered a new bull market following a decline in US inflation. European stocks have rallied too, albeit considerably less so, only rising 12.5% since their July 5th low. We have participated in this rally, having taken a more constructive view on European equities and other risk assets since our return from a trip visiting clients in Europe. Related Report  European Investment StrategyQuestions From The Road The decline in US inflation is likely to remain a tailwind for global equities in the near future. The pandemic-related factors that spiked inflation in the past quarters are ebbing, and commodity inflation is decreasing. However, BCA’s US bond strategists expect this window to be short-lived. Labor market tightness and strong rents suggest that core CPI will stabilize around 4%. Nonetheless, as long as this window is open, stocks should remain bid. Investors expecting the demise of this current rebound continue to pin their view on stubborn inflation. While sticky inflation is an undeniable risk, it is a threat well understood by the market. However, another danger lurks, which is much less appreciated by investors: deflation. Investors currently underestimate its odds, when deflation could prove even more damaging to the market than sticky inflation. Remembering 1921 Chart 1The 1921 Bear Market The 1921 Bear Market The 1921 Bear Market The most famous period of deflation in US economic history is the Great Depression. This is not, however, an appropriate parallel. The 1921 recession, at which time deflation hit a historical low of 16% per annum, is the more direct potential equivalent to today. It was accompanied by a 47% crash in the market that brought the Shiller P/E to five (Chart 1, top panel). At the end of WWI, the stock market experienced a rapid rally, with the Dow Jones jumping 58% from its low in March 1918 to its peak in November 1919. In that time frame, inflation was robust, with headline CPI averaging 16% between 1917 and 1920. Inflation was high because of a combination of factors: The war had forced a substantial loosening of fiscal policy with the Federal debt rising from 2.7% of GDP in 1916, before the entry of the US in the conflict, to 32.9% in 1921. The money supply experienced an unprecedented surge. At the beginning of the war, the US was a neutral party and European powers purchased large quantities of US goods. The resulting trade surplus pushed the US stock of gold from $1.5bn in 1914 to $2.6bn in 1920. Meanwhile, to help finance the government’s wartime expenditures, the newly created Federal Reserve expanded its banknote issuance and its claims on the banking system, which meant that Fed money rose from 21% of high-power money in April 1917 to 59% by November 1918. As a result of these two concurrent trends, the money supply doubled between 1916 and June 1920. The Fed was slow to remove the accommodation. The New York discount rate, which had fallen from 6% to 4% as war broke out in Europe, was only increased to 4.75% in the Spring of 1918 and stayed there until January 1920. The global economy was facing potent supply constraints. Large swaths of the European capital stock had been destroyed by the war, at the same time as the US economy had been redesigned to supply military goods, not consumer goods. As a result, inflation remained perky in 1919 and 1920, despite the end of the conflict. The fiscal and monetary supports suddenly ended in 1920, and the economy entered a vicious contraction that caused industrial production to plunge by 36% in 1921 and deflation to hit 16% (Chart 1, second and third panel). The fiscal easing suddenly shifted toward fiscal rectitude under the administration of Warren Harding, which greatly hurt domestic demand in 1921. Additionally, the inflow of gold from the war period morphed into outflow, as European powers enjoyed trade surpluses after their currencies fell 60% to 30% against the dollar between 1919 and the start of 1921. Moreover, the Fed increased the discount rate to 6% in 1920 and cut back the ratio of Fed money to gold, which caused M2 to swing from a 20% growth annual growth rate in Q1 1920 to a 7% contraction in Q3 1921. Simultaneously, corporate borrowing rates soared (Chart 1, fourth and fifth panel) The shock of stagflation and the associated deep output contraction caused the Dow Jones to collapse by 47% from late 1919 to August 1921. The market only stabilized once deflationary pressures ebbed, after the Fed had cut back the discount rate to 6% and around the same time when commodity prices began to firm up. By the end of the bear market, the reconstituted S&P 500 was trading at a cyclically-adjusted P/E of 5.2, and profits had fallen 81% from their 1916 peak. Bottom Line: The 1921 bear market was one of the most violent of the twentieth century. It was caused by an economic contraction and deep deflation that engulfed the US economy after the monetary and fiscal support of WWI had been removed. It only ended once deflationary forces began to ebb, after commodity prices found a floor. What Are The Parallels? At first glance, the parallels between 1921 and today seem negligible. Yes, inflation was raging in 1920, but deflation was a direct consequence of the gold standard that forced a rapid contraction in high-powered money, especially as gold fled the US in 1921. Chart 2Inflationary Fiscal And Monetary Policy Inflationary Fiscal And Monetary Policy Inflationary Fiscal And Monetary Policy The similarities, however, are remarkable too. As a result of the COVID-19 pandemic, the economy was subjected to similar conditions as that of the US around WWI. The US economy witnessed a massive explosion of fiscal stimulus that pushed the Federal deficit from 5% in 2019, to 10% and 6% of GDP in 2020 and 2021, respectively. Moreover, the Federal Reserve generated extremely accommodative monetary conditions during and after the pandemic, when its balance sheet more than doubled and M2 grew by 41% (Chart 2). Additionally, the global economy has witnessed extraordinary supply-side disruptions that have added to inflationary pressures created by the extreme push to aggregate demand from fiscal and monetary policy.1 Chart 3The Money Supply Is Contracting The Money Supply Is Contracting The Money Supply Is Contracting However, as in 1921, these forces are moving in the opposite direction. The fiscal thrust in the US was deeply negative in 2021 and 2022, when fiscal policy subtracted 4% and 2% from GDP growth, respectively. Moreover, the Fed’s policy tightening campaign is exceptionally aggressive. The Fed has increased rates by 2.25% in five months, and, based on the OIS curve, will push up interest rates by an additional 1.3% by the year-end (Chart 3). As a result, the recent contraction in M2 has further to run, even if the US economy is not constrained by its golden tethers (Chart 3, bottom panel). Between 1920 and 1921, investors had trouble judging how far the Fed would tolerate money contraction, which is again the case. Chart 4The Dollar Is Deflationary The Dollar Is Deflationary The Dollar Is Deflationary While the gold standard has been dissolved, the recent wave of dollar strength creates deflationary forces that are similar to the bullion anchor in the 1920s. In the US, the strength in the dollar is limiting imported inflation. US import prices have rolled over, a trend likely to continue. Once converted in USD, Chinese PPI is almost contracting today, which is no small matter when China is the marginal supplier of goods for the world (Chart 4). A strong dollar is deflationary for the global economy, not just that of the US. A rising greenback hurts commodity prices and also tightens global liquidity conditions. Already, the dollar-based liquidity is contracting and EM FX reserves – which are a form of high-powered money similar to gold flows in the 1920s – are tanking, even after adjusting for the confiscation of Russian reserves in the wake of the Ukrainian conflict (Chart 4, bottom panel). To defend their currencies as the dollar rallies, EM central banks are forced to tighten policy, which hurts their domestic economies. This phenomenon is also visible in advanced economies. The weak euro has played a role inching the ECB toward aggressive rate hikes, while the Riksbank and the Swiss National Bank are both lifting interest rates to fight the inflationary impact of their currencies falling against the greenback. Global supply constraints are also defusing. The price of shipping commodities and goods around the world is declining meaningfully (Chart 5). Meanwhile, deliveries by suppliers are accelerating globally, which is contributing to a very rapid easing of our indicator of US Supply Constraints (Chart 5, bottom panel). Beyond these parallels with the early 1920s, demand is already weakening globally. Hampered by the current rise in living costs, households have begun to reduce the volume of goods they purchase, while companies have maintained robust production schedules. As a result, inventories are swelling around the world (Chart 6). Historically, the best cure for elevated inventories is lower prices. Chart 5Easing Supply Constraints Easing Supply Constraints Easing Supply Constraints Chart 6Inventories And Weak Demand Are Deflationary Inventories And Weak Demand Are Deflationary Inventories And Weak Demand Are Deflationary Bottom Line: There is no guarantee that deflation will become the prevailing force in the global economy. However, the risk is there—and this threat is woefully underappreciated by the investment community. At this current juncture, investors are welcoming lower commodity prices as they take the edge off ebullient inflation. However, if commodity prices do not stabilize by year-end, then investors will begin to worry about deflation. As the 1921 experience showed, deflation is very painful for stocks because it is so negative for profits. While the absence of the gold standard means that the deep deflation of 1921 is extremely unlikely, a period of deflation would nonetheless have a very negative impact on stocks, since they trade at 29 times cyclically-adjusted earnings, not 6.2 times, as was the case in November 1919. What Does This Mean For European Assets? A bout of global deflation would be especially painful for European equities. European equities are more cyclical than their US counterparts, which means that they often underperform when global growth is weak and global export prices of manufactured goods are falling (Chart 7). In other words, a deflationary shock in the US would be felt more acutely in the European market than in that of the US. Additionally, the euro would likely weaken further. Already, the European money impulse (the change in M1 flows) is contracting, which augurs poorly for European economic activity (Chart 8). The addition of a deflationary shock to the weak domestic backdrop would prompt further outflows from Europe, which would hurt the euro even more. Chart 7European Stocks Hate Deflationary Busts European Stocks Hate Deflationary Busts European Stocks Hate Deflationary Busts Chart 8European Activity Is Weak European Activity Is Weak European Activity Is Weak Chart 9A Value Trap? A Value Trap? A Value Trap? Finally, with respect to the European cyclicals-to-defensive ratio, our Combined Mechanical Valuation Indicator suggests that European cyclicals have purged their overvaluation relative to their defensive counterparts (Chart 9). However, in previous deflationary outbreaks such as those in 1921 or the 1930s, cyclicals deeply underperformed defensive equities, no matter how cheap they became. This time around, we would expect the same outcome from cyclicals. Moreover, even if investors do not price in a deflationary risk early next year, European cyclicals remain hampered by the deceleration in the Chinese economy and the energy rationing that will hit Europe this winter. As a result, we continue to fade any rebound in the European cyclicals-to-defensives ratio. Bottom Line: Even if a deflationary shock is a risk that is more likely to emanate from the US, European markets will not be immune. The European economy is already weak, and the cyclicality of European equities creates greater vulnerability to deflation. Thus, while deflation in 2023 is a tail risk, investors should use the current rebound in global risk assets to buy protection cheaply. Selling EUR/JPY and favoring defensive European markets continue to make sense in light of this risk.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1Another similarity is that the Spanish Flu was decimating the population from late WWI to 1921.   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary With the fourth Taiwan Strait crisis materializing, the odds of a major war between the world’s great powers have gone up. Our decision trees suggest the odds are around 20%, or double where they stood from the Russian war in Ukraine alone. The world is playing “Russian roulette” … with a five-round revolver. Going forward, our base case is for Taiwan tensions to flatten out (but not fall) after the US and Chinese domestic political events conclude this autumn. However, if China escalates tensions after the twentieth national party congress, then the odds of an invasion will rise significantly. If conflict erupts in Taiwan, then the odds of Russia turning even more aggressive in Europe will rise. Iran is highly likely to pursue nuclear weapons. Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Tactical Recommendation Inception Date Return LONG US 10-YEAR TREASURY 2022-04-14 1.3% LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 13.8% Bottom Line: Investors should remain defensively positioned at least until the Chinese party congress and the US midterm election conclude this fall. Geopolitical risk next year will depend on China’s actions in the Taiwan Strait. Feature Chart 1Speculation Rising About WWIII Roulette With A Five-Shooter Roulette With A Five-Shooter Pessimists who pay attention to world events have grown concerned in recent years about the risk that the third world war might break out. The term has picked up in online searches since 2019, though it is the underlying trend of global multipolarity, rather than the specific crisis events, that justifies the worry (Chart 1).1 What are the odds of a major war between the US and China, or the US and Russia? How might that be calculated? In this report we present a series of “decision trees” to formalize the different scenarios and probabilities. If we define WWIII as a war in which the United States engages in direct warfare with either Russia or China, or both, then we arrive at a 20% chance that WWIII will break out in the next couple of years! Those are frighteningly high odds – but history teaches that these odds are not unrealistic and that investors should not be complacent. Political scientist Graham Allison has shown that the odds of a US-China war over the long term are about 75% based on historical analogies. The takeaway is that nations will have to confront this WWIII risk and reject it for the global political environment to improve. Most likely they will do so as WWIII, and the risk of nuclear warfare that it would bring, constitutes the ultimate constraint. But the current behavior of the great powers suggests that they have not recognized their constraints yet and are willing to continue with brinksmanship in the short term. The Odds Of A Chinese Invasion Of Taiwan The first question is whether China will invade Taiwan. In April 2021 we predicted that the fourth Taiwan Strait crisis would occur within 12-24 months but that it would not devolve into full-scale war. This view is now being tested. In Diagram 1 we provide a decision tree to map out China’s policy options toward Taiwan and assign probabilities to each option. Diagram 1Decision Tree For Fourth Taiwan Strait Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter While China has achieved the capability to invade Taiwan, the odds of failure remain too high, especially without more progress on its nuclear triad. Hence we give only a 20% chance that China will mobilize for invasion immediately. Needless to say any concrete signs that China is planning an invasion should be taken seriously. Investors and the media dismissed Russia’s military buildup around Ukraine in 2021 to their detriment. At the same time, there is a good chance that the US and China are merely testing the status quo in the Taiwan Strait, which will be reinforced after the current episode. After all, this crisis was the fourth Taiwan Strait crisis – none of the previous crises led to war. If Presidents Biden and Xi Jinping are merely flexing their muscles ahead of important domestic political events this fall, then they have already achieved their objective. No further shows of force are necessary on either side, at least for the next few years. We give 40% odds to this scenario, in which the past week’s tensions will linger but the status quo is reinforced. In that case, the structural problem of the Taiwan Strait would flare up again sometime after the US and Taiwanese presidential elections in 2024, i.e. outside the time frame of the diagram. Unfortunately we are pessimistic over the long run and would give high probability to war in Taiwan. For that reason, we give equal odds (40%) to a deteriorating situation within the coming two years. If China expands drills and sanctions after the party congress, after Xi has consolidated power, then it will be clear that Xi is not merely performing for his domestic audience. Similarly if the Biden administration continues pushing for tighter high-tech export controls against China after the midterm election, and insists that US allies and partners do the same, then the US implicitly believes that China is preparing some kind of offensive operation. The danger of invasion would rise from 20% to 40%. Even in that case, one should still believe that crisis diplomacy between the US and China will prevent full-scale war in 2023-24. But the risk of miscalculation would be very high. The last element of this decision tree holds that China will prefer “gray zone tactics” or hybrid warfare rather than conventional amphibious invasion of the kind witnessed in WWII. The reasons are several. First, amphibious invasions are the most difficult military operations. Second, Chinese forces are inexperienced while the US and its allies are entrenched. Third, hybrid warfare will sow division among the US allies about how best to respond. Fourth, Russia has demonstrated several times over the past 14 years that hybrid warfare works. It is a way of maximizing strategic benefits and minimizing costs. The world knows how the West reacts to small invasions: it uses economic sanctions. It does not yet know how the West reacts to big invasions. So China will be incentivized to take small bites. And yet in Taiwan’s case those tactics may not be sustainable. Our Taiwan decision tree does not account for the likelihood that a hybrid war or “proxy war” will evolve into a major war. But that likelihood is in fact high. So we are hardly overrating the risk of a major US-China war. Bottom Line: Over the next two years, the subjective odds of a US-China proxy war over Taiwan are about 32% while the odds of a direct US-China war are about 4%. The true test comes after Xi Jinping consolidates power at this fall’s party congress. We expect Xi to focus on rebooting the economy so we continue to favor emerging Asian markets excluding China and Taiwan. The Odds Of Russian War With NATO The second question is whether Russia’s war in Ukraine will morph into a broader war with the West. The odds of a major Russia-West war are greater in this case than in China’s, as a war is already raging, whereas tensions in the Taiwan Strait are merely shadow boxing so far. An investor’s base case should hold that the Ukraine war will remain contained in Ukraine, as Europeans do not want to fight a devastating war with Russia merely because of the Donbas. But things often go wrong in times of war. The critical question is whether Russia will attack any NATO members. That would trigger Article Five of the alliance’s treaty, which holds that “an armed attack against one or more [alliance members] in Europe or North America shall be considered an attack against them all,” justifying the use of armed force if necessary to restore security. Since Russia’s invasion of Ukraine this year, President Biden has repeatedly stated that the US will “defend every inch of NATO territory,” including the Baltic states of Latvia, Lithuania, and Estonia, which joined NATO in 2004. This is not a change of policy but it is the US’s red line and highly likely to be defended. Hence it is a major constraint on Russia. In Diagram 2 we map out Russia’s different options and assign probabilities. Diagram 2Decision Tree For Russia-Ukraine War (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter We give 55% odds that Russia will declare victory after completing the conquest of Ukraine’s Donbas region and the land bridge to Crimea. It will start looking to legitimize its conquests by means of some diplomatic agreement, i.e. a ceasefire. This is our base case for 2023. There is evidence that Russia is already starting to move toward diplomacy.2 The reason is that Russia’s economy is suffering, global commodity prices are falling, Russian blood and treasure are being spent. President Putin will have largely achieved his goal of hobbling Ukraine as long as he controls the mouth of the Dnieper river and the rest of the territory he has invaded. Putin needs to seal his conquests and try to salvage the economy and society. The sooner the better for Russia, so that Europe can be prevented from forming a consensus and implementing a full natural gas embargo in the coming years. However, there is a risk that Putin’s ambition gets the better of him. So we give 35% odds that the invasion expands to southwestern Ukraine, including the strategic port city of Odessa, and to eastern Moldova, where Russian troops are stationed in the breakaway region of Transdniestria. This new campaign would render Ukraine fully landlocked, neutralize Moldova, and give Russia greater maritime access. But it would unify the EU, precipitate a natural gas embargo, and weaken Russia to a point where it could become desperate. It could retaliate and that retaliation could conceivably lead to a broader war. We allot only a 7% chance that Putin attacks Finland or Sweden for attempting to join NATO. Stalin failed in Finland and Putin’s army could not even conquer Kiev. The UK has pledged to support these states, so an attack on them will most likely trigger a war with NATO. A decision to attack Finland would only occur if Russia believed that NATO planned to station military bases there – i.e. Russia’s declared red line. Any Russian attack on the Baltic states is less likely because they are already in NATO. But there is some risk it could happen if Putin grows desperate. We put the risk of a Baltic invasion at 3%. In short, if Russia uses its energy stranglehold on Europe not to negotiate a favorable ceasefire but rather to expand its invasions, then the odds of a broader war will rise. Bottom Line: The result is a 55% chance of de-escalation over the next 24 months, a 35% chance of a small escalation (e.g. Odessa, Moldova), and a 10% chance of major escalation that involves NATO members and likely leads to a NATO-Russia war. Tactically, investors should buy developed-market European currency and assets if the global economy rebounds and Russia makes a clear pivot to halting its military campaign and pursuing ceasefire talks. Cyclically, there needs to be a deeper US-Russia understanding for a durable bull market in European assets. The Odds Of US-Israeli Strikes On Iran The third geopolitical crisis taking place this year could be postponed as we go to press – if President Biden and Ayatollah Ali Khamenei agree to rejoin the 2015 US-Iran nuclear deal. But we remain skeptical. The Biden administration wants to rejoin the 2015 nuclear deal and free up about one million barrels per day of Iranian crude oil to reduce prices at the pump before the midterm election. US grand strategy also wants to engage with Iran and stabilize the Middle East so that the US can pivot to Asia. The EU is proposing the deal since it has even greater need for Iranian resources and wants to prevent Iran from getting nuclear weapons. Russia and China are also supportive as they want to remove US sanctions for trading with Iran and do not necessarily want Iran to get nukes. There is only one problem: Iran needs nuclear weapons to ensure its regime’s survival over the long run. The question is whether Khamenei is willing to authorize a deal with the Americans a second time. The first deal was betrayed at great cost to his regime. President Ebrahim Raisi, who hopes to replace the 83-year-old Khamenei before long, is surely staunchly opposed to wagering his career and personal security on whether Republicans win the 2024 election. Iran has already achieved nuclear breakout capacity – it has enough 60%-enriched uranium to construct nuclear devices – and it is unclear why it would achieve this capacity if it did not ultimately seek to obtain a nuclear deterrent. Especially given that it may someday need to protect its regime from military attacks by the US and its allies. However, our conviction level is medium because President Biden wants to lift sanctions and can do so unilaterally. The Biden administration has not taken any of the preliminary actions to make a deal come together but that could change.3 There is a good cyclical case to be made for short-term, stop-gap deal. According to BCA’s Commodity & Energy Strategist Bob Ryan, Saudi Arabia and the UAE only have about 1.5 million barrels of spare oil production capacity between them. The EU oil embargo and western sanctions on Russia will force about two million barrels per day to be stopped, soaking up most of OPEC’s capacity. Hence the Biden administration needs the one million barrels that Iran can bring. We cannot deny that the Iranians may sign a deal to allow Biden to lift sanctions. That would benefit their economy. They could allow nuclear inspectors while secretly shifting their focus to warhead and ballistic missile development. While Iran will not give up the long pursuit of a nuclear deterrent, it is adept at playing for time. Still, Iran’s domestic politics do not support a deal – and its grand strategy only supports a deal if the US can provide credible security guarantees, which the US cannot do because its foreign policy is inconsistent. US grand strategy supports a deal but only if it is verifiable, i.e. not if Iran uses it as cover to pursue a bomb anyway. Iran has not capitulated after three years of maximum US sanctions, a pandemic, and global turmoil. And Iran sees a much greater prospect of extracting strategic benefits from Russia and China now that they have turned aggressive against the West. Moscow and Beijing can be strategic partners due to their shared acrimony toward Washington. Whereas the US can betray the Raisi administration just as easily as it betrayed the Rouhani administration, with the result that the economy would be whipsawed again and the Supreme Leader and the political establishment would be twice the fools in the eyes of the public. Diagram 3 spells out Iran’s choices. Diagram 3Decision Tree For Iran Nuclear Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter If negotiations collapse (50% odds), then Iran will make a mad dash for a nuclear weapon before the US and Israel attack. If the US and Iran agree to a deal (40%), then Iran might comply with the deal’s terms through the 2024 US election, removing the issue from investor concerns for now. But their long-term interest in obtaining a nuclear deterrent will not change and the conflict will revive after 2024. If talks continue without resolution (10%), Iran will make gradual progress on its nuclear program without the restraints of the deal (though it may not need to make a mad dash). In short, Russia and China need Iran regardless of whether it freezes its nuclear program, whereas the US and Israel will form a balance-of-power Abraham Alliance to contain Iran even if it does freeze its nuclear program. Bottom Line: Investors should allot 40% odds to a short-term, stop-gap US-Iran nuclear deal. The oil price drop would be fleeting. Long-term supply will not be expanded because the US cannot provide Iran with the security guarantees that it needs to halt its nuclear program irreversibly. The Odds Of World War III Now comes the impossible part, where we try to put these three geopolitical crises together. In what follows we are oversimplifying. But the purpose is to formalize our thinking about the different players and their options. Diagram 4 begins with our conclusions regarding the China/Taiwan conflict, adjusts the odds of a broader Russian war as a result, and adds our view that Iran is highly likely to pursue nuclear weapons. Again the time frame is two years. Diagram 4Decision Tree For World War III (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter The alternate conflict scenario to WWIII consists of “limited wars” – a dangerous concept that refers to hybrid and proxy wars in which the US is not involved, or only involved indirectly. Or it could be a conflict with Iran that does not involve Russia and China. We begin with China because China is the most capable and most ambitious global power today. China’s strategic rise is upsetting the global order and challenging the United States. We also start with China because we have some evidence this year that Russia does not intend to expand the war beyond Ukraine. Either China takes further aggressive action in Taiwan – creating a unique opportunity for Russia to take greater risks – or not. If not, then the odds of WWIII fall precipitously over the two-year period. This scenario is our base case. But if China attacks Taiwan and the US defends Taiwan, we give a high probability to Russia invading the Baltics. If China stages hybrid attacks and the US only supports Taiwan indirectly, then we increase the odds of Russian aggression only marginally. The result is 20% odds of WWIII, i.e. a direct war between the US and Russia, or China, or both. Whether this war could remain limited is debatable. War gaming since 1945 shows that any war between major nuclear powers will more likely escalate than not. But nuclear weapons bring mutually assured destruction, the ultimate constraint. The nuclear escalation risk is why we round down the probability of WWIII in our decision trees. The more likely 59% risk scenario of “limited wars” may seem like a positive outcome but it includes major increases in geopolitical tensions from today’s level, such as a Chinese hybrid war against Taiwan. Bottom Line: According to this exercise the odds of WWIII could be as high as 20%. This is twice the level in our Russia decision tree, which is appropriate given that our Taiwan crisis forecast has materialized. The critical factor is whether Beijing continues escalating the pressure on Taiwan after the party congress this fall. That could unleash a dangerous chain reaction. The global economy and financial markets still face downside risk from geopolitics but 2023 could see improvements if Russia moves toward a ceasefire and China delays action against Taiwan to reboot its economy. Investment Takeaways When Russia invaded Ukraine earlier this year, our colleague Peter Berezin, Chief Global Strategist, argued that the odds of nuclear Armageddon were 10%. At very least this is a reasonable probability for the odds that Russia and NATO come to blows. Now the expected Taiwan crisis has materialized. We guess that the odds of a major war have doubled to 20%. The corollary is an 80% chance of a better outcome. Analytically, we still see Russia as pursuing a limited objective – neutralizing Ukraine so that it cannot be prosperous and militarily powerful – while China also pursues a limited objective – intimidating Taiwan so that it pursues subordination rather than nationhood. Unless these objectives change, we are still far from World War III. The world can live with a hobbled Ukraine and a subordinated Taiwan. However, there can be no denying that the trajectory of global affairs since the 2008 global financial crisis has followed a pathway uncomfortably similar to the lead up to World War II: financial crisis, economic recession, deflation, domestic unrest, currency depreciation, trade protectionism, debt monetization, military buildup, inflation, and wars of aggression. If roulette is the game, then the odds of a global war are one-sixth or 17%, not far from the 20% outcome of our decision trees. Even assuming that we are alarmist, the fact that we can make a cogent, formal argument that the odds of WWIII are as high as 20% suggests that investors should wait for the current tensions over Ukraine and Taiwan to decrease before making large new risky bets. A simple checklist shows that the global macro and geopolitical context is gloomy (Table 1). We need improvement on the checklist before becoming more optimistic. Table 1Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Chart 2Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Specifically what investors need is to be reasonably reassured that Russia will not expand the war to NATO and that China will not invade Taiwan anytime soon. This requires a new diplomatic understanding between the Washington and Moscow and Washington and Beijing that forestalls conflict. That kind of understanding can only be forged in crisis. The relevant crises are under way but not yet complete. There is likely more downside for global equity investors before war risks are dispelled through the usual solution: diplomacy. Wait for concrete and credible improvements to the global system before taking a generally overweight stance toward risky assets. Favor government bonds over stocks, US stocks over global stocks, defensive sectors over cyclicals, and disfavor Chinese and Taiwanese currency and assets (Chart 2).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017). 2     For example, the Turkish brokered deal to ship grain out of Odessa, diplomatic support for rejoining the 2015 Iran nuclear deal, referendums in conquered territories like Kherson, and attempts to build up leverage in arms reduction talks. Cutting off Europe’s energy is ultimately a plan to coerce Europe into settling a ceasefire favorable for Russia. 3     Iran is still making extraneous demands – most recently that the IAEA drop a probe into how certain manmade uranium particles appeared in undisclosed nuclear sites in Iran. The IAEA has not dropped this probe and its credibility will suffer if it does. Meanwhile Biden is raising not lowering sanctions on Iran, even though sanction relief is a core Iranian demand. Biden has not removed the Iranian Revolutionary Guards or the Qods Force from the terrorism list. None of these hurdles are prohibitive but we would at least expect to see some movement before changing our view that a deal is more likely to fail than succeed. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades ()

S&P 500 Chart 1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 2Profitability Profitability Profitability Chart 3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 4Uses Of Cash Uses Of Cash Uses Of Cash Cyclicals Vs Defensives Chart 5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 6Profitability Profitability Profitability Chart 7Valuation And Technicals Valuation And Technicals Valuation And Technicals Chart 8Uses Of Cash Uses Of Cash Uses Of Cash Growth Vs Value  Chart 9Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 10Profitability Profitability Profitability Chart 11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 12Uses Of Cash Uses Of Cash Uses Of Cash Small Vs Large Chart 13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 14Profitability Profitability Profitability Chart 15Valuations and Technicals Valuations and Technicals Valuations and Technicals Chart 16Uses Of Cash Uses Of Cash Uses Of Cash Table 1Performance Chartbook: Style Chart Pack Chartbook: Style Chart Pack Table 2Valuations And Forward Earnings Growth Chartbook: Style Chart Pack Chartbook: Style Chart Pack Recommended Allocation  

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price ...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis Stocks Caught Between Scylla And Charybdis 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-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  

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL AT REVERSAL AT REVERSAL Chart 13AT REVERSAL AT REVERSAL AT REVERSAL Chart 14The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 15The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 16A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 26Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-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  

Executive Summary Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism ​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far ​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked ​​​​​​ Chart 5Hong Kong Faces More Troubles Hong Kong Faces More Troubles Hong Kong Faces More Troubles ​​​​​​ Chart 6Japan Undercuts China Japan Undercuts China Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much ​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 11Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas ​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy China Will Shift To Russian Energy China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Global Economic Disintegration Global Economic Disintegration ​​​​​​ Chart 16Internal Sources Of Nationalism Internal Sources Of Nationalism Internal Sources Of Nationalism ​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 ​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades ​​​​​​ Chart 21Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan ​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks ​​​​​ Chart 23Overweight ASEAN Overweight ASEAN Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc  Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007.Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades (Feature Chart). Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks.Feature Chart 1The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation The SNB Has Capitulated To Rising Inflation  Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains.Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition.To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor.An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish.Switzerland Versus The WorldGlobal economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy The SNB Is Tightening Into A Slowing Economy  Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy:Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical The Swiss Economy Is Procyclical   Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative Swiss Monetary Conditions Are Still Accommodative  Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside Swiss Inflation Is Surprising To The Upside  Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland A Productivity Profile For Switzerland A Productivity Profile For Switzerland  Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization.  Chart 7Structural Tailwinds For The Franc Structural Tailwinds For The Franc Structural Tailwinds For The Franc  Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas.Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy.The SNB, The SARON Curve, And The Swiss FrancIf the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency.Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Less Intervention By The SNB Less Intervention By The SNB   Chart 9The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher The SARON Curve Has Adjusted Higher   Chart 10EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge EUR/CHF And Bund Yields Can Continue To Diverge  The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate Higher Rates Are A Risk For Swiss Real Estate   Chart 12Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices Some Adjustment Already In Investment Home Prices  In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices A Small Demographic Tailwind For Home Prices  Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant.The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP   Chart 14BA CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP A CHF Is At Fair Value Versus The EUR And GBP  Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive  Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve.What About Swiss Equities?Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark.This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Swiss Stocks Are Expensive Swiss Stocks Are Expensive   Chart 17A Lost Tailwind A Lost Tailwind A Lost Tailwind  In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer.Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion Near-term, Follow Risk Aversion   Chart 19Swiss Stocks Are About Quality Swiss Stocks Are About Quality Swiss Stocks Are About Quality  These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples Dangerous Setup For Swiss Materials and Staples   Chart 21The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey The Swiss Heavyweight Is Becoming Pricey  Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector. Investment ConclusionsVolatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1).Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades.Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comMathieu Savary Chief European StrategistMathieu@bcaresearch.com